Based on Mankiw, Taylor (2007): Macroeconomics

Macroeconomics Notes

Peter C. May
University of Oxford
Worcester College
June 2009
-2- Peter C. May

- Content -

Introduction: A Big, Comprehensive Model ........................................................................................... 2

Ch. 2: The Data of Macroeconomics........................................................................................................ 5
Ch. 3: National Income............................................................................................................................. 12
Ch. 4: Money and Inflation....................................................................................................................... 23
Ch. 5: The Open Economy ...................................................................................................................... 32
Ch. 6: Unemployment ............................................................................................................................... 44
Ch. 9: Introduction to Economic Fluctuations..................................................................................... 54
Ch. 10: Aggregate Demand I: Building the IS-LM Model................................................................... 63
Ch. 11: Aggregate Demand II: Applying the IS-LM Model ................................................................ 74
Ch. 12: The Small Open Economy ......................................................................................................... 89
Ch. 13: Aggregate Supply and the Phillips Curve................................................................................ 102
Ch. 14: Stabilization Policy ..................................................................................................................... 117
Ch. 15: Government Debt...................................................................................................................... 128
Ch. 16: Common Currency Areas and EMU....................................................................................... 140
Ch. 17: Consumption .............................................................................................................................. 151
Ch. 18: Investment................................................................................................................................... 162
Ch. 19: Money Supply and Money Demand........................................................................................ 172
Ch. 20: Advances in Business Cycle Theory........................................................................................ 184
Epilogue..................................................................................................................................................... 193
Introduction: A Big, Comp rehensive Model
Ch. 2: The Data of Macroeconomic s
Ch. 3: Nationa l Income
Ch. 4: Money and Inflation
Ch. 5: The Open Econ omy
Ch. 6: Une mploy ment
Ch. 9: Introduction t o Economic Fluctuations
Ch. 10: Aggre gate De mand I: Bu ildin g the IS-LM Model
Ch. 11: Aggre gate De mand II: Apply ing the IS-LM Model
Ch. 12: The Sma ll Open Economy
Ch. 13: Aggre gate Supply and the Ph illips Cu rve
Ch. 14: Stab ilizat ion Policy
Ch. 15: G overnment Debt
Ch. 16: Common Currency Areas and EMU
Ch. 17: Consumpt ion
Ch. 18: Investment
Ch. 19: Money Supply and Money De mand
Ch. 20: Advances in Business Cycle Theory
Epilogue
 Peter C. May -3-

- Introduction: A Big Comprehensive Model -

The economy is described by 7 equations:

1. Y = C(Y - T) +I(r) + G + NX(") IS : Goods Market Equilibrium

2. M/P = L(i, Y) LM : Money Market Equilibrium
3. NX(") = CF(r - r*) Foreign Exchange Market Equilibrium
4. i = r + # e Relationship betwen Real and Nominal Interest Rates
5. " = e $ (Pd /Pf ) Relationship betwen Real and Nominal Exchange Rates
6. Y = Y + %(P - Pe ) Aggregate Supply
7. Y = F(K, L) Natural Level of Output

! Special Case 1: The Classical Closed Economy (Long-run) ! Chapters 3-4

Assumptions:
- Pe=P ! expectations of the price level adjust so that expectations are correct
- L(i, Y)=(M/P)d=kY=(1/V)"Y=M/P ! Money demand is proportional to income [not
affected by the interest rate!]
- CF(r#r*)=0 ! No international capital flows
Result:
- Output is always at its natural level [eq. 6]
- Real interest rate adjusts to equilibrate the goods market [eq. 1]
- Price level moves parallel with the money supply (when V is fixed) [eq. 2]
- Nominal interest rate adjusts one-for-one with expected inflation [eq. 4]

Special Case 2: The Classical Open Economy (Long-run) ! Chapter 5

Assumptions:
- Pe=P ! expectations of the price level adjust so that expectations are correct
- L(i, Y)=(M/P)d=kY=(1/V)"Y=M/P ! Money demand is proportional to income [not
affected by the interest rate!]
- CF(r#r*): infinitely elastic ! International capital flows respond greatly to any
differences between domestic and world interest rates
Result:
- r=r*
- NX equals the difference between saving and investment [I(r*)] at the world interest
rate r* [eq. 1]
-4- Peter C. May

Special Case 3: The Basic AD/AS Model (Short-run) ! Chapter 9

Assumptions & Results:
- $ infinite ! SRAS horizontal
- L(i, Y)=(1/V)"Y ! Aggregate demand is determined only by the quantity equation

Special Case 4: IS-LM Model (Short-run) ! Chapters 10-11

Assumptions:
- $ infinite ! SRAS horizontal
- CF(r#r*)=0 ! No international capital flows
Result:
- For any given level of expected inflation !e the level of income and interest rate must
adjust to equilibrate the goods market and the money market

Special Case 5: Mundell-Fleming Model with a Floating ER (Short-run) ! Chapter 12

Assumptions:
- $ infinite ! SRAS horizontal
- CF(r#r*): infinitely elastic
Result:
- International capital flows are so great as to ensure that r=r*
- NX equals the difference between saving and investment [I(r*)] at the world interest
rate r* [eq. 1]
- Exchange rate floats freely to reach its equilibrium level

Special Case 6: Mundell-Fleming Model with a Fixed ER (Short-run) ! Chapter 12

Assumptions:
- $ infinite ! SRAS horizontal
- CF(r#r*): infinitely elastic
- e is fixed
Result:
- International capital flows are so great as to ensure that r=r*, but e is set by the CB
- Exchange rate is now an exogenous policy variable, but the money supply M is an
endogenous variable that must adjust to ensure the exchange rate hit the fixed level
 Peter C. May -5-

- Chapter 2: The Data of Macroeconomics -

3 main statistics that economists and policy makers use:

1. Gross Domestic Product (GDP)
2. Inflation – Consumer Price Index (CPI)
3. Unemployment rate

2-1. MEASURING THE VALUE OF ECONOMIC ACTIVITY: GDP

- 3 ways of measuring gross national income [capital depreciation is not subtracted]

1. Total income, GDP(I) % sum of all income earned in the economy
a. Wages & salaries
b. Profits
c. Rents
d. Net interests
e. Production taxes/subsidies
NO transfer payments: merely reflect transfer of money without any
corresponding increase in economic activities
2. Total expenditure, GDP(E) % sum of all expenditure on finished goods
and services in the economy
a. Consumption
b. Investment
c. Government purchases
d. Net exports
3. Total output, GDP(O) % sum of all production/output in the economy at
market prices
a. Sum of value added at each production stage: Value added = value of
its output minus the value of the intermediate goods

Income = Expenditure = Output

! Because every transaction has a buyer and seller, every ! of expenditure on any output
worth ! by a buyer must become a ! of income for the seller

Simple Circular Flow

- Illustrates the flows between firms and households in a closed economy that produces
one good from one input
o Inner loop = flow of labour and goods
! Households sell their labour to firms
! Firms sell their goods to households
o Outer loop = flow of money
! Households pay firms for the goods
! Firms pay households for the labour + profits
-6- Peter C. May

Income

Labour

Households Firms

Goods

Expenditure

- Stock = quantity measured at a given point in time (e.g. wealth, number of unemployed)
- Flow = quantity measured per unit of time (e.g. income, number of people losing jobs)

Rules for computing GDP

Definition: Gross Domestic Product (GDP) is the market value of all final goods and services
produced within the geographic boundaries of an economy in a given period of time

1. Market prices: To compute the total value of different goods and services, the national
income accounts use market prices because these prices reflect how much people are
willing to pay for a good or service

2. Used goods: Sale of used goods (i.e. second-hand goods) is not included as part of
GDP, as it merely reflects the transfer of an asset, not an addition to the economy’s
income

3. Inventories: When a firm increases its inventory of (durable) goods, the investment is
inventory is counted as an expenditure by the firm’s owners [BUT: a sale out of
inventory is a combination of positive spending (the purchase) and negative spending
(inventory disinvestment), so it does not influence GDP]

4. Intermediate goods & value-added: GDP includes only the value of final goods;
measured by computing the value added at each stage of production (to avoid double
counting)

5. Imputed values: Some goods or services do not have a market prices, so the values
must be estimated through imputations; e.g. housing services:
o GDP includes rent if people rent a house from a landlord
o If people live in their own house, national statistical agencies estimate the rent
homeowners would pay themselves and include that imputed rent as part of
GDP
 Peter C. May -7-

6. Black economy [Shadow/underground economy]: Not included in GDP; part of the

economy people hide from the government either because they wish to evade taxation
or because the activity is illegal (estimated size in the UK: 13% of GDP)

What GDP does not measure:

1) Black market goods & services, 2) Non-commercial goods & services, 3) Value of leisure,
4) Quality of life/happiness, 5) Distributional aspects: Income, inequality, poverty, 6) Civil &
political rights, 7) Environmental costs of production
! High GDP does not guarantee overall well-being!

Real GDP versus Nominal GDP

- Nominal GDP: Computed at current prices

- Real GDP: Value of output of goods and services measured using a constant set of
prices % to compare changes in GDP over time
- Base-year prices: Chosen set of prices for comparison
Nominal GDP
- GDP deflator = (for inflation : > 1)
Real GDP
o Measures the price of output relative to its price in the base year
- Chained-volume measures: Base-year changes continuously over time
!
The Components of Expenditure

1. Final consumption expenditure

a. Households
i. Non-durable goods [e.g. food]
ii. Semi-durable goods [e.g. clothing]
iii. Durable goods [e.g. car]
iv. Services
b. Non-profit institutions serving households (NPISH) [e.g. universities]
c. General government
i. Local
ii. Central
d. Net tourism

2. Gross capital formation

a. Gross fixed capital formation
i. Business fixed investment
ii. General government fixed investment
iii. Residential fixed investment
b. Inventory investment

3. Net exports
-8- Peter C. May

National Income Accounts Identity

Y = C + I + G + NX

- C = Consumption
+ Household final consumption expenditure
+ Final consumption expenditure of NPISH
- I = Investment
+ Business fixed investment
+ Residential fixed investment
+ Inventory investment
- G = Government purchases
+ General government consumption
+ General government fixed investment
- NX = Net exports
+ Exports – Imports
+ Net tourism

Note on investment:
- General rule: economy’s investment does not include purchases that merely
reallocate existing assets among different individuals (e.g. only building a new
house, not buying an existing one)
- Investment has to create new capital (e.g. company selling shares to public to
build new plant, not transaction of shares between individuals)
- Difference between investment and capital:
o Capital is one of the factors of production [At any given moment, the
economy has a certain overall stock of capital]
o Investment is spending on new capital

Other Measures of Income

- Gross Domestic Product (GDP): measures the total income produced domestically
(within the geographic boundaries of the country)
- Gross National Product (GNP): measures the total income produced by nationals
(residents of a nation)
• GNP = GDP + factor payments from abroad # factor payments to abroad
- Net National Product (NNP): GNP # Depreciation
• Depreciation = consumption of fixed capital
- Seasonal adjustments: take into account the predictable seasonal fluctuations (e.g.
lower GDP in winter due to less building activity, little agriculture etc.)
 Peter C. May -9-

- Subjective question: Is it better for a country to have bigger GDP than GNP or vice versa?
• Better to have GNP > GDP ! means nation’s income is greater than the value
of what it is producing domestically
• If, instead, GDP > GNP, then a portion of the income generated in the country
is going to people in other countries ! less income left for domestic citizens

2-2. MEASURING THE COST OF LIVING: CPI

- Inflation: an increase in the overall level of prices

• Measured by the Consumer Price Index (CPI) % Statistical agency weighs
different items by computing the price of a basket of goods and services
purchased by a typical consumer
• Other measures:
! Producer Price Index (PPI) % measures prices of a typical basket of
goods and services bought by firms rather than consumers
! Retail Price Index (RPI) % includes a number of items related to
housing such as council tax & house mortgage interest payments
! Harmonized Indices of Consumer Prices (HICP) % EU wide
standard of measuring inflation

The CPI versus the GDP Deflator

- 3 key differences:

GDP deflator CPI

1. Measures the prices of all goods and 1. Measures the prices of only the goods
services produced [i.e. includes prices and services bought by consumers [i.e.
of capital goods] excludes prices of capital goods]

2. Only takes into account those goods 2. Includes the prices of imported goods
that are produced domestically

3. Allows the basket of goods to change 3. Computed using a fixed basked of

over time as the composition of GDP goods % Laspeyres Price Index: [uses
changes % Paasche Price Index: geometric mean]

ptq t ptq 0
"p q "p q
0 t 0 0

! !
- 10 - Peter C. May

- Laspeyres Index: Price index with a fixed basket of goods (e.g. CPI) % tends to
overstate increase in cost of living
• Ignores consumers’ ability to substitute to relatively less expensive goods

- Paasche Index: Price index with a changing basked of goods (e.g. GDP deflator) %
tends to understate increase in cost of living
• Includes substitution, but does not show that higher prices of goods from which
consumers substitute away make them worse off

- Fisher Index: Average of Paasche (GDP deflator) and Laspeyres (CPI) index

- Useful trick: Working with percentage changes

• For any variables X and Y,
! Percentage change in (X " Y) & Percentage change in X + Percentage
change in Y
! Percentage change in (X/Y) & Percentage change in X # Percentage
change in Y

Does the CPI Overstate Inflation?

- Arguments:
1. Substitution bias % does not take into account that consumers have the
opportunity to substitute less expensive goods for more expensive goods
2. Introduction of new goods % does not reflect increase in utility from
greater choice
3. Unmeasured changes in quality % Quality improvements increase the
purchasing power of a unit of currency, but they are often not fully measured

! Zero measured inflation not recommended!

2-3. MEASURING JOBLESSNESS: THE UNEMPLOYMENT RATE

- Unemployment Rate: measures the percentage of those people wanting to work, but
who do not have a job
- 2 measures:

1. Claimant Count:
! Counting the number of people who, on any given day, are claiming
unemployment benefits form the government
! BUT problem: subject to changes in the rules the government applies for
eligibility of unemployment benefits
 Peter C. May - 11 -

2. Labour Force Survey (recommended by the International Labour

Organisation – ILO)
! Distinguishes between 3 categories: each person above 16 years is either
a) Employed
b) Unemployed
c) Economically inactive (includes discouraged workers – a person who
wants a job but has given up looking)

- Labour force: Sum of the employed and unemployed, L=E+U

- Unemployment rate: Percentage of the labour force that is unemployed

No. of Unemployed
Unemployment Rate = " 100
Labour force

- Labour-force participation rate: percentage of the adult population that is in the

! labour force
Labour force
Labour - force participation rate = " 100
Adult population

- Okun’s Law: States that a one-percent decrease in unemployment is associated with

! two percentage points of additional growth in real GDP
• Employed workers help produce GDP, while unemployed workers do not
• HENCE: negative relationship between unemployment & real GDP
! %' real GDP = 3.5% - 2%"(%' in unemployment)

SUMMARY:

1. Gross Domestic Product (GDP) measures the income of everyone in the

economy and, equivalently, the total expenditure on the economy’s output of
goods and services.
2. Nominal GDP values goods and services at current prices. Real GDP values
goods and services at constant prices. Real GDP rises only when the amount of
goods and services has increased, whereas nominal GDP can rise either because
output or prices have increased.
3. GDP is the sum of four categories of expenditure: consumption, investment,
government purchases and net exports
4. The Consumer Price Index (CPI) measures the price of a fixed basket of goods
and services purchased by a typical consumer. Like the GDP deflator, which is
the ratio of nominal GDP to real RDP, the CPI measures the overall level of
prices.
5. The unemployment rate shows what fraction of those who would like to work do
not have a job. When unemployment rises, the growth rate of real GDP falls.
- 12 - Peter C. May

- Chapter 3: National Income -

4 groups of questions about sources and uses of a nation’s GDP

1. How much do the firms in the economy produce? What determines a national
income?
2. Who gets the income from production? How much goes to compensate workers,
and how much goes to compensate owners of capital?
3. Who buys the output of the economy? How much do households purchase for
consumption, how much do households and firms purchase for investment, and
how much does the government buy for public purposes?
4. What equilibrates the demand for and supply of goods and services? What ensures
that desired spending on consumption, investment and government purchases
equals the level of production?

The Circular Flow of Money

Income Factor payments

Markets for factors of production

Private saving
Financial markets

Investment
Public saving

Households Taxes Government Firms

Government
purchases

Consumption Markets for goods and services Firm Revenue

3-1. WHAT DETERMINES THE TOTAL PRODUCTION OF GOODS AND SERVICES?

- GDP depends on:

1. Factors of production (quantity of inputs)

a. Capital (K) % set of tools workers use (e.g. machinery)
b. Labour (L) % time people spend working
 Peter C. May - 13 -

! Assumptions:
a. Fixed amounts of capital and labour: K=K " and L=L
"
b. Factors of production are fully utilized

2. Production function
• Reflects available technology for turning capital and labour into output
[altered by technology]
• Y = F(K, L)
• Constant returns to scale: zY = F(zK, zL) % increase of an equal percentage in
all factors of production causes an increase in output of the same percentage

Y = F(K
" ,L
") = Y
" % Output is fixed at Y
"

3-2. HOW IS NATIONAL INCOME DISTRIBUTED TO THE FACTORS OF PRODUCTION?

- Neoclassical theory of distribution

• Prices adjust to balance demand & supply
• Demand for each factor of production depends on the marginal productivity of
that factor

- Factor prices = amounts paid to the factors of production (e.g. wage, interest, rent)
• Wage (W) is the factor price of labour
• Rental rate (R) is the factor price of capital

FACTOR PRICE

Factor supply

Equilibrium
factor price

p*

Factor demand

Q* QUANTITY OF FACTOR
- 14 - Peter C. May

Decisions Facing the Competitive Firm

- Assumptions:
1. Firm behaves competitively
• Small relative to market
• Little/no influence on market price % price taker
• Cannot influence wages/rent
! Firm’s production function: Y = F(K, L)
2. Goal: Profit-maximization
• Profit = Revenue # Costs
• ( = P"Y # W"L # R"K = P"F(K, L) # W"L #R"K

- Marginal Product of Labour (MPL) = extra amount of output the firm gets from one
extra unit of labour, holding the amount of capital fixed
"Y
• MPL = or MPL = F(K, L +1) - F(K, L)
"L

- Diminishing marginal product: Holding the amount of one/all other input(s) fixed,
! the marginal product of the variable factor of production falls as its quantity increases
• )L while holding K fixed ! fewer machines per worker ! *productivity

Y 1. The slope of the

Y = F(K
" , L) production function
equals the marginal
MPL product of labour
1
2. As more labour is added,
the marginal product of
MPL labour declines

- The Marginal Product of Labour & Labour Demand

• When deciding upon the quantity of labour to hire:
" Profit = " Revenue - " Cost
= P # MPL - W
Equilibrium : P # MPL - W = 0
W W
$ P # MPL = W or MPL = (where = real wage)
P P
• To maximize profits, firms hire up to the point at which MPL equals the real
wage % HENCE: the MPL schedule is also the firms’ labour demand curve
!
 Peter C. May - 15 -

- The Marginal Product of Capital & Capital Demand

• When deciding upon the quantity of capital to hire:
" Profit = " Revenue - " Cost
= P # MPK - R
Equilibrium : P # MPK - R = 0
R R
$ P # MPK = R or MPK = (where = real rental price)
P P
• To maximize profits, firms rent more capital until the MPK falls to equal the real
rental price % HENCE: MPK schedule is also the firms’ capital demand curve
!
Rule: A firm demands each factor of production until that factor’s marginal product falls to equal its real
factor price! If L < L*, benefit of hiring one more worker (MPL) exceeds cost (W/P), so firm can increase profits by
hiring one more worker. If L > L*, benefit of the last worker hired (MPL) is less than the cost (W/P), so firm should
reduce labor to increase its profits. If L = L*, then firm cannot increase its profits either by raising or lowering L.

The Division of National Income

- Real Economic Profit = Y – (MPL"L) – (MPK"K)

• Y = Real Economic Profit + (MPL"L) + (MPK"K)
• Euler’s Theorem: z"F(K, L) = (MPL"L) + (MPK"K) [CRS: z=1%F(K, L)=Y]
! Real Economic Profit = 0

Rule: If the production function has constant returns to scale, and each
factor of production is paid its marginal product, economic profits must be 0!

• BUT: accounting profit + economic profit

! In real world, most firms own rather than rent capital
! HENCE: Accounting profit = Economic profit + (MPK"K)

- HENCE: Total output is completely divided between the payments to capital and the
payments to labour, depending on their marginal productivities

The Cobb-Douglas Production Function

- Fact: division of NY between capital & labour has been roughly constant over a long
period of time (labour share: ~70%, capital share: ~30%)
F(K, L) = A " K # " L1-#
$F Y
MPL = = (1- #) " A " K # " L-# = (1- #) "
$L L
$F Y
MPK = = # " A " K #%1 " L1-# = # "
$K K
Y Y
= average labour productivty, = average capital productivity
L K

!
- 16 - Peter C. May

Rule: There exists a close link between average labour productivity (APL), marginal
labour productivity (MPL) and the real wage (W/P) ! W/P=MPL=(1-$)"APL

- Scenario: A major natural disaster destroys a large part of a country's capital stock but
miraculously does not cause anybody bodily harm
• Result: If a large part of the capital stock is destroyed, then there will be less
capital per worker, which means the MPL will be lower and the real wage, too!

3-3. WHAT DETERMINES THE DEMAND FOR GOODS AND SERVICES?

Closed Economy: Y = C + I + G

I. Consumption (C) % 60-65% of GDP

- Households receive income from their labour and their ownership of capital, pay taxes
to the government and then decide how much of their after-tax income to consume and
how much to save

- Disposable income = Income after payment of all taxes % Y # T

• Households divide their personal disposable income between
a) Consumption
b) Saving

- Consumption function: Consumption is a function of disposable income: C = C(Y#T)

- Marginal propensity to consume (MPC): Amount by which consumption changes as

disposable income increases by 1 unit
"C
• MPC =
"(Y - T)

CONSUMPTION, C Consumption
! function

Slope: MPC

DISPOSABLE INCOME, Y-T

 Peter C. May - 17 -

II. Investment (I) % 17-20% of GDP

- Types of investment
• Firms buy investment/capital goods to add to their stock of capital and to
replace existing capitals as it wears out (depreciation)
• Households buy new houses

- Quantity of investment goods depends on the interest rate, which measures the cost of
the funds used to finance investment

- Profitable investment: When Return (revenue from increased future production) >
Costs (payments for borrowed funds)

- Types of interest rates

• Nominal interest rate = rate of interest that investors pay to borrow money
• Real interest rate = Nominal interest rate corrected for the effects of inflation

- Investment function: Investment is a negative function of the real interest rate: I=I(r)

REAL INTEREST RATE, r

The real interest rate is

a) The cost of borrowing
b) The opportunity cost of using
one’s own funds to finance
investment spending
HENCE: )r ! *I
Investment
function, I(r)

QUANTITY OF INVESTMENT, I

III. Government purchases (G) % 15-20% of GDP

- Transfer payments are not made in exchange for some of the economy’s output of
goods or services, they merely reallocate income % not included in the variable G
• HENCE: definition of T: taxes # transfer payments
• In simple model: G & T = exogenous variables % G=G " and T=T "
! Assumes T % lump-sum tax
! More sophisticated model: T=tY, where t is the tax rate
- 18 - Peter C. May

3-4. WHAT BRINGS SUPPLY AND DEMAND FOR GOODS AND SERVICES INTO EQUILIBRIUM?

- In classical model, the interest rate is the price that has the crucial role of equilibrating
supply and demand

- 2 ways to think about role of interest rate:

1) How it affects supply and demand for goods and services
! Y=Y " =F(K", L
" )=C(Y" -T
" )+I(r)+G"
2) How it affects supply and demand for loanable funds
! D: I(r), S: S; D=S % I(r)=S "= Y
" -C
" (Y
" -T
" )-G
"

1) Equilibrium in the Market for Goods and Services

- Summary of equations
Y = C +I + G
C = C(Y - T)
I = I(r)
G=G
T=T
Y = F(K, L) = Y
- Combining the equations:
Y = C(Y - T) +I(r) + G
!
! Interest rate (r) is the only variable that is not already determined

- Meaning of equation: Supply of output (fixed) equals its demand, which is the sum of consumption
!
(fixed), investment (variable) and government purchases (fixed)

Rule: At the equilibrium interest rate, the demand for goods and
services equals the supply in an economy

2) Equilibrium in the Financial Markets

- National saving (S): Output that remains after the demands of consumers and the
government have been satisfied
• S=Y#C#G
• Consists of
! Private saving: (Y#T#C)
! Public saving: (T#G)
 Peter C. May - 19 -

- National accounts identity:

S = (Y - T - C) +(T - G) = I
S = Y - C- G =I
S = Y - C(Y - T) - G = I(r)
S = I(r)

REAL INTEREST RATE, r Saving, S

!
- Saving = Supply of loanable
funds
- Investment = Demand for
loanable funds

r*
Investment
function, I(r)

"S INVESTMENT, S AVING , I, S

Rule: At the equilibrium interest rate, households’ desire to save balances firms’
desire to invest, and the quantity of loanable funds supplied equals the quantity
demanded!

Changes in Saving: The Effects of Fiscal Policy

a) Increase in government purchases ('G)

- Increases demand for goods and services by increasing G
• BUT: Y=Y " and disposable income (Y#T) and consumption (C) unchanged
• HENCE: )G % *S % *I [since )r]
- Government purchases crowd out investment by increasing the real interest rate!

r S2 S1
1. A fall in saving (caused by
1 lower public savings) by 'G
[consumption unchanged
because Y-T unchanged]
r2 2. Causes an increase in the real
interest rate
2 3. And thus a fall in investment
r1 I(r) by the initial 'G [Y
unchanged]

I, S
3
- 20 - Peter C. May

b) Decrease in taxation ('T)

- Increases disposable income (Y#T) by 'T and thus consumption (C) by 'T"MPC
• BUT: Y=Y " and G unchanged
• HENCE: *T % *S % *I [since )r]
- Decreased taxation crowds out investment by increasing the real interest rate

r S2 S1
1 1. A fall in saving (caused by
lower private savings) by
r2 'T"MPC
2. Causes an increase in the real
2 interest rate
3. And thus a fall in investment
r1 I(r) by the initial 'T"MPC [Y
unchanged]

I, S
3

c) Increase in government spending matched by an equal increase in taxes

- National saving (supply of loanable funds) decreases since the reduction in consumption
caused by the tax increase (-'T"MPC) is not large enough to offset the increase in
consumption through the increase government spending 'G [Overall change in C:
'G/(1-MPC)+(-'T"MPC)/(1-MPC)= 'G] ! 'S = -'G
- HENCE: real interest rate must rise so that investment (demand for lf) will also fall

Changes in Investment Demand

- Increase in investment demand may be caused by:

1. Technological innovation ()MPK)
2. Government encourages investment through tax laws (e.g. investment tax
credit)

A) Simplified model: Saving independent of interest rate:

r S
1. An increase in investment demand
2. Raises the interest rate
3. BUT: the equilibrium amount of
r2 investment is unchanged!

2 I2
r1 I1
1

3 I, S
 Peter C. May - 21 -

B) Allow consumption (-ve) and saving (+ve) to depend on the interest rate

r S
1. An increase in desired
investment
2. Raises the real interest rate
r2 3. And raises equilibrium
investment and saving
2 I2
r1
I1
1

S1 S2 I, S
3

3-5. CONCLUSION

- 5 Simplifying assumptions used in the model:

1) Ignored the role of money, the asset with which goods and services are bought
and sold
2) No trade with other countries
3) No unemployment (labour force is fully employed)
4) Capital stock, labour force and production technology are fixed
5) Ignored the role of short-run sticky prices

3-6. APPENDIX: LABOUR INCOME

- Why the labour share of income is (1-$) for a Cobb-Douglas production function:

Y = AK "L1-"
#Y Y
1) MPL = = AK "L-" (1- ") = (1- ")
#L L
2) $ = P % Y(K, L) - WL - RK
#$
= P % MPL - W = 0
#L
W
& MPL =
P
W Y W L
HENCE (combining 1 and 2) : = (1- ") & Real labour share of income : % = (1- ")
P L P Y
Y W WL
OR : MPL = (1- ") = , so that = 1- "
L P PY

!
- 22 - Peter C. May

SUMMARY:

1. The factors of production and the production technology determine the

economy’s output of goods and services. An increase in one of the factors of
production or a technological advance raises output.
2. Competitive, profit-maximizing firms hire labour until the marginal product
equals the real wage [MPL=W/P]. Similarly, these firms rent capital until the
marginal product of capital equals the real rental price [MPK=R/P]. Therefore,
each factor of production is paid its marginal product. If the production function
has constant returns to scale, all output is used to compensate the inputs
3. The economy’s output is used for consumption, investment and government
purchases.
a. Consumption depends positively on disposable income
b. Investment depends negatively on the real interest rate
c. Government purchases and taxes are the exogenous variables of fiscal
policy
4. The real interest rate adjusts to equilibrate the supply and demand for the
economy’s output – or, equivalently, to equilibrate the supply of loanable funds
(saving) and the demand for loanable funds (investment).
a. A decrease in national saving, perhaps because of an increase in
government purchases or a decrease in taxes, reduces the equilibrium
amount of investment and raises the interest rate.
b. An increase in investment demand, perhaps because of a technological
innovation or a tax incentive for investment, also raises the interest rate.
c. An increase in investment demand increases the quantity of investment
only if higher interest rates stimulate additional saving.
 Peter C. May - 23 -

- Chapter 4: Money and Inflation -

- Classical theory on inflation: assumes prices are flexible

• Most economists today agree that prices are flexible in the long-run, BUT sticky
in the short-run [OR: LR: P=Pe, SR: P+Pe]

- Definitions:
• Inflation: Overall increase in price level OR decrease in the value of money
• Hyperinflation: Extraordinary high inflation (>50% per month), e.g. Germany
in 1923
• Hume (1752): Money = Oil which renders the motion of the wheels of trade
more smooth and easy

4-1. WHAT IS MONEY?

- Money: Stock of assets that can be readily used to make transactions

• Money = Currency + Demand Deposits

- 3 functions of money:
1) Store of value % way to transfer purchasing power from present to future
2) Unit of account % provides the terms in which prices are quoted and debts are
recorded
3) Medium of exchange % used to buy goods and services

- Liquidity: Ease with which money is converted into other things – goods and services

- Barter economy (without money) requires double coincidence of wants: the unlikely
happenstance of two people each having a good that the other wants at the right time
and place to make an exchange % permits only simple transactions

- 2 types of money:
1) Commodity money: Money with some intrinsic value (e.g. gold standard)
2) Fiat money: Money that has no intrinsic value (e.g. notes) ! Use of money is a
social convention: everyone values fiat money because they expect everyone else
to value it

- Pro/Contra fiat money

• Pro: Transactions efficiency as medium of exchange
• Contra: How good as store of value?
! Can governments be trusted not to ‘print money’ problem of debt and
deficits
! History of (hyper-)inflations

- Possible means of attempted commitment: Convertibility to gold, peg to another (well

anchored) currency, policy rules (e.g. money supply growth limit or inflation targeting)
- 24 - Peter C. May

How the Quantity of Money is Controlled

- Money supply: Quantity of money available in an economy

- Central bank: Institution controlling the money supply through monetary policy
• Major central banks:
! Euro Area: ECB % Governing Council
! UK: Bank of England % Monetary Policy Committee (MPC)
! US: Federal Reserve % Federal Open Market Committee (FOMC)
• Open-market operations: Primary way in which central bank controls the
supply of money
! If CB wants to )M it ‘creates’ money and uses it purchase government
bonds from the public (the people) [government bonds + money!]
! If CB wants to *M it sells government bonds from its portfolio and thus
‘destroys’ money

How the Quantity of Money Measured

- 2 components:
1) Currency: sum of outstanding paper money and coins
! BUT: Debit and credit cards or cheques are not counted as money –
they are merely a way of transferring money between bank accounts
2) Demand deposits: balances in bank accounts that depositors can access on
demand (simply by using their debit card/cheque)

- Euro Area: 3 measures [M1 most liquid, M3 least liquid]

• M1 = currency + overnight deposits
• M2 = M1 + longer-term deposits
• M3 = M2 + other money market instruments (e.g. repurchase agreements,
shares in money market funds)

- UK: main measure M4, similar to Euro Area M3

- Definition used in the book: Money stock = currency + all deposits in banks and other
financial institutions that can be readily accessed and used to buy goods and services
• Currency comprises only a small proportion of the overall money stock!

4-2. THE QUANTITY THEORY OF MONEY

Money " Velocity = Price " Output

M " V = P " Y

!
 Peter C. May - 25 -

- Meaning of terms:
• M = Quantity of money
• V = Income velocity of money
! Measures the rate at which money circulates in the economy %
number of times a given unit of money enters someone’s income in a
given period of time
• P = Price of a typical transaction % price level
• Y = Total output
! Initially T = number of transactions, BUT difficult to measure!
! Quantity equation is an identity: the definitions of the 4 variables make it always true!

The Money Demand Function and the Quantity Equation

- Real money balances (M/P): Quantity of goods and services money can buy
• HENCE a measurement of the purchasing power of the stock of money
! If )M or *P % )purchasing power
! If *M or )P % *purchasing power

- Money demand function: Equation that shows the determinants of the quantity of real
money balances people wish to hold:
• Simple money demand function: quantity of real money balances demanded is
(only) proportional to real income
(M/P)d = k " Y
where k = how much money people want to hold for every unit of income

- Derivation
! of quantity equation from money demand function:
Money demand = Money supply
k " Y = M/P
M " (1/k) = P " Y
M " V = P " Y, where V = 1/k

- Relationship between V and demand for money:

! • If people want to hold a lot of money for each unit of income ()k), then money
changes hands infrequently (*V)

The Assumption of Constant Velocity

- If we assume that the income velocity is constant [V changes only when money demand
changes, e.g. introduction of ATMs % lower average money holdings % *k % )V]:
M"V=P"Y
M #P " Y

!
- 26 - Peter C. May

Rule: If V is fixed, the quantity of money (M) determines the monetary value
of the economy’s output (i.e. in terms of !/$)!

Theory of Money, Prices and Inflation

- 3 building blocks:
1) Y=F(K, L): factors of production and production technology determine the level
of output Y
2) M "P"Y: Money supply determines the nominal value of output
3) P=PY/Y: The price Level is the ratio of the nominal value of output (PY) to real
output (Y)
!
- Quantity theory: The quantity theory implies that the price level is proportional to the
money supply
• Y already fixed by production function [Y" =F(K ", L
" )]

M "P

- Quantity
! equation in percentage terms:
% change in M + % change in V = % change in P + % change Y
1) % change in M: controlled by central bank
2) % change in V: 0, since V assumed constant
! 3) % change in P: ( (inflation rate)
4) % change in Y: 0 (assume no growth) or g (constant if steady growth)

- HENCE:
%" M = # + g (where g constant)

- Normal economic growth requires a certain amount of money supply growth to

! facilitate the growth in transactions
• Money growth in excess of this amount leads to inflation

Rule: The quantity theory of money states that the central bank, which controls
the money supply, has ultimate control over the rate of inflation:
• If the CB keeps the money supply stable, the price level will be stable
• If-the CB increases the money supply rapidly, the price level will rise
rapidly
! Friedman: “Inflation is always and everywhere a monetary phenomenon”
[works in the long-run, but not in the short-run (V variable)]
BUT problems: Is the velocity reliably stable & how to control money supply?
 Peter C. May - 27 -

4-3. SEIGNIORAGE: THE REVENUE FROM PRINTING MONEY

- Government can raise money in 3 ways:

1) Taxes
2) Borrow from the public by selling bonds
3) Print money

- Seigniorage: Government revenue raised by printing money (option 3)

• Printing money % )M % ( (inflation)
• Seignorage = ‘Inflation tax’, pay by the holders of money as their purchasing
power decreases

- In countries experiencing hyper-inflation, seigniorage is one of the government’s chief

source of revenue – indeed the need to print money to finance expenditure is a primary
cause of hyperinflation

- BUT Keynes: “superficial advantages” of relying on inflation tax as the major source of
government revenue
• This is because the inflation caused by printing money also affects the real value
of the seignorage revenue, so that the government has to print more and more
money to maintain its spending, and so inflation spirals higher and higher %
hyperinflation
• RESULT: decreasing importance of seigniorage (~0.5% of GDP)

4-4. INFLATION AND INTEREST RATES

- Interest rate: The market price at which resources are transferred between the present
and the future AND the return to saving and the cost of borrowing

- 2 interest rates:
1) Nominal interest rate (i): Actual interest rate paid by debtor to creditor;
opportunity cost of holding money
2) Real interest rate (r): Increase in purchasing power of creditor (inflation
adjusted)

r = (1+ i)/(1+ ") # i - "

The Fisher Effect

!
- Fisher equation: i = r + (
• Nominal interest rate changes for 2 reasons:
a) Real interest rate changes [determined in the market for loanable funds,
independently of monetary policy]
b) Inflation rate changes [determined by the money supply – quantity theory]
- 28 - Peter C. May

Rule: According to the quantity theory, an increase in the rate of money

growth of 1% causes a 1% increase in inflation. According to the Fisher
equation, a 1% increase in the rate of inflation, in turn, causes a 1% increase in
the nominal interest rate (“Fisher effect”)

- 2 real interest rates:

1) Ex ante real interest rate: Real interest rate that is expected when the loan is
made: r = i # (e
2) Ex post real interest rate: Real interest rate that is actually realized: r = i # (

- Fisher Effect: Higher inflation leads to higher nominal interest rate (i = r + ()

• BUT: modified i = r + (e % higher expected inflation leads to higher NIR

4-5. THE NOMINAL INTEREST RATE AND THE DEMAND FOR MONEY

- Quantity Theory of Money assumes that the demand for real money balances depends
only on real income Y
• BUT another determinant of money demand: nominal interest rate
• Nominal interest rate i = opportunity cost of holding money (instead of bonds
or other interest-earning assets)
! Hence, )i ! * in money demand.

- Cost of holding money: Sum of foregone real interests (r) & expected inflation rate ((e)
• HENCE: modified demand for real money balances
- + - - +
(M/P)d = L(i , Y ) = L(r + " e , Y )

- More sophisticated story about the determination of the price level than the quantity
theory, which assumes that demand for real money balances is independent of NIR
•! Quantity theory: if the nominal interest rate and the level of output are held
constant, the price level moves proportionately with the money supply
• BUT nominal interest rate not constant: it depends on expected inflation, which
in turn depends on growth in the money supply
! If )M % )(e % )i % *(M/P)d % *k % )V
! Additional channel through which the money supply affects the price level!
(blue line; ignored by quantity theory!)

Money Supply

Price Level Inflation Rate Nominal Interest Rate

Money Demand
 Peter C. May - 29 -

- Importance of expectations and the expected inflation rate:

• Over the long run, people don’t consistently over- or under-forecast inflation, so
(e = ( on average
• In the short run, (e may change when people get new information
! Price level depends not only on today’s money supply, but also on the
money supply expected in the future
• If CB announces )M in the future % )(e % )i % *(M/P)d
! Since (M/P)d=M/P and present M constant, P has to increase in order
to make up for decrease in demand for real money balances ! )P
• Cagan Model: Price level depends on a weighted average of the current money
supply and the money supply expected to prevail in the future % Importance of
credibility!
1 # 1 1 2 &
Pt = ( )" %m t +( ) " E(m t+1 ) +( ) " E(m t+2 ) + ...(
1+ y $ 1+ y 1+ y '

!
4-6. THE SOCIAL COSTS OF INFLATION

- Common misperceptions about costs of inflation:

• “Inflation reduces real wages”
! This is true only in the short run, when nominal wages are fixed by
contracts
! BUT: (Chap 3) In the long run, the real wage is determined by labor
supply and the marginal product of labor, not the price level or inflation rate

- According to the classical theory of money, a change in the overall price level is like a
change in the units of measurement
• Economic well-being depends on relative prices, not the overall price level
• Differentiate between:
1. Expected inflation
2. Unexpected inflation

- Costs of expected inflation:

a) Shoe-leather costs: People hold less money on average and thus need to
withdraw money from banks more frequently (higher (e leads to higher nominal
interest rate, which in turn leads to lower demand for real money balances)
! HENCE: Same monthly spending but lower average money holdings
means more frequent trips to the bank to withdraw smaller amounts of
cash
b) Menu costs: Costs of having to change prices more often
c) Economic distortion: Greater variability in relative prices because firms do not
change prices immediately (menu costs); prices do not reflect true scarcity
anymore ! microeconomic inefficiencies in the allocation of resources.
- 30 - Peter C. May

d) Tax distortion: Taxes often do not take into account effects of inflation
e) General inconvenience of living in a world with changing price level % need
to correct for inflation, complicating financial planning

- Costs of unexpected inflation:

a) Redistribution: Unexpected inflation arbitrarily redistributes wealth among
individuals
! Debtors/borrowers gain (* value of debt), creditors/lenders lose
! SR: Many nominal wages are fixed by contracts ! transfer of purchasing
power between firms and their employees whenever inflation is different
than expected when the contract was written and signed
b) Fixed Income: Unexpected inflation hurts individuals on fixed income, e.g.
pensioners

- One benefit of inflation:

• Wages are sticky downwards (nominal wage cuts are rare) % inflation makes the
labour market work better, by allowing firms to have real wage cuts

4-7. HYPERINFLATION

- Hyperinflation: Inflation rate > 50% per month

• Social costs much more significant than for moderate inflation % dangerous!
• Money ceases to be a store of value and medium of exchange

- Causes:
• Excessive growth in money supply
! Caused by money printing due to inadequate government tax revenue
and inability to borrow due to low credit ratings (unable to raise revenue
from options 1 and 2)
! Inadequate tax revenue % Rapid money creation % Hyperinflation %
Larger budget deficit (because of the delay in collecting tax payments,
real tax revenue falls) % Even more rapid money creation

- To end hyperinflation, governments need fiscal reforms to eliminate need for seigniorage

4-8. CONCLUSION: THE CLASSICAL DICHOTOMY

- Real variables: measured in physical units (e.g. quantities, relative prices)

- Nominal variables: expressed in terms of money (e.g. price level, money wage)

- Classical dichotomy: Theoretical separation of real and nominal variables

• Irrelevance of money for real variables % ‘monetary neutrality’
• The equilibrium in the money market determines the price level
! HALLMARK of classical macroeconomic theory [long-run!]
 Peter C. May - 31 -

SUMMARY:

1. Money is the stock of assets used for transactions. It serves as a

a. Store of value
b. Unit of account
c. Medium of exchange
Different sorts of assets are used as money: commodity money systems use an asset
with intrinsic value, whereas fiat money systems use an asset whose sole function is to
serve as money. In modern economies, the central bank is responsible for controlling
the supply of money.
2. The quantity theory of money assumes that the velocity of money is stable and
concludes that nominal GDP is proportional to the stock of money. Because the
factors of production and the production function determine real GDP, the quantity
theory implies that the price level is proportional to the quantity of money. Therefore,
the rate of growth in the quantity of money determines the inflation rate [%' M = ( +
g].
3. Assuming that demand for money balances is proportional to nominal GDP, Md=kPY,
or in real terms, (M/P)d=kY; since (M/P)d=(M/P)S % kY=M/P or M(1/k)=PY or
P=[M(1/k)]/Y ! rate of price inflation ( = rate of growth of money – rate of growth
of output (g)
4. Seigniorage is the revenue that the government raises by printing money. It is a tax on
money holding. Although seigniorage is quantitatively small in most economies, it is
often a major source of government revenue in economies experiencing hyperinflation.
5. The nominal interest rate is the sum of the real interest rate and the inflation rate
[i=r+(]. The Fisher effect says that the nominal interest rate moves one-for-one with
expected inflation.
6. The nominal interest rate is the opportunity cost of holding money. Thus, one might
expect the demand for money to depend on the nominal interest rate. If it does, then
the price level depends on both the current quantity of money and the quantities of
money expected in the future. [)E(mt+x) % )(e % )i % *(M/P)d % *(M/P) % )P]
7. The costs of expected inflation include shoe-leather costs, menu costs, the cost of
relative price variability, tax distortions and the inconvenience of making inflation
corrections. In addition, unexpected inflation causes arbitrary redistributions of wealth
between debtors and creditors. One possible benefit of inflation is that it improves the
functioning of labour markets by allowing real wages to reach equilibrium levels
without cuts in nominal wages.
8. During hyperinflations, most of the costs of inflation become severe. Hyperinflations
typically begin when governments finance large budget deficits by printing money.
They end when fiscal reforms eliminate the need for seigniorage.
9. According to classical economic theory, money is neutral: the money supply does not
affect real variables. Therefore, classical theory allows us to study how real variables are
determined, without any reference to the money supply. The equilibrium in the money
market then determines the price level, and as a result, all other nominal variables. This
theoretical separation of real and nominal variables is called the classical dichotomy.
- 32 - Peter C. May

- Chapter 5: The Open Economy -

Increasing globalization of world economy since 1950:

- World GDP rose by a factor of 7 (ca. 3.8% per year)
- World exports rose by a factor of 232 (ca. 10.8% per year)
- UK: average of imports and exports as a percentage of output in 2003: ca 40%

5-1. THE INTERNATIONAL FLOWS OF CAPITAL AND GOODS

- Key macroeconomic difference between open and closed economies:

• In an open economy,
! Spending in any given year need not equal its output of goods and
services
! Saving need not equal investment
• Instead:
! Country can borrow from abroad to spend more than it produces
! OR: country can lend to foreigners if it produces more than it spends

- Net exports (NX): Exports # Imports % NX=X#M

Y = C +I + G + NX
or : NX = Y - (C +I + G)
" Net exports = Output - Domestic Spending

Rule:
! 1) If output exceeds domestic spending, we export the difference: net exports
are positive
2) If output falls short of domestic spending, we import the difference: net
exports are negative

International Capital Flows and the Trade Balance

- National accounts identity:

Y = C +I + G + NX
Y - C - G = I + NX
S = I + NX
or S - I = NX

- HENCE: An economy’s net exports must always equal the difference between its
savings and investments
!
• Another name for exports: trade balance
• S#I % net capital outflow: domestic purchases of foreign assets minus foreign
purchases of domestic assets
 Peter C. May - 33 -

Net Capital Outflow = Trade Balance

- Trade balance:
• If S#I = 0 (or S=I) % Balanced trade
• If S#I > 0 (or S>I) % Trade surplus ! country is a net lender
• If S#I < 0 (or S<I) % Trade deficit ! country is a net borrower

Rule: The national income accounts identity shows that the international flow of funds to
finance capital accumulation and the international flow of gs are two sides of the same coin!
! A country with a trade surplus is a net lender internationally; its residents are lending more
to foreigners than foreigners are lending its residents. HENCE: it is a net acquirer of foreign
assets (+ve net capital outflow)

International Flow of Goods and Capital: Summary

Trade Surplus Balanced Trade Trade Deficit

X>M X=M X<M
NX > 0 NX = 0 NX < 0
Y>C+I+G Y=C+I+G Y<C+I+G
S>I S=I S<I
Net capital outflow > 0 Net capital outflow = 0 Net capital outflow < 0

GDP, GNP, the Trade Balance and the Current Account

- Definitions:

GDP = C +I + G + NX
GNP = GDP + factor payments from abroad - factor payments to abroad
= GDP + net factor income from abroad (NFIA)

- Unilateral transfers = payments (or goods and services rendered) for which nothing in
! return is recorded in the national accounts (e.g. foreign aid payments)

- Current Account Balance = Net exports + net factor income from abroad + net
unilateral transfers
• HENCE: It is possible to have 0 or even positive current account balance, but a
negative trade balance

- Note: Although current account is an important concept in macroeconomics, it is often

sufficient to stick with net exports (i.e. the trade balance) as a measure of a country’s
current transactions with the rest of the world
- 34 - Peter C. May

5-2. SAVING AND INVESTMENT IN A SMALL OPEN ECONOMY

- NOT assume that the real interest rate (r) equilibrates saving and investment, RATHER
allow the economy to run a trade surplus and lend to other countries or run a trade
deficient and borrow from other countries

- Assumptions:
• Small = small part of the world market % cannot influence the world real
interest rate r*
! World economy is a closed economy, so the equilibrium of world saving
and world investment determines the world interest rate
• Perfect capital mobility: full access to world financial markets; ensures r = r*

- Model:
1) Economy’s output fixed by factors of production
Y = F(K, L) = Y
2) Consumption is positively related to disposable income
C = C(Y - T)
! 3) Investment is negatively related to the real interest rate
I = I(r)
!
- HENCE:

! NX = S - I
NX = Y - C(Y - T) - G - I(r*)
" NX = S - I(r*)
- From the equation above we can see that the trade balance (NX) depends on those
variables that determine saving and investment
! • Fiscal policy: G, T
• World real interest rate: r*

Rule: The trade balance is determined by the difference between saving and investment
at the world real interest rate! [I/S-r space diagram shows whether trade surplus/deficit,
whereas NX-, space diagram shows corresponding change in ,]

r
S - r* = world interest rate
- rc = interest rate if economy
were closed
NX(+) If interest rate is determined by world
r*
financial markets, the difference
between saving and investment
determines the trade balance!
rc I(r)
The exogenous world interest rate (r*)
determines the country’s level of
investment & thus net exports
I(r*) S I, S
 Peter C. May - 35 -

How Policies Influence the Trade Balance

- Suppose economy begins in a position of balanced trade: I=S % S#I=NX=0

a) Fiscal policies at home

- If )G or *T % *S=Y#C#G
- r* fixed, so NX=S#I < 0 % trade deficit

r S2 S1
1. The economy begins with
2 balanced trade
2. But when a fiscal expansion
reduces saving
3. A trade deficit results

1
r* I(r)
NX(#)
3

S2 I(r*) I, S

- HENCE: starting from balanced trade, a change in fiscal policies that reduces national
saving leads to a trade deficit

b) Fiscal policies abroad

- If world )G, world *S % )r*
- Domestic saving unchanged, but *I(r*) % NX=S#I > 0 % trade surplus

r S1
1. An increase in the world
2 interest rate
2. Reduces investment and leads
NX(+) to a trade surplus
r*2
1

r*1 I(r)

I(r*2) S I, S

- HENCE: starting from balanced trade, an increase in the world interest rate due to a
fiscal expansion abroad leads to a trade surplus
- 36 - Peter C. May

c) Shifts in investment demand

- If )I and S fixed % NX=S#I < 0 % trade deficit
- Example: investment tax credit
S
r
1. An increase in
investment demand
2. Leads to a trade deficit
2

NX(#)
r* I2
I1
1

S I(r*) I, S

- HENCE: starting form balanced trade, an outward shift in the investment schedule
causes a trade deficit

Problems of Trade Deficits

- Not a problem in itself, rather symptom of a problem (especially low saving)

• Low saving % trade deficit % growing foreign debt % must be repaid in future
• HENCE: high current consumption financed through trade deficit leads to
lower future consumption

- BUT: one cannot judge economic performance form the trade balance alone, instead
one must look at the underlying causes of international flows

- Twin deficit: Government budget deficit and trade deficit at the same time
• Budget deficit % Low public saving % Low national saving % NX=S#I < 0 %
Trade deficit

Why Doesn’t Capital Flow to Poor Countries?

- Cobb-Douglas production function:

F(K, L) = A " K # " L1-#
$F
MPK = = # " A " K #%1 " L1-#
$K
K
MPK = # " A " ( ) #%1
L

!
 Peter C. May - 37 -

- Since ($#1) < 0, )(K/L) should *MPK

• Ceteris paribus, the more capital a nation has, the less valuable an extra unit of
capital is (diminishing marginal productivity)
• HENCE capital should be more value where capital is scarce [LEDCs]

- BUT:
• Developing countries have a lower parameter A (technology) because of
! Less access to advanced technologies
! Lower levels of education (or human capital)
! Less efficient economic policies
• Property rights are often not enforced in developing countries

5-3. EXCHANGE RATES

- Exchange Rate: Price at which residents of two countries trade with each other

- Nominal Exchange Rate (NER): Relative price of the currency of two countries; two
ways to express NER
a) As the foreign price of domestic currency (OR: foreign currency per unit of
domestic currency) e.g. for Germany NER to UK: 0.9£ per ! [more common!]
b) As the domestic price of foreign currency (OR: domestic currency per unit of
foreign currency) e.g. for Germany NER to UK: 1.1£ per !

- Movements in the exchange rate

• Depreciation: Fall in the exchange rate (expressed in way a.) % weakening of
the domestic currency; e.g. for Germany NER to UK: from 0.9£ per ! to 0.8£
per !
• Appreciation: Rise in the exchange rate (expressed in way a.) % strengthening
of the domestic currency; e.g. for Germany NER to UK: from 0.9£ per ! to
1.0£ per !

- Real Exchange Rate (RER): Relative price of goods of 2 countries % terms of trade
• Real exchange rate measures amount of purchasing power in foreign country
that must be sacrificed for each unit of purchasing power in domestic country
• Terms on which domestic goods can be traded for foreign goods
• Example:
! Japanese car: 2,800,000 yen, French car: 10,000!; NER: 140 yen/!
! HENCE: France RER to Japan % 0.5"(Japanese Car/French Car)
! In order to buy a French car, a Japanese citizen has to give up 0.5 of the
purchasing power he has to give up in Japan for buying a Japanese car

Real Exchange Rate = Nominal Exchange Rate " Ratio of Price Levels
Pd
# = e "
Pf

!
- 38 - Peter C. May

Rule:
1) If the real exchange rate is high (>1), foreign goods are relatively cheap and
domestic goods relatively expensive (high Pd, low Pf)
2) If the real exchange rate is low(<1), foreign goods are relatively expensive
and domestic goods relatively cheap (low Pd, high Pf)

- In the real world: We can think of " as the relative price of a basket of domestic goods in
terms of a basket of foreign goods
- In our macro model: There’s just one good, “output” ! " is the relative price of one
country’s output in terms of the other country’s output

The Real Exchange Rate and the Trade Balance

- Net exports are a function (negative relationship) of the real exchange rate
• NX = NX(,)

, When " is relatively low, UK goods

are relatively inexpensive ! UK net
exports will be high [trade surplus,
NX>0]
At high enough values of ", UK
goods become too expensive ! UK
exports less than it imports [trade
deficit, NX<0]
NX(,) ! Higher RER means fewer
domestic (UK) goods needed to buy
a given amount of foreign goods

#ve 0 +ve NX

The Determinants of the Real Exchange Rate

- Real exchange rate is related to NX % when *,, )NX and when ),, *NX
- NX = Net Capital Outflow = S#I
• Saving is fixed by the consumption function and government fiscal policy
• Investment is fixed by the investment function and the world interest rate

S#I [FX mkt: Net supply

, of domestic currency] - S#I schedule is vertical because
S & I are independent of ,
- At equilibrium, the quantity of
domestic currency supplied for
the flow of capital abroad (S#I)
equals the quantity of domestic
money demanded for the net
,* export of goods and services!

NX(,)[FX mkt: Net demand

of domestic currency]
NX
 Peter C. May - 39 -

Rule: At the equilibrium exchange rate, the supply of domestic currency

available from net capital outflow balances the demand for domestic currency
by foreigners buying our net exports.
HENCE: , must ensure that NX(,)=S"#I(r*)!

- NX is actually the net demand for dollars: foreign demand for dollars to purchase our
exports minus domestic supply of dollars to purchase imports
- Net capital outflow is the net supply of dollars: The supply of dollars from domestic
residents investing abroad minus the demand for dollars from foreigners buying
domestic assets

Economic Policy

a) Expansionary fiscal policy at home

, S2#I S1#I
1. A fiscal expansion which
causes a reduction in saving
1 reduces the supply of domestic
currency
2. Which raises the real exchange
,2 rate
3. And causes net exports to fall
2
,1 NX(,)

NX2 NX1 NX

b) Expansionary fiscal policy abroad

, S#I1 S#I2
1. An increase in world interest
rate reduces investment, which
1 increases the supply of
domestic currency (by ) net
capital outflow, S-I)
,1 2. Which causes the real exchange
rate to fall,
2
,2 NX(,) 3. And raises net exports

NX1 NX2 NX

3
- 40 - Peter C. May

c) Shifts in investment demand

, S#I2 S#I1
1. An increase in investment
reduces the supply of domestic
1 currency (by * net capital
outflow, S-I)
2. Which raises the real exchange
,2 rate
3. And causes net exports to fall
2
,1 NX(,)

NX2 NX1 NX

d) Protectionist trade policies

- Trade policies: Policies designed to influence directly the amount of goods and
services exported or imported
• Quota: Limit on imports of foreign goods and services
• Tariff: Tax on imports of foreign goods and services
• Embargo: Ban on imports of foreign goods and services

, S#I 1. Protectionist trade policies (e.g.

ban on imported cars) raise the
demand for net exports [by *M
% )(X#M)], increasing the net
demand for domestic currency
2. Which raises the real exchange
,2 rate (since net supply is fixed)
NX2(,)
2 3. But leave net exports unchanged
,1 1

NX1(,)

NX NX
3

- The appreciation offsets the increase in net exports due to lower imports
• HENCE: Protectionist trade policies do not affect the trade balance BUT the
amount of trade
! *M (due to trade policy) & *X (due to appreciation) % NX unchanged
• Diminish gains from trade that arise when countries specialize in what they
produce best (comparative advantage)
 Peter C. May - 41 -

The Determinants of the Nominal Exchange Rate

Nominal Exchange Rate = Real Exchange Rate " Inverted Ratio of Price Levels
Pf
e = # "
Pd

- The nominal exchange rate (e) depends on the real exchange rate and the price levels of
! the two countries

- Changes in the exchange rate over time:

% change in e = % change in " + % change in pf - % change in pd

% change in e = % change in " +(# f - # d )

- HENCE: the percentage change in the nominal exchange rate between the currencies of
! two countries equals the percentage change in the real exchange rate plus the difference
in their inflation rates [if )(d % *e]
• Growth rate of NIR = difference between foreign and domestic inflation rates

Rule:
1) If the domestic country has a low rate of inflation relative to the foreign
country, the domestic currency will buy an increasing amount of the foreign
currency over time ()e)
2) If the domestic country has a high rate of inflation relative to the foreign
country, the domestic currency will buy a decreasing amount of the foreign
currency over time (*e)

The Special Case of Purchasing Power Parity

- Law of One Price: The same cannot sell for different prices in different locations at the
same time % no arbitrage opportunities

- Purchasing Power Parity (PPP): If international arbitrage is possible, then a currency

must have the same purchasing power in every country
! Goods must sell at the same (currency-adjusted) price in all countries
! NIR adjusts to equalize the cost of a basket of goods across countries
• REASON: If a ! could buy more wheat abroad than domestically, the
arbitrageurs would buy wheat abroad and sell it domestically, driving down the
domestic price relative to the foreign price
• Quick action of international arbitrageurs % NX(,) schedule highly sensitive to
small movements in the real exchange rate
• Extreme sensitivity of NX to , guarantees that the equilibrium , is always close
to the level that ensures PPP
- 42 - Peter C. May

, S#I The law of one price applied to the

international marketplace suggests
that net exports are highly sensitive
to small movements in the real
exchange rate. This high sensitivity
NX(,) is reflected here with a very flat
net-exports schedule

NX NX

- 2 implications of PPP theory

1. Changes in S or I do not influence , or e
2. All changes in ‘e’ result from changes in price levels
- BUT: PPP unrealistic because many goods and services are not tradable (e.g. haircuts)
and even tradable goods and services are not always perfect substitutes
- In the real world, nominal exchange rates have a tendency toward their PPP values over
the long run
- If the RER (,) is constant, at say 1, then the NER: e=pf/pd % %'e = (f - (d [NER of a
high inflation country will tend to fall]

CASE STUDY: The Reagan Deficits

- 1970s-80s: )G & *T ! ) government deficit (G#T)

• Closed economy model correctly predicted that national saving would fall and
the interest rate would rise
! BUT the closed economy model predicted that investment would fall as
much as saving; actually, investment fell by much less than saving.
! Also, the closed economy model by definition could not have predicted
the effects on the trade balance or exchange rate.
• The small open economy model correctly predicted what would happen to NX
and the real exchange rate, but incorrectly predicted that the interest rate and
investment would not change.
- HENCE: In order to explain the U.S. experience, we need to combine the insights of
the closed & small open economy models!

1970s 1980s Actual change Closed economy Small open economy

G" T 2.2 3.9 ) ) )
S 19.6 17.4 * * *
r 1.1 6.3 ) ) No change
I 19.9 19.4 * * No change
NX -0.3 -2.0 * No change *
# 115.1 129.4 ) No change )
 Peter C. May - 43 -

SUMMARY:

1. Net exports are the difference between exports and imports. They are equal to
the difference between what we produce and what we demand for consumption,
investment and government purchases. [NX=X#M=Y#C#I#G]
2. The net capital outflow is the excess of domestic saving over domestic
investment. The trade balance is the amount received for our net exports of
goods and services. The national income accounts identity shows that the net
capital outflow always equals the trade balance. [S#I=NX]
3. The impact of any policy on the trade balance can be determined by examining its
impact on saving and investment. Policies that raise saving or lower investment
lead to a trade surplus, and policies that lower saving or raise investment lead to a
trade deficit. [if )S or *I ! )NX; if *S or )I % *NX] However, NX does not
change if neither S or I are affected (e.g. trade policies).
4. The nominal exchange rate is the rate at which people trade the currency of one
country for the currency of another country. The real exchange rate is the rate at
which people trade the goods produced by the two countries [terms of trade].
The real exchange rate equals the nominal exchange multiplied by the ratio of the
domestic price level to the foreign price level.
5. Because the real exchange rate is the price of domestic goods relative to foreign
goods, an appreciation of the real exchange rate tends to reduce net exports. The
equilibrium real exchange rate is the rate at which the quantity of net exports
demanded equals the net capital outflow.
6. The nominal exchange rate is determined by the real exchange rate multiplied by
the ratio of the foreign price level to the domestic price level. Other things equal,
a high rate of inflation leads to a depreciating currency.
a. For a given value of the real exchange rate, the percentage change in the
nominal exchange rate equals the difference between the foreign &
domestic inflation rates
- 44 - Peter C. May

- Chapter 6: Unemployment -

6-1. JOB LOSS, JOB FINDING AND THE NATURAL RATE OF UNEMPLOYMENT

- Labour force (L): Those in the population who have a job or are looking for one
[willing and able to work]
Labour force = Employed workers + Unemployed workers
L = E + U

- Unemployment rate (U): Percentage of the labour force who do not have jobs
• HENCE: People who are willing and able to work at the current wage but do
!
not have a job
U
Rate of unemployment (in %) = " 100
L

- Natural rate of unemployment: Rate of unemployment towards which the economy

gravitates in the long-run, given all the labour-market imperfections that impede
!
workers from instantly finding jobs [NRU=frictional + structural unemployment]
• The average rate of unemployment around which the economy fluctuates
! Boom: actual rate of unemployment < natural rate
! Recession: actual rate of unemployment > natural rate
! Cyclical unemployment: the unemployment associated with short-run
fluctuations; the deviation of the unemployment rate from the natural rate
• The steady-state rate of unemployment

A First Model of the Natural Rate of Unemployment

- Perpetual ebb and flow (i.e. hiring and firing) determines the fraction of the labour force
that is unemployed

- Assumptions:
1. Labour force (L) is exogenously fixed
2. During any given month,
a. Rate of job separation (s) = fraction of employed workers that
become separated from their jobs
b. Rate of job finding (f) = fraction of unemployed workers that find jobs
%Both exogenous
Friedman (1968): “The natural rate of
unemployment is the level which would
- Transition between employment and unemployment: be ground out by the Walrasian system
of general equilibrium equations,
provided there is embedded in them the
Job Separation (s)
actual structural characteristics of the
labour and commodity markets,
including market imperfections,
Employed Unemployed stochastic volatility in demands and
supplies, the cost of gathering
information about job vacancies and
Job Finding (f) labour availabilities, the costs of
mobility, and so on.”
 Peter C. May - 45 -

- Steady-state condition: The labour market is in steady rate, or long-run equilibrium, if

the unemployment rate is constant

Steady state condition : s " E = f " U (combine with L = E + U)

U s 1
# = =
L s + f 1+ f/s

• Shows that the steady-state rate of unemployment (natural rate) depends

! positively on the rate of job separation (s) and negatively on the rate of job
finding (f)
! )s % )(U/L)
! )f % *(U/L)
• Numerical example:
! s = 0.01 % 1% of the employed lose their jobs every month ! jobs last
on average 100 months & 8 years
! f = 0.19 % 19% of the unemployed find a job each month !
unemployment spells last on average 5 months
U 1 1
= = = 0.05 " the unemployment rate is 5%
L 1+ f/s 1+ 0.19/0.01

Rule:
! 1) Any government policy aimed at lowering unemployment in the long-run
must either reduce the rate of job separation or increase the rate of job finding.
2) Any government policy that affects the rate of job separation or job finding
also changes the natural rate of unemployment.

- Why is there unemployment in the long-run?

• If job finding were instantaneous (f=1), then all spells of unemployment would
be brief, and the natural rate would be near zero
• There are two reasons why f < 1:
1. Imperfect job search process % frictional unemployment
2. Real wage rigidity % structural unemployment

6-2. JOB SEARCH AND FRICTIONAL UNEMPLOYMENT

- Frictional unemployment: Unemployment that is caused by the time it takes workers

to search for and find a new job
• Causes:
1) Workers have different abilities, preferences (heterogeneity)
2) Jobs have different skill requirements
3) Geographic mobility of workers not instantaneous
4) Flow of information about vacancies and job candidates is imperfect
- 46 - Peter C. May

- Some frictional unemployment is inevitable in a flexible, changing economy:

• Sectoral shift = change in the composition of demand among industries or
regions
• Examples:
! Technological change increases demand for computer repair persons,
decreases demand for typewriter repair persons
! A new international trade agreement causes greater demand for workers
in the export sectors and less demand for workers in import-competing
sector
• Because sectoral shifts are always occurring, and because it takes time for
workers to change sectors, there is always some frictional unemployment
! BUT: Sectoral shifts are distinct from recessions
• In recessions, there is a general fall in demand across industries,
and the unemployment that results is cyclical
• Sectoral shifts, though, are changes in the composition of
demand across industries, and lead to frictional unemployment

Government Policy and Frictional Unemployment

- Public policies seek to decrease the natural rate of unemployment by reducing frictional
unemployment:
• Disseminate information about job opportunities in order to match jobs and
workers more efficiently
• Publicly funded retraining schemes to ease the transition of workers from
declining to growing industries

- BUT other government programmes inadvertently increase the amount of frictional

unemployment: Unemployment insurance and unemployment benefits
• Reduction in rate of job finding (*f):
a) Unemployed are less pressed to search for new employment
b) Unemployed are more likely to turn down unattractive job offers
• Increase in rate of job separation ()s):
c) Workers are less likely to seek jobs with stable employment opportunities
d) Workers are less likely to bargain for guarantees of job security
e) Unemployment insurance is partially experience rated % when a firm lays off
a worker, it is charged for only part of the worker’s unemployment
benefits, the remainder comes from the programmes general revenue
[incentive to fire workers more quickly]
• Solution: 100% experience rated system % rate that each firm pays
into the unemployment-insurance system fully reflects the
unemployment experience of its own workers [BUT probably
reduces incentive to hire people, too]
 Peter C. May - 47 -

• Studies: The longer a worker is eligible for UI, the longer the duration of the
average spell of unemployment.

• One possible benefit of unemployment insurance:

! By allowing workers more time to search, UI may lead to better matches
between jobs and workers, which could lead to greater productivity and
higher incomes in the longer term.

6-3. REAL WAGE RIGIDITY AND STRUCTURAL UNEMPLOYMENT

- Wage rigidity: Failure of wages to adjust to a level at which labour supply equals labour
demand

Labour - LS=Amount of labour willing to

REAL WAGE supply work
3 Structural - LH=Amount of labour hired
unemployment
1 Rigid real wage 1. When the real wage is above the
level that equilibrates demand
and supply (w*/p)
2. Then the quantity of labour
w*/p supplied (LS) exceeds the
quantity demanded (LH)
Labour 3. Firms must in some way ration
demand the scarce jobs among workers
% structural unemployment!
LH 2 LS LABOUR

- Structural unemployment: Unemployment caused by real-wage rigidity and job

rationing
• Fundamental mismatch between the number of people who want to work and
the number of jobs available
• At w/p: QLS > QLD % )(U/L) because (w/p) > (w*/p)

- Causes for real-wage rigidity:

1. Minimum-wage laws
2. Unions and collective bargaining
3. Efficiency wages
- 48 - Peter C. May

1. Minimum Wage Laws

- Minimum wage: A legal minimum set by the government on the wages that firms pay
to their employees (normally between 30-50% of the economy-wide average wage)
• For most workers, the minimum wage is not binding % no effect
• BUT for some workers, especially the unskilled and inexperienced, the minimum
wage raises their wage above its equilibrium level and thus reduces QLD
! Impact on youth unemployment since equilibrium wages of youths low
for 2 reasons
1) Low MPL
2) Compensation in form of training rather than direct pay (e.g.
apprenticeship)

- Advocates:
• Raising income of the working poor
• Cost through higher unemployment worth bearing to raise others out of poverty

- Opponents:
• Not the best way to help the working poor
• High unemployment creates long-term damage to economy’s human capital
• Poorly targeted: Supports youths from middle-class homes working for
discretionary spending rather than heads of households working to support their
families

2. Unions and Collective Bargaining

- Unionization (in 2005):

• US: 18%
• UK: 35%
• Germany: 90%

- The wages of unionized workers are determined not by the equilibrium of supply and
demand, but by bargaining between union leaders and firm management
• Unions exercise monopoly power to secure higher wages for their members
• w/p > w*/p % )(U/L)

- Insider-outsider conflict:
• Workers/Unions (insiders) try to keep their wages high
• Unemployed (outsiders), who might be employed at a lower (equilibrium) wage,
bear part of the costs by being unnecessarily unemployed
! Outcome of bargaining process depends on relative power of groups
! If insiders powerful: )(w/p) % )(U/L)
! If outsiders powerful: *(w/p) % *(U/L)
 Peter C. May - 49 -

3. Efficiency Wages

- Efficiency wages theory: Increased productivity through higher wages justify above-
equilibrium wages
• High wages increase worker productivity by:
1) Attracting higher quality job applicants
• Adverse selection: tendency of people with more information
(workers who know about outside opportunities) to self-select in
a way that disadvantages people with less information (the firm,
remaining employees)
2) Increasing worker effort and reduce “shirking”
• Moral hazard: tendency of people to behave inappropriately
when their behaviour is imperfectly measured ! when )(w/p)
% ) costs of being fired % ) efforts
3) Reducing turnover
• Reducing the time and money spent on hiring and training
4) Improving health of workers (in developing countries)
• Consequence: Some alternative workers want jobs at the going wage rate but
cannot get them, so they are involuntarily unemployed
! w/p > w*/p % )(U/L) ! structural unemployment!

Note on NRU versus NAIRU

- Both denote an equilibrium level of unemployment towards which the economy
reverts and at which there are no inflationary pressures arising from the labour market
o NAIRU = Non-accelerating inflation rate of unemployment
o NRU = Natural rate of unemployment
- SOME economists distinguish between the two by saying that
o The NRU assumes a competitive labour market in which the labour market
clears and there is no involuntary unemployment apart from frictional
unemployment
o NAIRU is largely due to various labour-market imperfections (e.g. real-wage
rigidity) and is composed of both frictional and structural unemployment
! NRU is the lower bound which the NAIRU would attain in the absence of
labour-market imperfections
- BUT: to a large extent, the broader concept of the NAIRU has now largely
superseded the strict interpretation of the NRU
o Natural rate of unemployment = equilibrium unemployment, which may be
affected by labour-market imperfections (real wage rigidities) ! used by
Mankiw!
- How the NRU may change
1. Changes in the factors affecting job market separation and matching
2. Changes in the causes of real wage rigidity (unionization, minimum wage laws)
3. Hysteresis (history dependence)
- 50 - Peter C. May

Summary
Job Separation

Unemployment
Process of job search

Job Finding Minimum wage laws

Wage rigidity Unionization

Efficiency wages

6-4. LABOUR-MARKET EXPERIENCE: THE UK

The Duration of Unemployment

- Data on duration of unemployment gives hints about reasons for unemployment:

• If short-term % most likely to be frictional
• If long-term % most likely to be structural
- UK: most spells of unemployment are short, but most months of unemployment are
attributable to the long-term unemployed

Variation Across Demographic Groups

- 2005: overall: 4.9% BUT 15-24 years: 13.4%

• ) rate of job separation (s) for younger workers because they are often uncertain
about future career plans and want to try different jobs before making a definite
long-term commitment to a specific occupation
• * rate of job finding (f) due to minimum wage laws
- 2005: Men: 5.2% BUT women: 4.6%
• Discouraged worker effect: Women are more likely to drop out of the labour
force if unsuccessful with finding a job
 Peter C. May - 51 -

Trends in UK Unemployment

- Natural rate of unemployment (NRU) unstable:

! 1980: 9%
! 2000: 5%
• Reasons:
1) Demographics: Changing composition of UK labour
• ) birth rates after WW2 % younger workers have higher
unemployment rates % ) (U/L) in 1970s [baby-boomers]
• 1990s: baby-boomers aged and left the labour force % *(U/L)
2) Sectoral shifts: High reallocation among regions and industries since oil
crises % less oil-intensive
3) Productivity: Slow productivity growth in the 1970s, but 1990s pickup in
productivity growth
4) Decline in unionization: Union coverage down from 70% (1980) to 35%
(2005) caused by Thatcher government, privatizations and sectoral shifts
5) Changes in unemployment benefit system: Average level of
unemployment benefit relative to average after-tax wages fell from 50% to
40%; creates more incentives to actively look for new jobs

Transition Into and Out of the Labour Force

- Model of natural rate of unemployment assumes that the labour force (L) is fixed [only
‘s’ and ‘f’ matter]
• BUT: about 1/3 of the unemployed are workers who have only recently entered
the labour force (e.g. young workers) and almost # of all spells of unemployment
end in the unemployed person’s withdrawal from the labour force
• Discouraged workers: Those who want a job, but, after unsuccessful searches,
have given up looking % do not show up in unemployment figures

6-5. LABOUR-MARKET EXPERIENCE: CONTINENTAL EUROPE

The Rise in European Unemployment

- High levels of unemployment (~10%) since 1990s caused by

• Interaction between
! Long-standing policies % generous unemployment benefits & inflexible
labour markets
! Recent shock % technologically driven fall in the demand for unskilled
workers relative to skilled workers
• Unemployment trap: more attractive to remain unemployed than taking a job
% result of generous unemployment benefits
- 52 - Peter C. May

• Inflexibility caused by expensive hiring and firing ! firms substitute capital for
workers
• Trade-off between equality (welfare state) and flexible labour markets

Variation Among Demographic Groups

- As in the UK, Europe has very high youth unemployment rates

- Higher female unemployment rates than male because
1) No discouraged worker effect, since leaving the labour force means giving up
substantial government benefits
2) Significant non-wage costs % firms reluctant to take on female workers who are
likely to have children and become entitled to maternity, for example

6-6. CONCLUSION

- 4 types of unemployment
1) Frictional [caused by the time it takes workers to find new jobs]
2) Structural [real wage rigidities ! mismatch between quantity of labour
demanded and supplied at going real wage rate]
3) Cyclical [demand-deficiency]
4) Voluntary [low inter-temporal relative wage, but called unemployed due to
unemployment benefits]
• 1) & 2) % NRU
• 1), 2) & 3) % involuntary unemployment
- Unemployment represents wasted resources % a lost potential to contribute to national
income
- Zero unemployment is impossible in free-market economies as the government cannot
make job search instantaneous (no zero frictional unemployment)
 Peter C. May - 53 -

SUMMARY:

1. The natural rate of unemployment is the steady-state rate of unemployment. It

depends on the rate of job separation and the rate of job finding.
[U/L=1/(1+f/s)]
2. Because it takes time for workers to search for the job that best suits their
individual skills and tastes, some frictional unemployment is inevitable. Various
government policies, such as unemployment insurance, alter the amount of
frictional unemployment.
3. Structural unemployment results when the real wage remains above the level that
equilibrates labour supply and labour demand [(w/p) > (w*/p)]. Causes:
a. Minimum wage legislation
b. Unions and the threat of unionization
c. Efficiency wages % profitable for firms to keep wages high to increase
productivity
4. The unemployment rates among demographic groups differ substantially. In
particular, the unemployment rates for younger workers are much higher than for
older workers in most countries. This results from a difference in the rate of job
separation, rather than from a difference in the rate of job finding.
5. The natural rate of unemployment in the UK has exhibited long-term trends. In
particular, it rose form the 1960s to the 1970s and early 1980s, and then stared
drifting downward again in the 1990s and early 2000s. Various explanations have
been proposed, but the two most important factors are probably the decline in
the unionization of the labour force and the reform of the unemployment benefit
system.
6. Individuals who have recently entered the labour force, including both new
entrants and re-entrants, make up about one-third of the unemployed.
Transitions into and out of the labour force make unemployment statistics more
difficult to interpret.
7. Continental European levels of unemployment tend to be much higher than in
the UK or the US. Major reasons for this are the more generous unemployment
benefit systems of many European countries, combined with various laws that
reduce labour-market flexibility.
- 54 - Peter C. May

- Chapter 9: Introduction to Economic Fluctuations -

- If prices clear markets (LR) % classical dichotomy

• BUT: in the SR, many prices and wages appear ‘sticky’ and unresponsive !
then, quite unlike the classical model, quantities, rather than prices, may do the
adjustment to economic shocks

- Business cycle: Short-run fluctuations in output and employment

• Fluctuations vary greatly in terms of both their frequency and severity
• Long-term growth rate of real GDP: 2-3%
• Recession: 2 consecutive quarters of -ve economic growth, i.e. falling real GDP

9-1. THE FACTS ABOUT THE BUSINESS CYCLE

- GDP and its components:

• Usually, growth in both consumption and investment declines during recessions
[Note: the actual growth figures need not turn negative]
• Investment is far more volatile than consumption over the business cycle

- Unemployment and recessions:

• Unemployment tends to vary over the business cycle; recessions are associated
with more or less sharp increases in unemployment
• Okun’s Law: Negative relationship between %' in GDP and the change in U

9-2. TIME HORIZONS IN MACROECONOMICS

- Macroeconomists’ consensus: Difference between SR and LR is the behaviour of prices

Rule:
1) In the long-run, prices are flexible and can respond to changes in supply or demand.
2) In the short-run, many prices are ‘sticky’ at some predetermined level.

- Example:
• LR: ) 5% M % ) 5% all prices % Y unchanged
• SR: ) 5% M % not all prices ) 5% % changes in Y

- AD/AS model: Aggregate demand – aggregate supply model ! Framework to analyze

macroeconomic fluctuations

9-3. AGGREGATE DEMAND

- Aggregate demand (AD): Negative relationship between the quantity of output

demanded in the economy and the aggregate price level
• AD curve tells us the quantity of gs people want to buy at any given price level
 Peter C. May - 55 -

- Simple AD derivations:
1. Using quantity equation:
MV = PY
Assuming V is constant and M is fixed by the central bank :
PY = constant OR P "1/Y
2. Using supply and demand for real money balances:
(M/P)d = kY = (M/P) " M # (1/k) = PY
!
Assuming k (how much money people want to hold for every unit of income)
is constant and M is fixed by the central bank :
PY = constant OR P $1/Y

PRICE LEVEL, P
! The AD curve slopes downwards:
The higher the price level (P), the
lower the level of real money
balances (M/P) and therefore the
lower the quantity of goods and
services demanded (Y)!

AD

INCOME, OUTPUT, Y

- Shifts in the AD curve:

• AD curve is drawn for a fixed value of the money supply
• Changes in the money supply shift the AD curve:
! If )M % AD shifts outwards (rightwards)
! If *M % AD shifts inwards (leftwards)
• BUT: fluctuations in M are not the only source of fluctuations in AD; AD curve
can shift if V changes
! If )V % AD shifts outwards (rightwards)
! If *V % AD shifts inwards (leftwards)

9-4. AGGREGATE SUPPLY

- Aggregate supply (AS): (Positive) Relationship between the quantity of goods and
services supplied in the economy and the aggregate price level
• Because of price-stickiness in the short-run, the AS relationship depends on the
time horizon
a) Long-run aggregate supply curve (LRAS)
b) Short-run aggregate supply curve (SRAS)
- 56 - Peter C. May

a) The Long Run

- Classical model: Y = F(K

" ,L
")=Y "
• Y " = Full-employment or natural level of output ! the level of output at which
the economy’s resources are fully employed [unemployment at its natural rate]
• HENCE: output does not depend on the price level % LRAS vertical

LRAS To show that output, i.e. the

PRICE LEVEL, P supply of goods and services,
does not depend on the price
level (P) in the long-run, the
LRAS is drawn as a vertical
line!
! Output is purely determined
by the (fixed) amounts of
labour and capital and the
available production
technology

Y
" INCOME, OUTPUT, Y

- Impact of monetary policy in the long-run:

• *M % AD curve shifts leftwards % LRAS vertical: Y unchanged, *P by %' in
M [BUT: AD/AS model can show long-run, but is not classical model]

b) The Short Run

- Assume extreme example:

• Infinite menu costs in short-run
• HENCE: all prices are stuck at their predetermined level in the short-run %
SRAS horizontal

PRICE LEVEL, P

SRAS

INCOME, OUTPUT, Y

- Impact of monetary policy in the short-run (extreme case):

• *M % AD curve shifts leftwards % SRAS horizontal: *Y, P unchanged
 Peter C. May - 57 -

Rule:
1) In the short-run, a reduction in AD causes a reduction in output [no/small change in price level].
2) In the long-run, a reduction in AD causes a fall in the aggregate price level [no change in output].

- NOTE: As we will see in the coming chapters, some prices are able to respond quickly
to changing circumstances % SRAS is upward sloping, not horizontal

Rule:
1) Over long periods of time, prices are flexible, the aggregate supply curve is vertical and
changes in aggregate demand affect the price level, but not output! ! classical theory!
2) Over short periods of time, prices are sticky, the aggregate supply curve is horizontal
and changes in aggregate demand do affect the economy’s output of goods and services!

Transition from the Short Run to the Long Run

- Long-run equilibrium: AD=LRAS=SRAS

PRICE LEVEL, P LRAS

SRAS

AD

INCOME, OUTPUT, Y

- Now CB *M % AD curve shifts inwards (AD1%AD2)

LRAS
PRICE LEVEL, P
1 1. A fall in AD from AD1
to AD2
2. Results in a reduction of
2 output in the short-run
SRAS
(Y
" % Y S)

Y
"
AD2 AD1

YS Y
" INCOME, OUTPUT, Y
- 58 - Peter C. May

- BUT in the long-run wages and prices fall in response to low demand (SRAS curve
shifts downwards)

PRICE LEVEL, P LRAS 3. The gradual reduction in the

1 price level moves the economy
downwards along the AD2
curve. In the new long-run
2 equilibrium E output (Y) and
SRAS1
P1 employment are back to their
original levels, but prices are
lower (P1 % P2)
3 SRAS2
P2 E
AD2 AD1

YS Y
" INCOME, OUTPUT, Y

- HENCE: the adjustment of prices is what moves the economy to its long-run
equilibrium:
• Over time, prices gradually become “unstuck”

SR equilibrium In LR prices will

Y<Y
" Fall
Y>Y
" Rise
Y=Y
" Remain constant

- Intuition behind the transition from short-run to long-run:

1) Suppose that output is below its natural rate in the short-run

• Downward pressure on prices:
! Firms can’t sell as much output as they’d like at their current prices, so
they would like to reduce prices
! With lower than normal output, firms won’t need as many workers as
normal, so they cut back on labour, and the unemployment rate rises
above the “natural rate of unemployment.”
! The high unemployment rate puts downward pressure on wages. Wages
and prices are “stuck” in the short run, but over time, they fall in
response to these pressures.

2) Suppose aggregate demand is higher than the full-employment level of output

• Upward pressure on prices:
! In order for firms to produce this above-average level of output, they
must pay their workers overtime and make their capital work at a high
intensity, which causes more maintenance, repairs, and depreciation.
 Peter C. May - 59 -

! For all these reasons, firms would like to raise their prices. In the short
run, they cannot. But over time, prices gradually become “unstuck,” and
firms can increase prices in response to these cost pressures.

3) Suppose output equals its natural level in the short-run

• There is no pressure for prices to rise or fall:
! Over time, as prices become “unstuck,” they will simply remain
constant.

9-4. STABILIZATION POLICY

- Shock: Exogenous event that shifts the AD or AS curve [mainly short-run]

• Demand shock: Shift in aggregate demand (AD)
• Supply shock: Shift in aggregate supply (AS)
! Disrupt the economy by pushing output & employment away from their natural
level

- Stabilization policy: Policy actions aimed at reducing the severity of short-run

economic fluctuations % dampen the business cycle by keeping output and
employment as close to their natural levels as possible ! Accomodating
• Monetary policy: controlling the money supply (M) and interest rate (i)
• Fiscal policy: controlling government purchases (G) and taxes (T)

Note: The economy has a “self-correction” mechanism: When in a recession, the

economy – left to its own devices – “fixes” itself: the gradual adjustment of prices helps
the economy recover from the shock and return to full employment
BUT reasons for stabilization policy:
1) Self-correction often takes too much time
2) Danger of hysteresis & high social costs of unemployment

Demand Shocks

- Example: Introduction of credit cards

• * money demand % *k % )V, M " % ) nominal spending % AD curve shifts
rightwards
! SR: )Y
! LR: ) prices and wages, BUT output back to Y
"
- 60 - Peter C. May

LRAS Economy begins at the long-run

PRICE LEVEL, P equilibrium A
SRAS2 1. A positive demand shock ()V)
C
P2 shifts the AD curve from AD1
to AD2
3
2. SR: )Y, above natural level of
A 2 B SRAS1 output (A % B)
P1 3. BUT in LR:, wages and prices
adjust upwards, so output
1 gradually returns to its natural
level, but at a higher price level
AD1 AD2 (P1 % P2) ! C

Y
" YS INCOME, OUTPUT, Y

- Possible stabilization policy:

• CB could reduce M to dampen the change in V on P

Supply Shocks

- Supply shocks have a direct impact on the price level ! also called price shocks
• Examples:
! Drought destroys crops % *AS, )P
! Increase in union aggressiveness % *AS, )P (and )w)
! OPEC raises oil price %*AS, )P
• Difference between
a) Adverse shocks: ) costs & )P [all 3 examples above]
b) Favourable shock: * costs & *P
• Stagflation: Stagnation (recession) + inflation
! Often caused by adverse supply shock

- Need to distinguish between:

1. LR supply shocks % change in natural level of output (e.g. new technologies)
2. SR supply shocks % change in SRAS; temporary [Mankiw’s focus]

LRAS Economy begins at LR eq. A

PRICE LEVEL, P 1. An adverse supply shock
SRAS2 pushes up costs and thus prices
B
P2 (P1 % P2 as SRAS1 % SRAS2)
2 2. Economy moves from A to B
1 3 in short-run: stagflation! (*Y
4 A and )P)
SRAS1
P1 3. In long-run, prices will fall (P2
% P1 as SRAS2 % SRAS1)
4. Economy moves back from B
to A ! returns to natural level
AD of output and initial price level

YS Y
" INCOME, OUTPUT, Y
 Peter C. May - 61 -

- Possible government policies:

1. Hold AD constant by holding M constant and wait until economy returns to
LR equilibrium as prices fall [passive!]
2. Expand M and thus AD to bring economy back to natural level of output Y
"
! Advantage: Economy moves quicker to full employment (no
unemployment)
! Disadvantage: Price level (P) is permanently higher

PRICE LEVEL, P LRAS

C SRAS2 1. Adverse supply shock so

P2 SRAS1 % SRAS2
3 2. BUT CB )M, so AD1 % AD2
1 3. In total: movement from A to
A SRAS1 C, so Y unchanged at natural
P1 level of output, but price level
2 increased from P1 to P2

AD1

Y
" INCOME, OUTPUT, Y
- 62 - Peter C. May

SUMMARY:

1. Economies experience short-run fluctuations in economic activity, measured

most broadly by real GDP. These fluctuations are associated with movement in
many macroeconomic variables. In particular, when GDP growth declines
a. Consumption growth falls (typically by a smaller amount)
b. Investment growth falls (typically by a larger amount)
c. Unemployment rises
Although economists look at various leading indicators to predict these
fluctuations, they are largely unpredictable.
2. The crucial difference between how the economy works in the long-run and how
it works in the short-run is that prices are flexible in the long-run, but sticky in
the short-run. The model of aggregate demand and aggregate supply provides a
framework to analyse economic fluctuations and see how the impact of policies
and events varies over different time horizons.
3. The aggregate demand curve slopes downward. It tells us that the lower the price
level, the greater the aggregate quantity of goods and services demanded. [simple
model: )P % *(M/P) % * purchasing power % *AD]
4. In the long-run, the aggregate supply curve is vertical because output is
determined by the amounts of capital and labour and by the available technology,
but not the level of prices. Therefore, shifts in aggregate demand affect the price
level, but not output or employment.
5. In the short-run, the aggregate supply curve is horizontal, because wages and
prices are sticky at predetermined levels. Therefore, shifts in aggregate demand
affect output and employment.
6. Summary of long-run vs. short-run:
- Long-run
o Prices flexible
o Output determined by factors of production & technology
o Unemployment equals its natural rate
- Short-run
o Prices fixed
o Output determined by aggregate demand
o Unemployment is negatively related to output
7. Shocks to aggregate demand and aggregate supply cause economic fluctuations.
Because the central bank can shift the aggregate demand curve, it can attempt to
offset these shocks to maintain output and employment at their natural levels %
active stabilization policy
 Peter C. May - 63 -

- Chapter 10: Aggregate Demand I: Building the IS-LM Model -

- According to the classical theory, Y depends on factor supplies and available technology
• BUT: both did not substantially change during the Great Depression
• HENCE: Keynes’ “General Theory” (1936) % new understanding of economic
fluctuations

- Keynes’ explanations
1) Low AD responsible for low Y and high unemployment
! criticizing classical theory for assuming that AS alone – capital, labour and
technology – determines Y
2) IS-LM model: Shows what causes income to change in the short-run when the
price level is fixed because all prices are sticky [OR what causes AD to shift, but
equivalent because SRAS horizontal]
! IS curve (Investment & Saving) % represents the goods market
equilibrium between Investment and Savings
! LM curve (Liquidity & Money) % represents the money market
equilibrium between demand for Liquidity and Money supply
! Interest rate = variable that links IS and LM (influences both
investment and money demand)

- IS-LM model assumes SRAS curve horizontal (prices fully sticky in SR)% IS-LM model
perfect representation of economy in the SR [takes the price level (P) as given/fixed]

10-1. THE GOODS MARKET AND THE IS CURVE

- IS curve: Plots the relationship between the interest rate and the level of income that
arises in the market for goods and services

The Keynesian Cross

- Keynesian Cross: A simple closed economy model in which income is determined by

expenditure (i.e. spending plans of households, businesses and government)

- Actual vs. planned expenditure:

a) Planned expenditure (E) % amounts households, firms and government
would like to spend on goods and services
b) Actual expenditure (Y) % amount households, firms and government end up
spending on goods and services ! GDP
! DIFFER because firms might engage in unplanned inventory investment
because their sales do not meet their expectations (if they sell less than
expected [Y>E], ) inventories, and vice versa)
- 64 - Peter C. May

a) Planned expenditure
E = C +I + G (where I = planned investment)
E = C(Y - T) + I + G (I exogenous, for now)
! Planned expenditure is a function of income!

!
PLANNED
EXPENDITURE, E
Why the slope of E equals the MPC:
E=C(Y#T
" )+I"+G
" - With I and G exogenous, the
only component of (C+I+G)
that changes when income
changes is consumption.
- A one-unit increase in income
Slope=MPC causes consumption - and
When Y=0:
(-MPC"T
" )+I"+G
") therefore E - to increase by the
MPC.

INCOME, OUTPUT, Y

b) The economy in equilibrium and actual expenditure

- Equilibrium condition:
Actual Expenditure = Planned Expenditure
Y = E
! People’s plans have been realized % no reason to change what they are doing
- HENCE: actual expenditure curve = 45° line through the origin
!

PLANNED
EXPENDITURE, E Y=E

E=C+I+G
A

Equilibrium value of income (Y*) at

point A, where Y=E!

45°
Y* INCOME, OUTPUT, Y

- Whenever the economy is not in equilibrium, firms experience unplanned changes in

inventories, and this induces them to change production levels ! change in total Y and
expenditure, moving the economy back towards equilibrium
 Peter C. May - 65 -

E
Y=E
Y1
E1 E=C+I+G
E* A

Unplanned inventory investment

E2 ! causes production/income to fall

Y2

Y2 Y* Y1 Y
Unplanned inventory disinvestment
! causes production/income to rise

- Movement towards equilibrium at point A

o If firms are producing at Y1, then planned expenditure falls short of production,
and firms accumulate inventories
! This inventory accumulation induces firms to decrease production
towards Y*
o If firms are producing at Y2, then planned expenditure exceeds production, and
firms run down their inventories
! This fall in inventories induces firms to increase production
! Firms’ decisions drive economy towards equilibrium

Fiscal policy and the Multiplier

1) Government purchases:
o )G % )Y=C(Y#T)+I+G % )C(Y#T) % )Y % )C …
o Government-purchases multiplier: The ‘multiplied’ change in national income
resulting from a one-unit change in government purchases

Important: This just the government-

"Y 1 purchase multiplier in the Keynesian
Government - purchases multiplier : = Cross analysis; in the IS-LM model,
"G 1- MPC the increase in income leads to an
increase in the interest rate, partially
o Derivation: crowding out investment ! the real
government-purchase multiplier is
! Y = C(Y - T) +I + G smaller than assumed here! [in IS-LM:
dY = C" # dY + dG 'Y='G+'C#'I]

dY 1 1
= =
dG 1- C" 1- MPC
$G # MPC $Y MPC 1
$Y = $G + $C = $G + % = 1+ =
1- MPC $G 1- MPC 1- MPC

!
- 66 - Peter C. May

E
Y=E
E2=C+I+G2 1. An increase in government
purchases shifts the
E2 planned expenditure curve
E1=C+I+G1
upwards by 'G
2 EX 2. At Y1, there is now an
unplanned drop in
E1 1 'G inventory (EX>Y1), so
firms increase output
3. Which increases
equilibrium income (Y1 %
Y2) by 'G/(1#MPC)
Y1 3 Y2 Y

'G/(1#MPC)

2) Taxes
o *T % )Y=C(Y#T)+I+G % )C(Y#T) % )Y % )C …
o Tax multiplier: The ‘multiplied’ change in national income resulting from a
one-unit change in taxes
Important: This just the tax
multiplier in the Keynesian Cross
"Y MPC analysis; in the IS-LM model, the
Tax multiplier : =#
"T 1- MPC increase in income leads to an
increase in the interest rate,
partially crowding out investment
o Derivation: ! the real tax multiplier is smaller
! Y = C(Y - T) +I + G than assumed here! [in IS-LM:
'Y='C#'I]
dY = C" # (dY - dT)
dY C" MPC
=$ =$
dG 1- C" 1- MPC
MPC # %T
%Y = %C = $
1- MPC

E
! Y=E
E2=C2+I+G 1. An tax cut shifts the
E2 planned expenditure
E1=C1+I+G curve upwards by
-'T"MPC
2. Which increases
E1 1 -'T"MPC equilibrium income
(Y1 % Y2) by
-'T"MPC /(1#MPC)

Y1 2 Y2 Y

-'T"MPC/(1#MPC)
 Peter C. May - 67 -

- Intuition behind expansionary government policy:

o Initially, the tax cut/increase in government expenditure increases consumption,
and therefore E
o At Y1, there is now an unplanned depletion of inventory because people are
buying more than firms are producing (E > Y)
o Hence, firms increase output, and income rises toward a new equilibrium Y2

- NOTE: Fiscal policy as a means by which to iron out the business cycle has largely
diminished since the 1980s
o Reasons:
! Time lags
! Effect on trade balance ()G % *S % *NX)
! Confusion caused by attempt of ‘fine-tuning’
o E.g. UK stop-go phenomenon: )G to boost AD % *NX % *G to reduce
trade deficit [no overall effect!]
o BUT: Keynes’ policy prescriptions were means not so much as means of fine-
tuning the economy, but as a means of shocking it out of deep recession

The Interest Rate, Investment and the IS Curve

- Addition to model: I=I(r)

o Since the real interest rate is the cost of borrowing to finance investment
projects, an increase in the interest rate reduces planned investment

E
Y=E
1. An increase in the real interest rate (r1 % r2)
2. Lowers planned investment E1 E1=C+I1+G
(I1 % I2)
3. Which shifts the planned expenditure curve
downwards E2=C+I2+G
4. And lowers income 3
5. The IS curve summarizes these changes in E2
the goods market equilibrium
! IS curve = combination of (Y, r) points that
bring about equilibrium in the goods market

Y2 4 Y1 Y
r r

r2 r2
5
1
r1 r1

I(r) IS

I2 2 I1 I Y2 Y1 Y
- 68 - Peter C. May

- The IS curve is negatively sloped

o Intuition:
! A fall in the interest rate motivates firms to increase investment
spending, which drives up total planned spending (E)
! To restore equilibrium in the goods market, output (e.g. actual
expenditure, Y) must increase

How Fiscal Policy Shifts the IS Curve

- Expansionary fiscal policy, e.g. )G

E r
Y=E
IS1 IS2
E2 E2=C+I+G2
3
E1=C+I+G1
1 'G "r
E1

Y1 2 Y2 Y Y1 Y2 Y
'G/(1#MPC)

1. An increase in G shifts planned expenditure upwards (E1 % E2)

2. Which raises income by 'G/(1#MPC)
3. And shifts the IS curve to the right by 'G/(1#MPC)
! At every real interest rate, there is a now a higher equilibrium level of income

Rule:
1) The IS curve shows the combinations of the interest rate and the level of income that
are consistent with equilibrium in the market for goods and services.
2) The IS curve is drawn for a given fiscal policy.
- Changes in fiscal policy that raise demand for goods and services shift the IS
curve to the right, and vice versa.

A Loanable-Funds Interpretation of the IS Curve

- National income accounts identity can be rewritten as:

Savings = Investment
Y - C(Y - T) - G = I(r)
Supply of loanable funds = Demand for loanable funds
! BUT: market for loanable funds (IS curve) + market for real money balances (LM curve)

!
 Peter C. May - 69 -

r S(Y1) S(Y2) r

1
3

r1 r1
2
r2 r2
I(r) IS

I, S Y1 Y2 Y

1. An increase in income raises savings [S(Y1) % S(Y2)]

2. Causing the interest rate to drop
3. The IS curve summarizes these changes

10-2. THE MONEY MARKET AND THE LM CURVE

- LM curve: Plots the relationship between the interest rate and the level of income that
arises in the market for money balances [combination of (Y, r) points that bring about
equilibrium in the money market]

Theory of Liquidity Preference

- Keynes (1936): Posits that the interest rate adjusts to balance the supply and demand for
the economy’s most liquid asset % money
o HENCE: Simple theory in which the interest rate is determined by money
supply and money demand

- Assume fixed supply of real money balances:

(M/P)S = M /P " M is fixed by CB, P fixed in the short - run

r Money Supply (M
" /P
")
!

Equilibrium interest rate

Money Demand, L(r)

M
" /P
" M/P
- 70 - Peter C. May

- Equilibrating process:
o If r > equilibrium: Money supply > money demand
! People want to convert more money into bonds
! *r
o If r < equilibrium: Money supply < money demand
! People want to sell more bonds, so need to offer higher interest rates
! )r

- Example:
o CB *M [monetary tightening]

1 1. A fall in the
r2 money supply
2. Raises the
equilibrium real
2
interest rate
r1
L(r, Y)

M2/P
" M1/P
" M/P

Note on monetary tightening:

- Short-run: Theory of Liquidity Preference ! *M % *(M/P) % )r % )i
- Long-run: Quantity Theory & Fisher Effect ! *M % *P & *(e % r shifts back
to initial level % but *(e so *i

Income, Money Demand and the LM Curve

- When income is high, people engage in more transactions that require the use of money
! )(M/P)d
- +
(M/P)d = L(r , Y )

- When )Y % )(M/P)d BUT M" /P

" % )r
!
o HENCE: upward sloping LM curve

Note:
Since the price level (P) is assumed to be constant, there is no inflation ((=0). HENCE,
there is no difference between the nominal and the real interest rate (i=r) ! Mankiw only
speaks of the ‘the’ interest rate [rather real than nominal interest rate]
 Peter C. May - 71 -

r r

3 LM

r2 r2
2
r1 r1
L(r, Y2)
1
L(r, Y1)

M
" /P
" M/P Y1 Y2 Y

1. An increase in income raises money demand

2. Increasing the interest rate
3. The LM curve summarizes these changes in the money market equilibrium

- The LM curve is positively sloped

o Intuition: Higher Y stimulates more demand for real money balances, which
needs restraining by lower ‘r’ for equilibrium
! An increase in income raises money demand
! Since the supply of real balances is fixed, there is now excess demand in
the money market at the initial interest rate
! The interest rate must rise to restore equilibrium in the money market

Rule:
1) The LM curve shows the combinations of the interest rate and the level of income that
are consistent with equilibrium in the market for real money balances
2) The LM curve is drawn for a given monetary policy [i.e. given supply of money balances]
- Decreases in the supply of real money balances shift the LM curve upward
- Increases in the supply of real money balances shift the LM curve downward

1. The CB reduces the money supply

How Monetary Policy Shifts the LM Curve 2. Raising the interest rate
3. And shifting the LM curve upwards

r r LM2
1
3 LM1
r2
r2
2
r1
r1

L(r, Y)

M2/P
" M1/P
" M/P Y
" Y
- 72 - Peter C. May

- Example: A wave of credit card fraud causes consumers to use cash more frequently in
transactions.
o This causes an increase in money demand
o In the Liquidity Preference diagram, the money demand curve shifts up
o Hence, at the initial value of income, the interest rate must rise to restore
equilibrium in the money market
o As a result, the LM curve shifts up: Each value of income (such as the initial
income) is associated with a higher interest rate than before

A Quantity-Equation Interpretation of the LM Curve

- Quantity Equation:
+
M " V(r ) = P " Y
o )r % ) cost of holding money % *(M/P)d % )V ! every unit of money has
to be used more often to support a given volume of transactions
! o HENCE: upward sloping LM curve
! Because an increase in the interest rate raises V, it raises Y for any given
level of P and M!

10-3. CONCLUSION: THE SHORT-RUN EQUILIBRIUM

- IS-LM model:
Y = C(Y - T) +I(r) + G (IS)
M/P = L(r, Y) (LM)

- Exogenous variables
! o Fiscal policy (G & T)
o Monetary policy (M)
o Price Level (P)

r
LM The short-run equilibrium is the
combination of Y&r that
simultaneously satisfies the
equilibrium conditions in the
goods & money market!
r*

IS

Y* Y
 Peter C. May - 73 -

The Theory of Short-Run Fluctuations

Keynesian Cross % IS curve

IS-LM model AD curve

Theory of Liquidity AD/AS model

Preference % LM curve

AS curve

SUMMARY:

1. Keynesian Cross:
a. Basic model of income determination
b. Takes fiscal policy & investment as exogenous
c. Shows that there is one level of national income at which actual
expenditure equals planned expenditure
d. Fiscal policy has a multiplied impact on income.
2. IS curve:
a. Comes from Keynesian Cross when planned investment depends
negatively on interest rate [I(r)]
b. A higher interest rate lowers planned investment, and this in turn lowers
national income % IS curve: downward sloping
c. Shows all combinations of r and Y that equate planned expenditure with
actual expenditure on goods and services
3. Theory of Liquidity Preference:
a. Basic model of interest rate determination
b. Takes money supply & price level as exogenous
c. Assumes that the interest rate adjusts to equilibrate the supply and
demand for real money balances
d. An increase in the money supply lowers the interest rate
4. LM curve:
a. Comes from Liquidity Preference Theory when money demand depends
positively on income
b. A higher level of income raises the demand for real money balances, and
this in turn raises the interest rate % LM curve: upward sloping
c. Shows all combinations of r and Y that equate demand for real money
balances with supply
5. The IS-LM model combines the elements of the Keynesian cross and the
elements of the theory of liquidity preference. The IS curve shows the points that
satisfy equilibrium in the goods market, and the LM curve shows the points that
satisfy equilibrium in the money market. The intersection of the IS and LM
curves shows the interest rate and income that satisfy equilibrium in both markets
for a given price level.
- 74 - Peter C. May

- Chapter 11: Aggregate Demand II: Applying the IS-LM Model -

11-1. EXPLAINING FLUCTUATIONS WITH THE IS-LM MODEL

Fiscal Policy

- Changes in G & T influence planned expenditure and thereby shift the IS curve
o E.g. )G by 'G

r
LM
1. The IS curve shifts to
the right by
r2 'G/(1#MPC)
3 2. Which raises income
r1 [by less than
'G/(1#MPC) IS2 'G/(1#MPC)]
3. And the interest rate
IS1
1

Y1 Y2 Y
2

- Mechanism:
o )G % ) Planned expenditure % )Y by 'G/(1-MPC) % )(M/P)d=L(r, Y) with
M
" /P
" % )r % *I which partially offsets the expansionary impact of )G

Rule: The increase in income through expansionary fiscal policy is smaller in the IS-LM
model than in the Keynesian Cross analysis ! small level of crowding out [BUT
crowding out not as big as in classical long-run model, where investment is reduced by
the exact amount of the expansionary fiscal policy]

- Change in taxes: same mechanism, except for the fact that the IS curve shifts to the right by
#'T"MPC/(1#MPC)
o HENCE: the effects on r and Y are smaller for a 'T than for an equal 'G!
o 'G financed by equal 'T has a positive impact on Y: 'Y='CG+'G-'CT='G

Monetary Policy

- Changes in M influence the real money supply and thereby shift the LM curve
o E.g. )M
 Peter C. May - 75 -

r LM1

LM2 1. An increase in the

1 money supply shifts
the LM curve
r1 downward
3 2. Which raises income
3. And lowers the
r2 interest rate

IS

Y1 Y2 Y
2

- Mechanism:
o )M % (M/P)S % ) buying of bonds/depositing at banks % *r (until people are
willing to hold all the extra money that CB has created) % ) planned I % )Y

- Monetary transmission mechanism: Process through which an expansion in the

money supply raises income and induces greater spending on goods and services

Rule: An increase in the money supply lowers the interest rate, which stimulates
investment and thereby expands the demand for goods and services

The Interaction between Monetary and Fiscal Policy

- Interdependence between monetary and fiscal policy:

o Example: Government )T ! leftward shift of the IS curve
1) CB holds M constant: *Y, *r
2) CB adjusts M to hold r constant: **Y, "r , *M
3) CB adjusts M & r to hold Y constant: Y
" , *M, **r

1) CB holds M constant
r
LM
2 1. A tax increase shifts
the IS curve to the left
r1 2. BUT because the
central bank holds the
r2 money supply
IS1 constant, the LM
curve stays the same
IS2
1

Y2 Y1 Y
- 76 - Peter C. May

2) CB holds interest rate constant

LM2
r
LM1
2 1. A tax increase shifts
the IS curve leftwards
"r 2. And to hold the
interest rate constant,
the central bank
IS1 contracts the money
supply
IS2
1

Y2 Y1 Y

2) CB holds income constant

r
LM1
LM2 1. A tax increase shifts
the IS curve leftwards
r1 2 2. And to hold income
constant, the central
bank expands the
IS1 money supply
r2
IS2
1

Y
" Y

Rule: The impact of a change in fiscal policy depends on the monetary policy the central
bank pursues – that is, on whether it holds M, r or Y constant [and vice versa]

Shocks in the IS-LM model

- IS shocks: Exogenous changes in the demand for goods and services

o Examples:
! Stock market boom or crash
! change in households’ wealth
! 'C
! Change in business or consumer confidence or expectations
! 'I and/or 'C
 Peter C. May - 77 -

- LM shocks: Exogenous changes in the demand for money

o Examples:
! A wave of credit card fraud increases demand for money
! More ATMs or the Internet reduce money demand

- BUT: impact on economy not inevitable % Policy makers can try to use the tools of
monetary and fiscal policy to offset exogenous shocks!

What is the CB’s Policy Instrument – the Money Supply or the Interest Rate?

- CB’s conduct of monetary policy

o Central bank will set an interest rate at which it is willing to lend to commercial
banks on a short-term basis (e.g. Repo rate in UK)
! Committee votes on a target for the policy rate that will apply until the
next meeting
! After the committee meeting, the CB’s bond traders are told to conduct
the open-market operations (OMOs) necessary to hit the target
! The OMOs change M and shift the LM curve so that the equilibrium
interest rate [determined by the intersection of the IS & LM curves]
equals the target interest rate

- Reasons for control of interest rate (r) instead of money supply (M):
1. Interest rate easier to measure than money supply
2. LM shocks are prevalent
! Targeting r automatically offsets LM shocks (although it exacerbates IS
shocks)

- Example: positive LM shock

r LM1/3

LM2 1. When the CB targets the

1 interest rate, then if LM
increases
"r 2 2. The CB’s OMOs ensure
that r and Y remain
constant [by buying
(r1)
Treasury bonds from the
public ! *M]
IS

Y1 Y
- 78 - Peter C. May

11-2. IS-LM AS A THEORY OF AGGREGATE DEMAND

- Deriving the AD curve with the IS-LM model

o Why not have expansionary fiscal and monetary policies to boost Y infinitely?
o To understand this ! move beyond the SR, sticky-prices IS-LM framework
o AD/AS model bridges the gap between the short and long run by yielding
equilibrium values of P and Y

LM2(P2)
r P
LM1(P1)
1
P2
r2 3

r1 P1

AD
IS

Y2 Y1 Y Y2 Y1 Y
2

1. An increase in the price level P shifts the LM curve upwards [by reducing (M/P)S]
2. Lowering income Y by raising the interest rate
3. The AD curve summarizes the inverse relationship between the price level P and
income Y

- Intuition for the negative slope of the AD curve:

o )P % *(M/P)S % LM curve shifts leftwards % )r % * planned I %*Y

What Causes the AD Curve to Shift?

Monetary expansion can increase AD: )M % LM shifts
a) Expansionary Monetary Policy right/down % *r % )I % )Y at each value of P

LM1
r P
LM2

r1
P
"
r2

AD2
IS AD1

Y1 Y2 Y Y1 Y2 Y
 Peter C. May - 79 -

b) Expansionary Fiscal Policy Fiscal expansion can increase AD (e.g. *T): )C % IS

shifts right % ) Y at each value of P

r LM P

r2

r1 P
"

IS2 AD2
IS1 AD1

Y1 Y2 Y Y1 Y2 Y

Rule:
1) A change in income in the IS-LM model resulting from a change in the price level
represents a movement along the AD curve.
2) A change in income in the IS-LM model for a given price level represents a shift in the
AD curve

The IS-LM Model in the Short-Run and Long-Run

- We can compare the short-run and long-run equilibria using either the IS-LM diagram
(a) or the AD-AS diagram b):

a) LRAS
b) LRAS
r LM(P1) P
LM(P2)

K K SRAS1
P1
C SRAS2
C P2

IS AD

Y1 Y
" Y Y1 Y
" Y

- In the short-run, the price level is stuck at P1 % Y1<Y " ! SR equilibrium: K [Keynesian]
- In the long-run, the price level adjusts to P2 so that the economy is at the natural level of
output Y" ! LR equilibrium C [Classical]
- 80 - Peter C. May

- We can think of the economy as being described by 3 equations:

1) Y = C(Y - T) +I(r) + G (IS)
2) M/P = L(r, Y) (LM)
rd
o 3 equation:
! Keynesians: 3) P = P1 % short-run
! ! Classical approach 3) Y = Y
" % long-run

The Short-Run and Long-Run Effects of an IS Shock

A) A negative IS shock shifts the IS and AD curves to the left, causing Y to fall

a) LRAS
b) LRAS
r LM P

SRAS
P1

IS1
AD1
IS2
AD2

YS Y
" Y YS Y
" Y

B) In the new short-run equilibrium, YS < Y"

C) Over time, P gradually falls, which causes:
a. SRAS to move down
b. M/P to increase, which causes LM to move down (*r % )I % )Y)

a) LRAS
b) LRAS
r LM1 P
LM2

SRAS1
P1

IS1 SRAS2
P2
AD1
IS2
AD2

YS Y
" Y YS Y
" Y

D) This process continues until economy reaches a long-run equilibrium with Y=Y
"
 Peter C. May - 81 -

11-3. THE GREAT DEPRESSION

1) The Spending Hypothesis: Shocks to the IS Curve

- Downward shift in consumption function caused by US stock market crash (*W & )
uncertainty)
- Large drop in investment in housing (excessive housing boom in 1920s & *
immigration)
- Bank failures exacerbated fall in investment () uncertainty & borrowing constraints)
- Contractionary fiscal policy to balance budget ()T & *G)

2.a) The Money Hypothesis: A Shock to the LM Curve

- *M by 25% between 1929 and 1933

- Friedman & Schwartz: Place primary blame on US central bank for allowing M to fall by
such a large amount, causing a contractionary shift of the LM curve

BUT:
- Real money balances actually rose slightly [fall in P was even greater than fall in M]
- Interest rate fell, not rose

2.b) The Money Hypothesis Again: The Effects of Falling Prices

- *P by 25% between 1929 and 1933

- Deflation turned what in 1931 was a typical economic downturn into the Great
Depression

The Stabilizing Effects of Deflation

- For any given level of M, a lower price level implies higher real money balances M/P %
outward shift of the LM curve % )Y
- Pigou effect: Falling prices expand income and thus consumption ! M/P part of
people’s wealth % as M/P rises due to deflation, )W % )C [outward shift of the IS
curve]

The Destabilizing Effect of Deflation

- 2 Theories to explain how falling prices could depress income rather than raise it:
1) Debt-Deflation Theory: Unexpected changes in the price level redistribute
wealth from debtors to creditors
! A fall in the price level raises the real amount of debt – the amount of
purchasing power the debtor must repay the creditor
! Since MPCdebtor>MPCcreditor ! decline in APC, so the redistribution of
wealth has a negative net effect on the IS curve and thus lowers Y
- 82 - Peter C. May

2) Expected deflation: Investment depends on the real interest rate, BUT money
demand on the nominal interest rate
! Extended IS-LM model to show how expected inflation can shift the AD
[assume SRAS horizontal and unaffected by (e]
1) Y = C(Y - T) +I(i - " e ) + G (IS)
2) M/P = L(i, Y) (LM)

i
! LM
(e Expected deflation: (e negative
r2 - Raises the real interest rate
for a given nominal interest
i1=r1 rate
- HENCE: )r % *I % *IS
i2 % *Y
IS1 - *NIR, )RIR
! RULE: changes in expected
IS2 inflation influence income (in IS-
LM model): if )(e % *r for any
given level of i % )I % )Y
Y2 Y1 Y

- HENCE: Both unexpected and expected deflation depress NY by causing a

contractionary shift in the IS curve
o Because a deflation of the size observed in the 1930s in the US is unlikely,
except in the presence of a major contraction of the money supply, these two
explanations give some of the responsibility for the Great Depression (especially
its severity) to the US central bank!

The Liquidity Trap

- If interest rate have fallen to, or close to 0, expansionary monetary policy becomes
ineffective
o The NIR cannot fall below 0 [economy might need r<0 to get out of recession]
! Rather than making a loan (depositing money at the bank) at negative
interest rate, a rational person would choose to hold cash
! AD, production and employment may be trapped at low levels [)M % "i %
no effect!]
o BUT:
1) )M could )(e % *r (negative) % )I
2) )M could *, % )NX

- Policy implication: Moderate inflation (~2%) gives monetary policy makers more room
to stimulate the economy ! real interest rate can fall to #2%
 Peter C. May - 83 -

Reasoning:
- Normally: )M % CB buys bonds from public with created money BUT people only
willing to hold )M when *r on bonds (substitute!) [or )M % )demand for bonds %
)P bonds % * yield on old bonds % *r on new bonds]
- The liquidity trap describes a situation in which expansionary monetary policy becomes
powerless
o The increase in money falls into a liquidity trap: People are willing to hold more money
(more liquidity) at the same nominal interest rate
o The central bank can increase “liquidity” but the additional money is willingly
held by financial investors at an unchanged interest rate, namely, 0
o Money and short-term interest bearing assets become perfectly substitutable:
increasing money supply has no effect % like pushing on a string

- As the nominal interest rate decreases to zero, once people have enough money for
transaction purposes, they are indifferent between holding money and holding bonds.
The demand for money becomes horizontal
o This is because when the nominal interest rate is equal to zero, further increases
in the money supply have no effect on the nominal interest rate

r M1/P
" M2/P
" M3/P
"

Once the interest rate is

L(r, Y) at 0, people are willing
to hold whatever level
of money available %
No effect on interest
rate!

r1

r2=r3=0
M/P

- Derivation of LM curve under liquidity trap

r L(r, Y2) r
L(r, Y1) L(r, Y3) LM

r3 r3

r2 r2

r1=0
M
" /P
" M/P Y1 Y2 Y3 Y
- 84 - Peter C. May

For low levels of output, the LM curve is a flat segment, with a nominal interest rate equal to zero.
For higher levels of output, it is upward sloping: An increase in income leads to an increase in the
nominal interest rate.

- In the presence of a liquidity trap, there is a limit to how much monetary policy can
increase output. Monetary policy may not be able to increase output back to its natural
level
o E.g. if CB increases the money supply:

i M2/P M4/P i
LM1 LM2 LM3 LM4
L(r, Y)
IS

i1

M1/P M3/P M/P Y1 Y2=Y3=Y4 Y

- In contrast, fiscal policy is more effective at increasing Y

i M1/P
"
LM

IS1 IS2

i1

M/P

- Example: Japanese economy since early 1990s:

o Policy recommendations for the Japanese economy include:
! Create inflation: More inflation is good because the real interest rate
would decrease, thereby stimulating spending and output [or increasing
(e, and thereby shifting the IS((e) curve to the right
! Quantitative easing: Buying unconventional range of assets (e.g.
commercial papers and corporate bonds) to increase liquidity
! Clean up the banking system: Too many bad firms continue to be
financed by the banks, thereby preventing the good firms from obtaining
financing at reasonable terms
 Peter C. May - 85 -

Why Another Great Depression is Unlikely

1. Policymakers (or their advisors) now know much more about macroeconomics
o The central banks know better than to let M fall so much, especially during a
contraction
o Fiscal policymakers know better than to raise taxes or cut spending during a
contraction
2. Federal deposit insurance makes widespread bank failures very unlikely
3. Automatic stabilizers make fiscal policy expansionary during an economic downturn
o Examples:
! Income tax: People pay less taxes [fall into lower tax brackets]
automatically if their income falls
! Unemployment insurance: Prevents income (and hence spending) from
falling as much during a downturn

11-4. APPENDIX: THE SIMPLE ALGEBRA OF THE IS-LM MODEL AND THE AD CURVE

The IS Curve

- National accounts identity:

Y = C(Y - T) +I(r) + G
o Assume consumption and investment functions are linear
! C(Y - T) = a + b"(Y - T)
! ! b = MPC
! I(r) = c - d"r
! d = sensitivity of investment to interest rate
o HENCE:
Y = a + b " (Y - T) + c - d " r + G
Solving for Y :
a +c 1 -b -d
Y= + "G+ "T+ "r
1- b 1- b 1- b 1- b

Verify conclusions:
!
1) IS curve downward sloping (Y = … + [(-d)/(1-b)]"r)
2) If investment sensitive to r [i.e. flat I(r) schedule] % )d % IS flat
3) If MPC is high % )b % IS flat
4) b=MPC also determines the impact of fiscal policy:
! If )b: 'G & 'T have a greater impact on Y () multiplier)
5)
- 86 - Peter C. May

The LM Curve

- Money market equilibrium:

M/P = L(r, Y)
o Assume linear money demand function
! L(r, Y) = e"Y - f"r = M/P
! ! e: sensitivity of M/P to Y
! f: sensitivity of M/P to r
o HENCE:
e 1
r = " Y # " M/P
f f

Verify conclusions:
!1) LM curve upward sloping (e/f positive)
2) (-1/f)"M/P: negative % if *M: LM curve shifts upward
3) If money demand is sensitive to changes in Y % )e % LM steep
4) If money demand not sensitive to interest rate % *f % LM steep

The AD Curve

- Determined by intersection of IS and LM curves:

a +c 1 -b -d $ e 1 '
Y= + "G+ "T+ " & " Y # " M/P)
1- b 1- b 1- b 1- b %f f (
f
let z = * 0< z<1
f + de/(1- b)
z(a + c) z -bz d
Y= + "G+ "T+ " M/P
1- b 1- b 1- b (1- b)(f + de/(1- b))

Verify conclusions:
! 1) Y depends on:
! Fiscal policy (G&T)
! Monetary policy (M)
! Price level (P)
2) AD slopes downwards: )P % *Y
3) )M % shifts AD to the right
4) )G or *T % shifts AD to the right
5) ‘z’ smaller than 1, so the fiscal policy multipliers are smaller than in the
Keynesian Cross analysis ! crowding out of investment
 Peter C. May - 87 -

- AD curve derived in Ch. 9 using Quantity Theory

o Special form of AD curve where interest rate does not affect AD [f=0 % z=0]
1
Y = " M/P (where 1/e = V)
e

The Effectiveness
! of Monetary and Fiscal Policy

- Whether fiscal OR monetary policy exerts a more powerful influence on AD depends

on the parameters of the IS and LM curves, especially ‘d’ and ‘f’ ! measure the
influence of the interest rate on investment and money demand
o Fiscal policy is powerful relative to monetary policy if MPC is large, investment
[steep IS curve] insensitive to r and demand for liquidity sensitive to r [flat LM
curve] % Fiscal expansion boosts demand a lot, while crowding out little
investment, and monetary expansion has little effect on demand – like pushing on
a string

A. Economists who believe that fiscal policy is more potent argue that ‘d’
[responsiveness of investment to the interest rate] is small % steep I(r) schedule
and steep IS curve
! Changes in LM (monetary policy, i.e. 'M) have little effect on Y
! BUT ‘z’ is large, so changes in G & T have a great impact on Y (large
fiscal policy multipliers)

B. Economists who believe that monetary policy is more potent than fiscal policy
argue that ‘f’ [responsiveness of money demand to the interest rate] is small %
steep L(r, Y) schedule and steep LM curve
! Changes in LM (monetary policy, i.e. 'M) have a large effect on Y
! BUT ‘z’ is small, so changes in G & T have little effect on Y (small fiscal
policy multipliers)

Slope of IS Curve Slope of LM Curve

1. Sensitivity of investment to interest rate 1. Sensitivity of money demand to interest rate

a) High sensitivity [steep I(r) schedule] a) High sensitivity [steep L(r, Y)
% IS steep schedule] % LM flat
b) Low sensitivity [flat I(r) schedule] b) Low sensitivity [flat L(r, Y) schedule]
% IS flat % LM steep

2. Marginal propensity to consume (MPC) 2. Sensitivity of money demand to Y

a) High MPC [steep ‘E’ schedule] a) High sensitivity
% IS flat % LM steep
b) Low MPC [flat ‘E’ schedule] b) Low sensitivity
% IS steep % LM flat
- 88 - Peter C. May

SUMMARY:

1. IS-LM model:
a. A general theory of aggregate demand
b. Exogenous variables: M, G, T; Endogenous variables: r
i. P exogenous in the short-run [sticky short-run prices], but
endogenous in the long-run
ii. Y endogenous in the short-run, but exogenous in the long-run
[natural level of output]
c. IS curve: negative relationship between the interest rate and the level of
income that arises from the goods market equilibrium
d. LM curve: positive relationship between the interest rate and the level of
income that arises from the money market equilibrium
e. Equilibrium: intersection of the IS and LM curves ! represents the
simultaneous equilibrium in the market for goods and services and in the
market for real money balances
2. AD curve:
a. Shows relationship between P and the IS-LM model’s equilibrium level of
income (Y) ! summarizes the results from the IS-LM model by showing
equilibrium income at any given price level
b. Negative slope because )P % *(M/P) % )r % *I % *Y
c. Expansionary fiscal policy shifts the IS curve to the right, increases the
interest rate (*I but smaller than )G or *T) and raises income, and shifts
the AD curve to the right
d. Expansionary monetary policy shifts the LM curve downward, lowers the
interest rate ()I) and raises income and shifts the AD curve to the right
e. IS or LM shocks shift the AD curve
 Peter C. May - 89 -

- Chapter 12: The Small Open Economy -

12-1. THE MUNDELL-FLEMING MODEL

- Key assumption:
o Small open economy with perfect capital mobility ! r=r*

The IS* Curve

- IS* curve: Goods market equilibrium in small open economy

+ - -
Y = C(Y - T ) +I(r ) + G + NX(e )

o Nominal exchange rate (e), expressed as the amount of foreign currency per unit
of domestic currency
! o Real exchange rate (,): Pd
"=e# f
P

o BUT: Mundell-Fleming model assumes that price levels at home (Pd) and abroad
(Pf) are fixed [short-run!] !
! ,-e
o Using the assumption of perfect capital mobility (r=r*)
+ - -
Y = C(Y - T ) +I(r *) + G + NX(e ) " IS * equation

E
Y=E
1. An increase in the exchange
! rate (e1 % e2) E1 E1
2. Lowers net exports by 'NX
'NX
(NX1 % NX2)
3. Which shifts the planned E2
expenditure curve downwards 3
4. And lowers income E2
5. The IS* curve summarizes this
relationship between the
exchange rate and income
()e % *NX % *Y
Y2 Y1 Y
e e 4

e2 r2
5
1
e1 r1

NX(e) IS*

2 'NX I Y2 Y1 Y
- 90 - Peter C. May

The LM* Curve

- LM* curve: Money market equilibrium in small open economy

M/P = L(r*, Y)

! LM* curve vertical in Y-e diagram because r* fixed at world interest rate ! given
this world interest rate, the LM* equation determines aggregate income, regardless
! of the exchange rate!

r
LM

r=r*
r*

LM*

Rule:
Both a shift in the LM curve (e.g. )M) and movement along the LM curve (shift of IS
curve) causes a movement of the LM* curve [only depicts LM relationship in regards to Y]

Equilibrium

- Equilibrium determined by intersection of IS* and LM* curves

Y = C(Y - T) +I(r*) + G + NX(e) (IS*)
M/P = L(r*, Y) (LM*)

!
 Peter C. May - 91 -

LM*

Equilibrium
exchange rate

IS*

Equilibrium Y
income

12-2. THE SMALL OPEN ECONOMY UNDER FLOATING EXCHANGE RATES

- Floating exchange rate system: Exchange rate is set by market forces (demand &
supply) and allowed to fluctuate in response to changing economic conditions

Impact of Fiscal Policy

- )G or *T [expansionary fiscal policy] % ) planned expenditure % shift of IS* curve to

the right % )e % Y constant (*NX by amount of increase in expenditure through )G
or *T)

e
LM*

Results:
1) 'e > 0
e2 2) 'Y = 0

e1

IS*2
IS*1

Y
" Y

- HENCE: fiscal policy has no effect on income under floating exchange rates because:
o When )G or *T % upward pressure on interest rate % ) foreign capital inflow
to take advantage of the interest rate difference () demand for economy’s
bonds) % ) foreign demand for currency in the foreign exchange market %
appreciation % *X & )M % *NX % fall in NX exactly offsets the effect of
the fiscal expansion
- 92 - Peter C. May

o How do we know that 'Y = 0?

! Because maintaining equilibrium in the money market requires that Y be
unchanged [all other variables are fixed, so Y cannot change]
M /P = L(r*, Y)
! Any change in income would throw the money market out of equilibrium
! HENCE: exchange rate has to rise until NX has fallen enough to
! perfectly offset the expansionary impact of the fiscal policy on output!
- Lessons about fiscal policy
o In a small open economy with perfect capital mobility, fiscal policy is utterly
incapable of affecting real GDP
o Crowding out
! Closed economy: Fiscal policy crowds out investment by causing the interest
rate to rise
! Small open economy: Fiscal policy crowds out net exports by causing the
exchange rate to appreciate

Impact of Monetary Policy

- )M % )(M/P) % LM* shifts to the right % *e, )NX & )Y

o Consumption rises in the process via the multiplier: 'Y='C+'NX

e LM*1 LM*2

Results:
1) 'e < 0
2) 'Y > 0
e1

e2

IS*

Y1 Y2 Y

- HENCE: expansionary monetary policy increases Y because:

o )M % downward pressure on the interest rate [in a closed economy, the interest
rate would fall] % savers send their loanable funds to the world financial market
% capital outflow % * demand for currency % depreciation % )X & *M %
)NX % )Y
o Monetary transmission mechanism somewhat different!
 Peter C. May - 93 -

- Intuition for the results

o At the initial (r*,Y), )M throws the money market out of equilibrium
o To restore equilibrium, either Y must rise or the interest rate must fall, or some
combination of the two
o In a small open economy, though, the interest rate cannot fall (r=r*)
o Thus, Y must rise to restore equilibrium in the money market

- Lessons about monetary policy:

o Monetary policy affects output by affecting one (or more) of the components of
AD
! Closed economy:)M % *r % )I % )Y
! Small open economy: )M % *e % )NX % )Y
o Expansionary monetary policy does not raise world aggregate demand, it shifts
demand from foreign to domestic products
! Thus, the increases in income and employment at home come at the
expense of losses abroad!

Impact of Trade Policy

- Suppose that the government reduces the demand for imported goods by imposing an
import quota or a tariff
o Since NX = X#M % if imports (M) * % )NX (shift to the right) % IS* curve
shifts to the right % )e & Y
"

a) b) LM*
e e

e2

3
1 2
e1
NX2
IS*2
NX1
IS*1

NX Y
" Y
4
1) A trade restriction shifts the NX curve outward
2) Which shifts the IS* curve outward
3) Increasing the exchange rate ()e)
4) And leaving income the same (Y ")

- HENCE: trade policy does not affect Y because:

- 94 - Peter C. May

o Trade policy % *M (imports) & )NX % shifts domestic residents’ demand

from foreign to domestic goods % * supply of currency in foreign exchange
market % )e (appreciation) % *NX [offsetting the import restriction’s initial
expansion of NX]

- How do we know that 'Y=0?

NX(e) = Y " C(Y " T) " I(r*) " G
o Since trade restrictions do not affect Y, C, I or G, NX cannot change
o Result: *M has to be offset by *X ! overall effect: less trade!
!
- Lessons about trade policy:
o Import restrictions cannot reduce a trade deficit
o Even though NX is unchanged, there is less trade:
! Trade restriction reduces imports
! Exchange rate appreciation reduces exports
! Less trade means fewer ‘gains from trade’
o Import restrictions on specific products save jobs in the domestic industries that
produce those products, but destroy jobs in export-producing sectors!
! Hence, import restrictions fail to increase total employment
! Worse yet, import restrictions create “sectoral shifts,” which cause
frictional unemployment.

12-3. THE SMALL OPEN ECONOMY UNDER A FIXED EXCHANGE RATE SYSTEM

- Fixed exchange rate system: Central bank announces a value for the exchange rate
and stands ready to buy and sell the domestic currency to keep the exchange rate at its
announced level
o HENCE: A fixed exchange rate system dedicates a country’s monetary policy to
the single goal of keeping the exchange rate at the announced level ! CB shifts
the LM* curve as required to keep ‘e’ at its pre-announced rate [M becomes
endogenous]

e LM*1 LM*2
If the equilibrium exchange
rate (e*1) exceeds the fixed
level, then arbitrageurs will
e*1 buy foreign currency and
sell it to the central bank at
profit % )M % )LM* %
efixed *e (until e*1=efixed)

IS*

Y1 Y2 Y
 Peter C. May - 95 -

- This system fixes the nominal exchange rate

o In the long run, when prices are flexible, the real exchange rate can move
even if the nominal rate is fixed!

Fiscal Policy

e 1. With a fixed exchange rate

LM*1 LM*2
system
3 2. A fiscal expansion shifts the IS*
curve to the right
3. To counter the upward pressure
on the exchange rate, the central
1 efixed bank sells domestic currency in
the foreign exchange market
()M), which induces a shift in
2 the LM* curve
IS*2 4. And raises income ()Y)
IS*1

Y1 Y2 Y
4
Monetary Policy

- Normal type of monetary policy ineffective:

o If CB )M % e* falls below efixed % arbitrageurs can buy domestic currency at e*
and sell it to the central bank for foreign currency at efixed % *M

e 1) )M % downward pressure on
LM*1 LM*2 exchange rate % to prevent it from
falling, CB buys domestic currency to
“prop up” its value % removes
domestic currency from circulation %
*M % LM* curve shifts back.
efixed 2) To keep efixed, CB must use monetary
policy to shift LM* as required so that
the intersection of LM* and IS* always
occurs at efixed % unless the IS* curve
shifts right, the CB cannot increase the
IS* money supply.

Y1/3 Y2 Y

- HOWEVER: CB can conduct another type of monetary policy

o It can decide to change the level at which the exchange rate is fixed
! Devaluation: *e % shifting LM* to the right [like )M]
! Revaluation: )e % shifting LM* to the left [like *M]
- 96 - Peter C. May

Trade Policy

- Quota or tariff: )NX by decreasing imports % )IS* (rightward shift) % upward

pressure on exchange rate % )M by CB: selling domestic currency in the foreign
exchange rate market % )LM* (rightward shift) until e*=efixed

e 1. With a fixed exchange rate

LM*1 LM*2
system
3 2. A trade restriction shifts the IS*
curve to the right
3. To counter the upward pressure
on the exchange rate, the central
1 efixed bank sells domestic currency in
the foreign exchange market
()M), which induces a shift in
2 the LM* curve
IS*2 4. And raises income ()Y)
IS*1

Y1 Y2 Y
4

- BUT: these gains come at the expense of other countries, as the policy merely shifts
demand from foreign to domestic goods

The Mundell-Fleming Model: A Summary of Policy Effects

Floating ER Fixed ER
Policy Y e NX Y e NX
1) Fiscal expansion 0 ) * ) 0 0
2) Monetary expansion ) * ) 0 0 0
3) Import restrictions 0 ) 0 ) 0 )

12-4. INTEREST-RATE DIFFERENTIALS

Country Risk & Exchange-Rate Expectations

- 2 reasons why r may differ from r* (r+r*)

1) Country risk: If a country is more likely to default on its debt, it has to offer
higher interest rates in return
2) Expected changes in exchange rate: If the exchange rate is likely to fall, the
interest rate has to be higher to compensate for expected reduction in value
through the depreciation
 Peter C. May - 97 -

Differentials in the Mundell-Fleming Model

Interest rate = World interest rate + Risk premium

r = r* + "

- Implications for IS*-LM* (MF) model:

! Y = C(Y - T) +I(r * +") + G + NX(e) (IS*)
M/P = L(r * +", Y) (LM*)

- Effects of an increase in the risk premium (.)

o E.g. caused by political turmoil, expectations of depreciation
!
e LM*1 LM*2
1. When an increase in the risk
e1 2 premium . drives up the
interest rate, the IS* curve
shifts to the left (*I)
2. And the LM* curve shifts to
3
the right [). % )i % *(M/P)d
but M" /P" % )Y to re-
equilibrate money market!]
1
IS*1 3. Resulting in a depreciation of
e2
IS*2 the exchange rate (*e)

- Intuition:
o If prospective lenders expect the country’s currency to depreciation, or if they
perceive that the country’s assets are especially risky, then they will demand that
borrowers in that country pay them a higher interest rate (above r*)
o The higher interest rate reduces investment and shifts the IS* curve to the left.
o BUT it also lowers money demand, so income must rise to restore money
market equilibrium
o Why does the exchange rate fall?
! The increase in the risk premium causes foreign investors to sell some of
their holdings of domestic assets and pull their ‘loanable funds’ out of
the country
! The capital outflow causes an increase in the supply of domestic
currency in the foreign exchange market, which causes the fall in the
exchange rate
! Or, in simpler terms, an increase in country risk or an expected
depreciation makes holding the country’s currency less desirable!

- Important implication:
o Expectations about the exchange rate are partially self-fulfilling
! If investors expect a depreciation (*ee) % ). % *e
- 98 - Peter C. May

Rule: The expectation that a currency will lose value in the future
causes it to lose value today!

- MF analysis above predicts that ). causes )Y

o )NX (*e) greater than *I ()r)
o BUT unlikely:
1) CB wants to avoid the large depreciation ! *M % *Y
2) Depreciation cause increase in PM and thus )P % *(M/P)S % *Y
3) If )., )(M/P)d not * because money=safest asset!
! All 3 changes would tend to shift the LM* curve to the left, which mitigates
*e & )Y

12-5. SHOULD EXCHANGE RATES BE FLOATING OR FIXED?

Pros and Cons of Different Exchange-Rate Systems

Pro Floating ER Pro Fixed ER

1) Allows monetary policy to be used for
other purposes, such as stabilizing
prices, employment and output
1) Avoids volatility and uncertainty
making international
transactions/trade easier
2) Disciplines a nation’s monetary
authority and prevents excessive
growth of the money supply &
hyperinflation

- In real world, we rarely observe exchange rate systems that are completely fixed/floating
o Instead, under both systems, stability of the exchange rate is usually one among
many of the central bank’s objectives!

Speculative Attacks, Currency Boards, ‘Dollarization’ and ‘Euroization’

- If ER is fixed, there exists one problem:

o The country can run out of foreign currency and thus has no choice but to
abandon the fixed ER and let the currency depreciate!
o Raises possibility of speculative attacks
! A change in investor’s perceptions that makes the fixed ER unattainable [e.g.
Black Wednesday, 1992]
o To avoid speculative attacks, countries can set up a currency board
! Arrangement by which the central bank holds enough foreign currency to back each
unit of domestic currency ! CB can never run out, domestic currency is
backed one-for-one with foreign currency
 Peter C. May - 99 -

! BUT: once a country has established a currency board, the next natural
step is to abandon its currency altogether for a foreign currency
- ‘Dollarization’/’Euroization’ % Foreign country adopts $ or !
(unilaterally or bilaterally) as its domestic currency!

The Policy Trilemma

- Policy Trilemma: Impossible trinity % It is possible for a nation to have free capital
flows, a fixed exchange rate and independent monetary policy
o 3 options
1) OPTION 1: To allow free flows of capital and conduct independent
monetary policy BUT fixed exchange rate impossible [e.g. UK, US,
Eurozone]
2) OPTION 2: To allow free flows of capital and have a fixed exchange
rate BUT loss of ability to run an independent monetary policy [e.g.
Hong Kong]
3) OPTION 3: Restrict flows of capital, so have independent monetary
policy and still a fixed exchange rate [e.g. China]

Free capital
flows

Option 2 Option 1
(e.g. UK) (e.g. Hong Kong)

Independent monetary Option 3 Fixed exchange

policy (e.g. China) rate

12-6. FROM THE SHORT-RUN TO THE LONG-RUN: AD CURVE IN THE MF MODEL

- If P changes, the nominal and real exchange rates will no longer move in tandem
o BUT: NX depends on the real exchange rate, not the nominal exchange rate!
! NX(,), not NX(e)!
o HENCE: New MF IS*-LM* model:
Y = C(Y - T) +I(r*) + G + NX(") (IS*)
M/P = L(r*, Y) (LM*)

!
- 100 - Peter C. May

,
LM*(P1) LM*(P2)

,1

2
,2 1. A fall in the price level
(*P) shifts LM* to the
IS*
right [by increasing the
real money supply]
Y1 Y2 Y 2. Which lowers the real
exchange rate
P 3. And raises income ()Y)
4. The AD curve
summarizes this inverse
relationship between P
&Y
P1
4

P2

AD

Y1 Y2 Y

- HENCE: *P % )(M/P) % LM* curve shifts to the left % *, % )NX % )Y

- Comparing the short-run and long-run equilibria using either the IS*-LM* diagram (a)
or the AD-AS diagram b):

a) LM*(P1) LM*(P2) b) LRAS

, P

K K SRAS1
P1
C SRAS2
C P2

IS* AD

Y1 Y
" Y Y
" Y

- Short-run: The price level is stuck at P1 % Y1<Y " ! SR equilibrium: K [Keynesian]

- Long-run: The price level adjusts (in this case: downwards) % )(M/P)S % *, % )NX
% )Y % Y=Y " ! C [Classical]
 Peter C. May - 101 -

SUMMARY:

1. Mundell-Fleming model:
a. IS-LM model for a small open economy
b. Takes the price level (P) as given
c. Can show how policies and shocks affect income and the exchange rate
2. Fiscal policy in small open economy:
a. Fiscal expansion under floating exchange rate system: )G % )IS* % * net
supply of domestic currency in FX market & upward pressure on ‘r’ %
)e % *NX % Y " (initial expansionary impact is offset)
b. Fiscal expansion under fixed exchange rate system: )G % )IS* % * net
supply of domestic currency in FX market & upward pressure on ‘r’ %
upward pressure on ‘e’ % )M by CB % e=efixed & )Y
! Fiscal policy affects income under fixed exchange rates, but not under
floating exchange rates!
3. Monetary policy in small open economy:
a. Monetary expansion under floating exchange rate system: )M % )LM* % )
supply of domestic currency % *e % )NX % )Y
b. Monetary expansion under fixed exchange rate system: )M % )LM* %
downward pressure on ‘e’ % *M by CB % e=efixed & Y "
! Monetary policy affects income under floating exchange rates, but not under
fixed exchange rates!
4. Interest rate differentials (r=r*+.):
a. Exist if investors require a risk premium to hold a country’s assets
i. Causes: political turmoil, expected depreciation
b. An increase in this risk premium raises domestic interest rates and causes
the country’s exchange rate to depreciate [self-fulfilling prophecy: if
investors expect *e % ). % *I & *(M/P)d % *IS & )LM % )) net
supply of currency in FX market % *e!
5. Fixed vs. floating exchange rates:
a. Under floating rates, monetary policy is available for can purposes other
than maintaining exchange rate stability
b. Fixed exchange rates reduce some of the uncertainty in international
transactions & disciplines the national monetary authority
c. Policy trilemma: Policy makers are constrained by the fact that it is
impossible to have free capital flows, a fixed exchange rate and
independent monetary policy (only 2 of the 3!)
Note: If no perfect capital flows % r can deviate from r*
- 102 - Peter C. May

- Chapter 13: Aggregate Supply and the Phillips Curve -

Aggregate supply in different time frames:

- Long-run: Prices are flexible % Prices have no influence on Y % AS curve is vertical at Y
"
o Shifts in AD affect the price level BUT the output of the economy remains at its
natural level
- Short-run: Prices are sticky % AS is not vertical and Y may deviate from Y
"
o Shifts in AD do cause fluctuations in output

13-1. THREE MODELS OF AGGREGATE SUPPLY

- 3 models of aggregate supply

1) Sticky-price model
2) Sticky-wage model
3) Imperfect-information model

- In all 3 models of aggregate supply, some market imperfections cause output to deviate
from its natural level
o Final destination

SRAS : Y = Y + "(P - Pe ), where " > 0

o Meaning: Output deviates from its natural level (Y

" ) when the price level deviates
from the expected price level
!
! If P=Pe % Y=Y "
e
! If P<P % Y<Y " % recession!
e
! If P>P % Y>Y " % boom!
o $ % Parameter which indicates how much output responds to unexpected
changes in the price level
! 1/$ ! slope of the AS curve!

Model 1: Sticky-Price Model

- Emphasizes that firms do not instantly adjust prices to changes in demand

o Causes for sticky prices:
! Long-term contracts between firms and customers
! Menu costs
! Firms do not want to annoy customers with frequent price changes
[would cause confusion]

- Assumes that firms are price-makers, not price-takers

o HENCE: assumes no perfect competition, but rather monopolistic competition!
 Peter C. May - 103 -

- A firm’s desired price (p) depends on 2 macroeconomic variables:

1) Overall price level (P): )P % ) costs % )p
2) Level of aggregate income (Y): )Y % ) demand % )MC % )p
! p = P + a(Y - Y), where a > 0 [if Y>Y
" % )P]

- Further assume 2 types of firms:

a) Firms with flexible prices % set prices continuously according to formula
!
[fraction of total number of firms: (1-s)]
% p = P + a(Y - Y)
b) Firms with sticky prices % announce prices in advance, based on what they
expect economic conditions to be [fraction of total number of firms: s]
! % p = Pe + a(Ye - Y) ! Demand part relevant because )SRMC

- For simplicity, we assume that type b) firms expect the economy to be at its natural level
e
of output
! % (Y - Y " )=0 ! p=Pe
o HENCE:
P = sPe +(1- s) " [P + a(Y - Y)]
sP = sPe +(1- s) " [a(Y - Y)]
P = Pe + [(1- s) " (a/s)] " (Y - Y)
(1) (2)

o Implications:

! 1. High Pe % High P
! When firms expect a high price level, they expect high costs
! Those firms that fix prices in advance (type b) set their prices high
! This causes other firms to set also high prices
! HENCE: )Pe % )P
2. High Y % High P
! When output is high, the demand for goods is high ()MC)
! Those firms with flexible prices set their prices high % )P
! The overall effect of output on prices depends on the proportion of
firms with flexible prices [if )(1-s), )slope of SRAS]
! HENCE: )Y % )P

o Algebraic rearrangements
Y = Y + "(P - Pe ), where " = s/(1- s)a

- Sticky-price model assumes a procyclical real wage [in contrast to sticky-wage model]
o! If aggregate output/income falls % firms see a fall in demand for their products
o Firms with sticky prices reduce production, and hence reduce their demand for
labour [firms with flexible prices not; adjust prices]
o The leftward shift in labor demand causes the real wage to fall
- 104 - Peter C. May

- Conclusion of sticky-price model:

o The deviation of output from its natural level is positively associated with the deviation of the
price level from the expected price level!

Model 2: The Sticky-Wage Model

- Emphasizes sluggish adjustment of nominal wages because

o Wages are set by long-term contracts
o Implicit agreements between workers & firms may limit wage changes
o Wages depend on social norms and notions of fairness
! )P % *(W/P) % )QLD % )Y

- Assumptions:

1. Workers & firms bargain and agree on the nominal wage before they know what the
price level will be when the agreement takes effect
o HENCE:
(Bargained) Nominal wage = Target real wage " Expected price level
W = # " Pe
o Solving for the real wage (important for QLD):

! Pe
W/P = " #
P

o Implication: Real wage deviates from its target if the actual price level deviates
! its target
from
! If P > Pe % (W/P) < / ! )QLD [Real wage is less than its target, so
firms hire more workers and output rises above its natural rate]
! If P < Pe % (W/P) > / ! *QLD [Real wage exceeds its target, so firms
hire fewer workers and output falls below its natural rate]
! If P = Pe % (W/P) = / ! no change in QLD [Unemployment and
output are at their natural rates]

2. Employment is determined only by the quantity of labour that firms demand

o Firms’ hiring decision:
L = Ld (W/P)
Y = F(L) " diminishing marginal productivity
o If the nominal wage is fixed (predetermined by bargaining), then increases in the
price level cause the real wage to fall, which causes firms to hire more workers
! and produce more output!
 Peter C. May - 105 -

W/P Y

Y=F(L)

Y2
W/P1
4
2 Y1
W/P2

L=Ld(W/P)

L1 L2 L L1 L2 L
3 P 3
SRAS:
Y=Y
" +$(P#Pe)
1. An increase in the price level
()P) P2
2. Reduces the real wage for a 1
given nominal wage P1
3. Which raises employment
4. Which in turn increases
output
5. And income ()Y) IS*

Y1 Y2 Y
5

- Intuition behind upward sloping SRAS:

o Because the nominal wage is sticky, an unexpected change in the price level
moves the real wage away from the target real wage, and this change in the real
wage influences the amount of labour hired and output produced
! Y=Y " +$(P#Pe)

- Sticky-wage analysis implies that the real wage should be countercyclical:

o Real wage should fluctuate in the opposite direction from employment and
output
! Booms: Price level (P) typically rises % real wage should fall
[)P % *(W/P)]
! Recessions: Price level (P) typically falls % real wage should rise
[*P % )(W/P)]
o BUT: This prediction does not come true in the real world
! Data shows real wage to be slightly procyclical
! Possible reason: QlD curve shifts over the business cycle due to
technological shocks!
- 106 - Peter C. May

Model 3: The Imperfect-Information Model

- Unlike models 1 & 2, the imperfect-information model assumes that markets clear
o All wages and prices are free to adjust to balance supply and demand
o BUT: SRAS and LRAS differ because of temporary misperceptions about
prices

- Assumptions:
o Each supplier in economy produces a single good and consumes many goods
o Because number of goods is large, suppliers cannot observe all prices at all times
o Because of imperfect information, they sometimes confuse changes in the
overall price level with changes in relative prices

- Derivation of model:
o Supply of each good depends on its relative price: the nominal price of the good
divided by the overall price level
o Suppliers do not know the ‘overall’ price level at the time she makes her
production decision, so uses the expected price level Pe
o If P rises but Pe does not rise as much
! Suppliers guesses (imperfect information) that there is a 50% chance of
" and 50% chance of )P % on average, he expects only a small increase
P
in P
- Supplier thinks her relative price has risen % produces more
[)P % *Y]
- With many producers thinking this way, Y will rise whenever P
rises above Pe

- Example: Wheat producer

o Since farmer’s income depends on PW and he uses his income to buy goods and
services at price level P
! If )(PW/P) % Motivated to work hard and produce more wheat because
the reward is great
! If *(PW/P) % Farmer prefers to enjoy more leisure and produce less
wheat
o BUT: farmer has more knowledge about PW (single good) than P (many goods)
! When )P and )PW there exist 2 possibilities
a) Farmer estimated )P & )PW, so his estimate of relative prices is
unchanged
b) Farmer did not expect )P & )PW
- Because of imperfect information, he only observes )PW
- Unsure about P [Case 1: )P or Case 2: P" ?]
- On average (50% probabilities on each case), he only expects a
small increase in P
- )(PW/P) % Increase production
 Peter C. May - 107 -

- HENCE: When the price level rises unexpectedly, all suppliers in the economy observe
increases in the prices of the goods they produce
o They all infer, rationally, but mistakenly, that the relative prices of the goods they
produce have rise ! ) production
o P>Pe % Y>Y "
! Y=Y " +$(P#Pe)

CASE STUDY: International Differences in AS

- When Lucas proposed the imperfect-information model, he derived a surprising

interaction between AD & AS
o The slope of the AS curve should depend on the volatility of AD
! If AD fluctuates widely, the aggregate price level fluctuates widely as well
[whereas Y fluctuates little] % suppliers have learned not to respond
much to unexpected price changes ! SRAS steep ($ small)
! If AD is relatively stable, suppliers should have learned that most price
changes are relative price changes % suppliers should be more
responsive to unexpected price changes ! SRAS flat ($ large)
o HENCE: ) volatility of AD % ) steepness of SRAS
- The sticky-price model also makes predictions about the SRAS
o Slope depends on the average rate of inflation
! When ) inflation % ) costs of keeping prices fixed for a long period of
time % ) frequency of price changes & *s (fraction of sticky-price
firms) % overall price level responds more quickly to changes in AD !
SRAS steep ($ small)
o HENCE: ) average rate of inflation % ) steepness of SRAS

Summary & Implications

- All 3 models explain why SRAS slopes upwards

o Note: the models are not incompatible with another!
- Summarized by equation:
o Y=Y " +$(P#Pe)

Rule:
1) If the price level is higher than the expected price level (P>Pe), output exceeds its natural
level (Y>Y")
2) If the price level is lower than the expected price level, output falls short of its natural
level (Y<Y")
- 108 - Peter C. May

P LRAS
SRAS:
Y=Y
" +$(P#Pe)
P>Pe Output deviates from its
natural level Y
" if the price
level P deviates from the
P=Pe expected price level Pe!

P<Pe

Y
" Y

- Exogenous variables that will shift the SRAS curve

o Pe % changes in the expected price level
o Y" % changes in the natural rate of output

- Bow-shaped SRAS curve?

o At low levels of output, there are lots of unutilized and under-utilized resources
available, so it is not very costly for firms to increase output
! Therefore, firms do not require a big increase in prices to make them
willing to increase output by a given amount [increase in MC is small]
o In contrast, at very high levels of output, when unemployment is below the
natural rate and capital is being used at higher than normal intensity levels, it is
relatively costly for firms to increase output further
! Hence, a larger increase in prices is required to make firms willing to
increase their output [increase in MC is big]

How Shifts in AD Lead to Short-Run Fluctuations

- Suppose a positive AD shock moves output above its natural rate and P above the
level people had expected
The economy begins in a long-run
equilibrium at A.
LRAS SRAS2 1. An unexpected positive AD
shock causes the actual price
SRAS1 level to exceed the expected
price level in the short-run
P3=Pe3 C (P2>Pe2)
3 2. As a result, output rises
P2 B temporarily above Y " (point B)
1
3. In the long-run, Pe adjusts and
P1=Pe1=Pe2 A AD2 rises from Pe1 to Pe3, causing
the SRAS to shift upwards
Hence, the economy moves
AD1 towards a new long-run equilibrium
at A % Y " BUT )P
Y1=Y
" =Y3 Y2 Y

2
 Peter C. May - 109 -

- Example:
o )M (unexpected) % )AD % )P % P2>Pe2 % )Y (Y2>Y
" ) % LR: )Pe3 %
Pe3>P2 % *Y (Y3=Y
" ) & Pe3=P3

Rule: In the long-run, when prices and expected prices are flexible, the economy adjusts
automatically back to the natural rate of output
! Long-run money neutrality & short-run non-neutrality are perfectly compatible

13-2. INFLATION, UNEMPLOYMENT & THE PHILLIPS CURVE

- 2 goals of economic policy makers:

o Low inflation
o Low unemployment
! Trade-off? [When )M % )AD % * unemployment BUT ) inflation in SR]

- Phillips curve: Negative relationship between unemployment and inflation ! As policy

makers move the economy along the upward sloping SRAS curve, unemployment and
inflation move in opposite directions
o Phillips curve = reflection of the SRAS!
o Historical Phillips curve (1958): negative relationship between unemployment
and the rate of wage inflation [observed in UK]

Deriving the Phillips Curve from the SRAS Curve

- Expectations-Augmented Phillips Curve states that inflation depends on 3 forces:

1) Expected inflation ! (e [)(e % )Pe % )P % )(]

2) Cyclical unemployment (deviation of unemployment from its natural rate) !

#0(u#un) [)CU % * pressure on wages % *(]

3) Supply shocks (exogenous events, such as a change in world oil prices, that
alter the price level and the shift the SRAS curve) ! v [)v % )P % )(]

Inflation = Expected Inflation - " # Cyclical Unemployment + Supply Shocks

$ = $e - " # (u - u n ) + v

- Okun’s Law: Negative relationship between unemployment and real GDP

!
o A decrease in unemployment of 1 percentage point is associated with additional
growth in real GDP of approximately 2 percent
- 110 - Peter C. May

1) Y = Y + "(P - Pe )
2) P = Pe +(1/")(Y - Y)
3) Add supply shocks (v) : P = Pe +(1/")(Y - Y) + v
4) Subtract last year's price level P-1 from both sides : P - P-1 = Pe - P-1 +(1/")(Y - Y) + v
5) # = # e +(1/")(Y - Y) + v
6) Okun's Law : (1/")(Y - Y) = -$(u - u n )
7) # = # e - $(u - u n ) + v

- HENCE: Phillips curve equation & SRAS represent essentially the same macroeconomic ideas
! o In particular, both show a link between real & nominal variables which causes
the classical dichotomy to break down in the short-run
! SRAS curve: Output is related to unexpected movements in the price
level ! more convenient to study relationship between unemployment
& inflation (unexpected)
! Phillips curve: Unemployment is related to unexpected movements in the
inflation rate ! more convenient to study relationship between output
& inflation (unexpected)
o Why would supply/unemployment respond to surprise inflation? % sticky-wage,
sticky-price and imperfect information models, which imply Y=Y " +$(P#Pe)

Adaptive Expectations & Inflation Inertia

- Adaptive expectations: An approach that assumes people form their expectations of

future inflation based on recently observed inflation
o A simple example: Expected inflation = last year’s actual inflation

" e = " #1 or: " e = (1# $)[" #1 + $" #2 + $2" #3 ...]

o Implication for Phillips curve:

! " = " #1 - $ % (u - u n ) + v
!
o In this form of the PC
! Natural rate of unemployment = NAIRU (non-accelerating inflation rate
! of unemployment) % trying to hold unemployment below un leads to
increasing inflationary pressures (should be NIIRU)

- The term (-1 implies that inflation has inertia

o Like an object in space it keeps going unless something acts to stop it
! In the absence of supply shocks or cyclical unemployment, inflation will
continue indefinitely at its current rate % inflation is constant
[unemployment at NAIRU]
 Peter C. May - 111 -

! Past inflation influences expectations of current inflation, which in turn

influences the wages & prices that people set
! Solow (1970s): “Perhaps it is simply that we have inflation because we
expect inflation, and we expect inflation because we’ve had it”

o In AD/AS model: Both AD & AS are persistently shifting upwards

! AS: depends on (e, which depends on (-1 % constantly shifting by (-1
! AD: persistent growth in money supply to make up for inflation
- BUT: if CB holds M constant % upward shift in AS causes
recession % ) u % *( % *(e % inflation inertia subsides!

Two Causes of Rising & Falling Inflation

1) Demand-pull inflation: Inflation resulting from demand shocks % positive shocks
to AD cause unemployment to fall below its natural rate, pulling inflation rate up
! if *u % *(u#un) % *#0( u#un) % )(

2) Cost-push inflation: Inflation resulting from supply shocks % adverse supply

shocks raise production costs & induce firms to raise prices, pushing inflation up
! if exogenous supply shock (e.g. ) oil prices) % )v [only one-off] % )(
- Higher expected inflation also leads to inflationary pressure [% importance of anti-
inflationary credibility]

The Short-Run Trade-Off between Inflation & Unemployment

- Expected inflation & supply shocks are beyond the policy maker’s immediate control
o BUT: policy-makers can alter AD to influence unemployment & inflation
! In the short-run, inflation & unemployment are negatively related: At
any point in time, a policy maker who controls AD can choose a
combination of inflation & unemployment on the SRPC

Important: In the Phillips curve analysis, the “short run” is the period until
people adjust their expectations of inflation!

Slope: #0

In the short-run,
(e+v policymakers face a trade-
off between inflation &
unemployment

SRPC

un U
- 112 - Peter C. May

- The position of the SRPC depends mainly on expected inflation (e

o If )(e % SPRC shifts outward % trade-off becomes less favourable: ( is higher
for any level of unemployment

SRPC2: High expected inflation

SRPC1: Low expected inflation

un U

- People adjust their expectations of inflation over time (in long-run!) % trade-off
between inflation & unemployment holds only in the short-run
o Policy makers cannot keep inflation above expected inflation forever [in LR:
(=(e] % ‘u’ cannot be kept below ‘un’ in the long-run
o Eventually, expectations adapt to whatever ( the policy maker has chosen
o In the LR, the classical dichotomy holds, unemployment returns to its natural
level and there is no trade-off between ( & u

LRPC
(
A: The initial LR
B equilibrium
(1=(e2=(2 C B: Policy maker tries to
push u below un % (1>(e1
C: BUT in LR expectations
adapt to high (, shifting
(e1 A the SRPC upwards
SRPC2
! LRPC vertical at un
SRPC1

u1 un U

- Impact of an increase in the natural rate of unemployment:

o At any given value of actual unemployment, an increase in the natural rate
implies (or acts like) a decrease in cyclical unemployment
o Increases inflation by increasing upward wage pressures ! Each value of ‘u’ has
a higher value of inflation associated with it than before [)SRPC]
 Peter C. May - 113 -

- Impact of an adverse supply shock:

o )v (e.g. ) oil prices) % upward shift of SRPC % when ‘v’ diminishes, we would
expect downward shift of SRPC, BUT: (>(e % )(e % SRPC remains at higher
level!

(e1+v=(e2

SRPC2=SRPC3
(e1

SRPC1

un U

Disinflation & the Sacrifice Ratio

- Before deciding whether to reduce (, policy makers must know how much output
would be lost during the transition to lower (
o This cost can then be compared with the benefits of lower (

- Sacrifice ratio: Percentage of a year’s real GDP that must be foregone to reduce ( by 1
percentage points ! with sluggish adaptive expectations getting inflation down is costly
in terms of unemployment and output
o Estimates vary between 2 & 10, but a typical one is 5
o Sacrifice ratio can also be expressed in terms of unemployment:
! An increase of 1 percentage point in unemployment translates into a 0.7
percentage point fall in output
! HENCE: if sacrifice-ratio=2: *( by 1pp requires *Y by 2pp, BUT )u
by 3pp (cyclical unemployment)

- Cold-turkey solution to inflation: Rapid disinflation, associated with a few years of

high unemployment and low Y
o Generally regarded as better than slow disinflation!

Rational Expectations & the Possibility of Painless Disinflation

- Alternative to adaptive expectations:

o Rational expectations: People optimally use all the available information (incl.
current & future/planned government policies) to forecast the future
! Inflation expectations are key: Attempts to exploit an imagined trade-off will lead
to spiralling inflation
- 114 - Peter C. May

o Example illustrating the difference between adaptive and rational expectations:

! Suppose the Fed announces a shift in priorities, from maintaining low
inflation to maintaining low unemployment without regard to inflation;
this shift will start affecting policy next week.
! If expectations are adaptive, then expected inflation will not change,
because it is based on past inflation. The Fed’s announcement pertains
to the future, and has no impact on past inflation.
! If expectations are rational, then expected inflation will increase right
away, as people factor this announcement into their forecasts.

- Assuming rational expectations:

o Monetary and fiscal policy influence (; HENCE: (e should also depend on
monetary and fiscal policy!
! If people form their expectations rationally, then ( may have less inertia
than it first appears
! T. Sargent : “It is actually the long-term government policy of
persistently running large deficits & creating money at high rates which
imparts the momentum to the inflation rate”
- HENCE: Stopping inflation would require a change in the
policy regime: there must be an abrupt change in the continuing
government policy, or strategy, for setting deficits now and in the
future that is sufficiently binding as to be widely believed

- According to the theory of rational expectations, traditional estimates of the sacrifice-

ratio are not useful for evaluating the impact of alternative policies [too high]
o Inflation can come down without a rise in unemployment & fall in Y, but simply
by reducing (e
o Under a credible policy (*(e), the costs of reducing ( may be much lower than
the sacrifice-ratio suggests
! Suppose u=un and (=(e=6% & Fed announces that it will do whatever is
necessary to reduce inflation from 6 to 2% as soon as possible
! If the announcement is credible, then (e will fall, perhaps by the full 4
percentage points
! Then, ( can fall without an increase in u

- Painless disinflation: 2 requirements

1. Plan to reduce ( must be announced before workers & firms who set wages &
prices have formed their expectations
2. Workers & firms must believe the announcement (credibility) to have an effect
on (e
! If both criteria are met: SRPC shifts downwards as *(e % lower ( for any level of u

- Note: CBs that are politically independent are typically more credible than those that are
controlled by the government (if CB not independent: ) sacrifice ratio)
 Peter C. May - 115 -

Hysteresis & the Challenge to the Natural-Rate Hypothesis

- Our analysis of the costs of disinflation, and of economic fluctuations in the preceding
chapters, is based on the natural-rate hypothesis
o Changes in aggregate demand affect output and employment
only in the short run
o In the long run, the economy returns to the levels of output, employment and
unemployment described by the classical model [classical dichotomy]

- BUT: AD may affect output & employment even in the LR

o Hysteresis: Long-lasting influence of history on variables such as the natural
rate of unemployment % Recessions might leave long-term scars on the
economy
! Workers might lose valuable skills while unemployed
! Long-lasting unemployment might change an individual’s attitude
towards work (*f)
! Unemployed become outsiders in the wage-setting process, so fewer
insiders push W/P up, which decreases the probability of outsiders to
find a new job ! ) structural unemployment
o HENCE: hysteresis % ) cost of recession & ) sacrifice ratio
- 116 - Peter C. May

SUMMARY:

1. 3 models of aggregate supply in the short run:

a. Sticky-price model % sticky factor: some prices
b. Sticky-wage model % sticky factor: nominal wages
c. Imperfect-information model
All three models imply that output rises above its natural rate when the price level
rises above the expected price level [Y>Y " when P>Pe] & output falls below its
natural level when the price level is less than the expected price level [Y<Y
" when
e
P<P ] ! SRAS upward sloping
2. Phillips curve
a. Derived from the SRAS curve
b. States that inflation depends on
i. Expected inflation
ii. Cyclical unemployment
iii. Supply shocks
c. Presents policymakers with a short-run tradeoff between inflation and
unemployment
3. How people form expectations of inflation
a. Adaptive expectations
i. Based on recently observed inflation
ii. Implies inflation inertia & high sacrifice ratios
b. Rational expectations
i. Based on all available information
ii. Implies that disinflation may be painless
4. The natural rate hypothesis and hysteresis
a. The natural rate hypotheses: states that changes in AD can only affect
output and employment in the short run
b. Hysteresis: states that AD can have permanent effects on output and
employment [not only SR]
 Peter C. May - 117 -

- Chapter 14: Stabilization Policy -

Government policy response to business cycle depends on view on stability of economy

1. Some economists (e.g. Keynes) view the economy as inherently unstable

a. Economy experiences frequent shocks to AD and AS
b. Unless policy makers use monetary and fiscal policy to stabilize the economy
(fine-tuning), these shocks will lead to unnecessary & inefficient fluctuations in
output, unemployment and inflation

2. Other economists (e.g. Friedman) view the economy as naturally stable

a. Blame bad economic policies for the large and inefficient fluctuations we have
sometimes experienced
b. Economic policy should not try to fine-tune the economy

! 2 questions:
1) Should policy be active or passive?
2) Should policy be conducted by rule or by discretion?

14-1. SHOULD POLICY BE ACTIVE OR PASSIVE?

- Growth of real GDP has been very volatile ! Should policymakers attempt to smooth
out these fluctuations by using fiscal and monetary policy to alter aggregate demand?

o Advocates for activist policy believe that policymakers should use the fiscal and
monetary policy tools at their disposal to try to reduce the length and severity of
recessions, or prevent them if possible
! Recessions cause economic hardship for millions of people
• During a recession, many people lose their jobs (the average for
a US recession is 2.3 million)
! IS-LM and AD/AS model show
• How shocks to the economy can cause recessions
• That monetary and fiscal policy can exert a powerful impact on
AD, and thereby, on inflation and unemployment
! Wasteful not to use these policy instruments to stabilize the economy!

o BUT other economists are critical of the government’s attempt to stabilize the
economy because of
1) Lags in the implementation and effects of policies
2) Difficulty of economic forecasting
3) Ignorance, expectations and the Lucas critique
- 118 - Peter C. May

1) Lags in the Implementation and Effects of Policies

- Economic stabilization would be easy if the effects of policy were immediate

o Like driving a car
o BUT: rather like piloting a large ship " lag between implementation and effect

- 2 types of active policy lags:

1) Inside lag: Time between a shock to the economy and the policy action
responding to that shock
a. Takes time to recognize shock
b. Takes time to implement policy, especially fiscal policy
• Fiscal policy (change in government spending and/or taxes)
requires an act of Congress " Process by which a bill becomes a
law is lengthy & often fraught with political difficulty!

2) Outside lag: Time between a policy action and its influence on the economy

- Destabilizing effect of active government policy with lags:

The economy begins in a long-
run equilibrium at A.
LRAS 1. Unexpected negative AD
P AD1/3 shock causes actual price
SRAS1 SRAS2 level to fall below expected
AD2 price level in SR " Y falls
1 2 temporarily below Y ! (pt. B)
A 2. However, in the longer-run,
Pe falls causing SRAS to shift
B C downwards ! self-correction
3. Yet, government’s activist
3 policy of increasing AD only
works with a lag, now
shifting AD back to AD1
4. As a result, the economy is in
Y2 Y1=Y
! Y2 Y disequilibrium again, as
Y2>Y ! (pt. C)
4

Rule: If the active policy lags are large, so that economic conditions change (self-correct)
before policy’s impact is felt, then policy may end up destabilizing the economy!

- Automatic stabilizers: Policies that stimulate or depress the economy when necessary
without any deliberate policy change
o Designed to reduce the lags associated with stabilization policy ! no inside lag!
o Examples:
! Income tax [if #Y " # marginal tax rate " # average tax rate " $#Y
smaller than without income tax]
! Unemployment insurance [if %Y " # unemployment " normally !C
causing further !Y BUT with UI: no %C " $%Y smaller]
 Peter C. May - 119 -

2) The Difficult Job of Economic Forecasting

- Because policies act with lags, policymakers must predict future conditions
o Ways to generate forecasts:

1) Leading economic indicators: Data series that fluctuate in advance of

the economy
Composition of US Leading Economic Indicators (LEI) Index
1) Average weekly hours, manufacturing (0.2549)
2) Average weekly initial claims for unemployment insurance (0.0307)
3) Manufacturers' new orders, consumer goods and materials (0.0774)
4) Index of supplier deliveries – vendor performance (0.0677)
5) Manufacturers' new orders, non-defence capital goods (0.0180)
6) Building permits, new private housing units 0(.0270)
7) Stock prices, S&P500 common stocks (0.0390)
8) Money supply, M2 (0.3580)
9) Interest rate spread, 10-year Treasury bonds less federal funds (0.0991)
10) Index of consumer expectations (0.0282)

2) Macroeconometric models: Large-scale models with estimated

parameters that can be used to forecast the response of endogenous
variables to shocks and policies

o BUT: forecasts are often not accurate, which opponents of activist policy
emphasize
! Without accurate forecasts, policies that act with uncertain lags may end
up destabilizing the economy

Note: Opponents of activist policy argue that in the presence of policy lags, active policy will be
destabilizing if one cannot perfectly predict the future. Since it is impossible to perfectly forecast
the future path of the economy [’black swans’], they therefore argue that active policy is always
destabilizing!

3) Ignorance, Expectations and the Lucas Critique

- Lucas: Expectations of the future play a crucial role in the economy because they
influence all sorts of behaviour (e.g. consumption, investment etc.)
o Expectations depends on many variables, but especially important are the
policies being pursued by the government
o Lucas critique: Traditional methods of policy evaluation (e.g. standard
macroeconometric models) do not adequately take into account the impact of
policy on expectations
- 120 - Peter C. May

- Forecasting the effects of policy changes has often been done using models estimated
with historical data
o Lucas pointed out that such predictions would not be valid if the policy change
alters expectations in a way that changes the fundamental relationships between
variables

- Example 1:
o Prediction (based on past experience): an increase in the money growth rate will
reduce unemployment
o BUT: Lucas critique points out that increasing the money growth rate may raise
expected inflation, in which case unemployment would not necessarily fall
! An increase in money growth and inflation only reduces unemployment
if expected inflation remains unchanged
! Perhaps that was the case in the past
! But now, if the money growth increase causes people to raise their
expectations of inflation, then unemployment won’t fall

- Example 2:
o Traditional estimates of sacrifice ratio (cost of reducing inflation) are very large
[e.g. 5% GDP has to be foregone to reduce inflation by 1 percentage point]
! Result: Economists argued that policy makers should learn to live with
inflation, rather than incur the large cost of reducing it
o BUT: Lucas critique points that these estimates are based on adaptive
expectations
! However, advocates of rational expectations (e.g. Lucas) argue that if
policy makers make a credible change in policy, workers and firms
setting wages and prices will rationally respond by adjusting their
expectations of inflation appropriately
! As a result, reducing inflation can potentially be much less costly than is
suggested by traditional estimates of the sacrifice ratio

The Historical Record

- Looking at recent history does not clearly answer whether government policy should be
active or passive
o Hard to identify shocks in the data
o Hard to tell how things would have been different had actual policies not been
used
 Peter C. May - 121 -

CASE STUDY: The Remarkable Stability of the Modern Economy

- 1990s and early 2000s stand out as a period of remarkable stability for the advanced
economies of the UK, Continental Europe and the US

o 3 possible reasons
1) Structural change: Economies are becoming more service-based and
less manufacturing-based than they were in the past, and service
industries are less volatile than manufacturing industries
2) Good luck: Lack of adverse supply shocks etc.
3) Good policy: Better macroeconomic management by governments and
the monetary authorities of the world’s major economies since the early
1990s [! BUT current financial crisis caused by too lenient monetary
policy?]

14-2. SHOULD POLICY BE CONDUCTED BY RULE OR BY DISCRETION?

- 2 ways of conducting policy

1. Policy conducted by rule:
Policymakers announce in advance how policy will respond in various situations,
and commit themselves to following through (e.g. inflation targeting)
2. Policy conducted by discretion:
As events occur and circumstances change, policymakers use their judgement
and apply whatever policies seem appropriate at the time (e.g fiscal stimulus
packages)

- Policy can still be passive or active

o Passive policy by rule: Steady growth in the money supply of 3% per year
o Active policy by rule: Money growth = 2% + (Unemployment rate – 5%)

Arguments against Discretionary Policy

- Disadvantages of discretionary policy (as argued by advocates of policy by rule):

1) Distrust of policymakers and the political process
a. Misinformed politicians
b. Politicians’ interests sometimes not the same as the interests of society
c. Political process is erratic
d. Political business cycle ! manipulation of economy for electoral gains
- 122 - Peter C. May

2) Time inconsistency of discretionary policy

a. Scenario in which policymakers have an incentive to renege on a
previously announced policy once others have acted on that
announcement
i. Example 1: CB: announces low inflation as paramount goal " %&e
" better Phillips curve trade-off " CB tempted to #M to %u "
households and firms discount announced policies of low inflation
ii. Example 2: To encourage investment, government announces it
won’t tax income from capital " BUT once the factories are built,
the government reneges in order to raise more tax revenue
b. HENCE: rational agents understand the incentive for the policy maker to
renege, and this expectation affects their behaviour
c. Destroys policymakers’ credibility, thereby reducing effectiveness of their
policies [Solution: policy by rule!]

Alternative: Monetary Policy by Rule

- 4 possibilities of conducting monetary policy by rule

I. Constant money supply growth rate

! Advocated by monetarists (Friedman)
! BUT stabilizes AD only if velocity is stable!

II. Targeting nominal GDP

! Automatic increase in money growth whenever nominal GDP grows
slower than targeted [to stimulate AD]
! Decrease money growth when nominal GDP growth exceeds target [to
dampen AD]

III. Inflation targeting

! Automatically reduce money growth whenever inflation rises above the
target rate [to dampen AD and reduce inflationary pressures]; vice versa
! Many countries’ central banks now practice inflation targeting, but allow
themselves a little discretion

IV. Taylor Rule (can be a complement, or tool of, inflation targeting)

! Target short-term real interest rate (NIR – inflation) based on
• Inflation rate
• GDP gap: Percentage by which GDP is below its level of full
employment " [(Y ! 'Y)/Y ! ](100% ! if Y>Y ! , GDP gap -ve

Taylor Rule :
Nominal Official Interest Rate = Inflation + 2.0 + 0.5(Inflation - 2.0) - 0.5(GDP gap)
Real Official Interest Rate = 2.0 + 0.5(Inflation - 2.0) - 0.5(GDP gap)

!
 Peter C. May - 123 -

- Explanation of Taylor rule:

o If & = 2 and output is at its natural rate, then monetary policy targets the real
Fed Funds rate at 2% (and the nominal rate at 4%)
o For each one-point increase in &, monetary policy is automatically tightened to
raise the real Fed Funds rate by 0.5pp [nominal by 1.5pp]
o For each one percentage point that GDP falls below its natural rate, monetary
policy automatically eases to reduce the Fed Funds Rate by 0.5pp

14-3. INFLATION TARGETING: RULE OR CONSTRAINED DISCRETION?

- Inflation targeting: Involves setting a target for inflation (e.g. 2%) and changing
interest rates from time to time in order to achieve that target
o Not appropriate to change interest rates in response to current inflation (already
too late to change current prices)
o BUT: based on forecasts of inflation (e.g. 18 months)

- Inflation targeting is not a total pre-commitment to a policy rule

o Central bankers are left with a fair amount of discretion
! No explicit formula that dictates interest rates
! If easily identified supply shocks, inflation allowed to deviate from target

- BUT: inflation targeting enables public to judge more easily whether the central bank is
meeting its objectives
o # transparency of monetary policy
o Makes central bankers more accountable for their actions
o HENCE: inflation targeting = framework for constrained discretion on the
part of the central bank

The Taylor Rule and Inflation Targeting

- Inflation targeting offers a plan for the central bank in the medium run, but it does not
tightly constrain its month-to-month policy decisions
o Taylor rule may be a good short-run operating procedure for hitting a medium-
run inflation target
o BUT: inflation targeting depends on setting interest rates according to forecasts of
inflation ! forward-looking Taylor rule

Forward - looking Taylor Rule :

NIR = Current Inflation + 2.0 + 0.5(Medium - Term Inflation Forecast " Inflation Target)- 0.5(GDP gap)
RIR = 2.0 + 0.5(Medium - Term Inflation Forecast " Inflation Target)- 0.5(GDP gap)

! According to the forward-looking Taylor rule, CB should raise short-term real interest rate if
! inflation is forecast to exceed its target over the medium term
- 124 - Peter C. May

- Studies on CBs: find a non-zero weight attached to output gap in the estimated forward-
looking Taylor rule, even where the CB in question is explicitly pursuing inflation
targeting
o CB does to some extent take into account the effect of its interest rate decisions
on the output gap and employment, even though its primary objective is to
maintain low and stable inflation

14-4. CENTRAL BANK INDEPENDENCE

- A policy rule announced by Central Bank will work only if the announcement is credible
o Credibility depends in part on degree of independence of central bank

- Studies: Higher average inflation in countries whose central banks are less independent,
as monetary policy could be used for political purposes (i.e., lowering unemployment
prior to elections)
o More independent central banks are strongly associated with lower and more stable inflation
o No relationship between central bank independence and real economic activity

Rule: Central bank independence seems to offer countries a free lunch " it has the benefit
of lower inflation without any apparent cost [# credibility " % sacrifice ratio]

14-5. INFLATION TARGETING AND CENTRAL BANK INDEPENDENCE

- In recent years, a number of countries have given their central banks greater
independence in the setting of interest rates, as well as instructing them to pursue and
explicit policy of inflation targeting

1) European Central Bank (ECB)

a. Objective & instrument independent
b. Officially created on 1 June 1998 due to creation of " [if a group of
countries has the same currency, then the countries in the group must have a
common monetary policy]
c. Monetary policy set monthly by Governing Council
d. Formally, ECB follows a ‘two-pillar strategy’ of monetary policy
i. Monitoring the growth rate of the money supply
ii. Maintaining stable inflation over the medium term " less than, but
close to 2%

2) Bank of England (BoE)

a. Independent since 1997
b. Monetary Policy Committee (MPC) sets interest rates monthly
 Peter C. May - 125 -

c. Unlike the ECB, however, the BoE does not have the freedom to define for
itself precisely what ‘price stability’ means ! only instrument independence

3) US Federal Reserve Bank (Fed)

a. Created in 1914
b. Monetary policy is made by the Federal Open Market Committee (FOMC)
every 6 weeks
c. Fed has so far not adopted an explicit policy of inflation targeting (although
some commentators have suggested that it is, implicitly, targeting inflation at
about 2%)

14-6. APPENDIX: TIME INCONSISTENCY AND THE INFLATION-UNEMPLOYMENT TRADE-OFF

- Phillips Curve:
o u = un ' )((" ' "e)
o Unemployment is low when inflation exceeds expected inflation, and high when
inflation falls below expected inflation
o Parameter ) determines how much unemployment responds to surprise
inflation

- Loss function:
o CB likes low unemployment and low inflation
o Cost of unemployment & inflation, as perceived by the CB can be represented
as:

L(u, ") = u + #"2

o CB's objective is to make the loss as small as possible

!

1) Policy under a fixed rule:

- Commits the CB to a particular level of inflation
- As long as private agents understand that the CB is committed to this rule, the expected
inflation will be the level the CB is committed to:
o "e="
o u=un
- Optimal rule:
o Because unemployment is at its natural rate regardless of the level of inflation,
the optimal fixed rule requires that the CB produce 0 inflation
o Result: !=0, u=un
- 126 - Peter C. May

2) Discretionary monetary policy

- Economy works as follows:
a) Private agents form their expectations of inflation " "e
b) CB chooses the actual level of inflation " "
c) Based on expected & actual inflation, ‘u’ is determined by u = un ' )((" ' "e)
- CB tries to minimize its loss L(u, "), subject to the constraint that the PC imposes
min L(u, ") = u + #" 2 subject to u = u n - $(" - " e )
"

L(u, ") = u n - $(" - " e ) + #"2

dL
= -$ + 2#" = 0
d"
% " = $ /(2#) > 0

- Whatever the level of inflation private agents expected, )/(2*) is the optimal level of
! inflation for the CB to choose
o Of course, rational private agents understand the objective of the CB and the
constraint that the PC imposes
o They therefore expect that the CB will choose this level of inflation
o Result: !=!e=)/(2*)>0, u=un

Comparing Monetary Policy by Rule and by Discretion

- In both cases, unemployment is at its natural rate

- Yet, discretionary policy produces more inflation than does policy under the rule
o HENCE: optimal discretion is worse than the optimal rule

- Reasoning:
o CB is playing a game against private decision makers who have rational
expectations ! unless it is committed to a fixed rule of 0 inflation, the CB
cannot get private agents to expect 0 inflation
! Suppose that the CB simply announces that it follows a 0 inflation policy
! Such an announcement by itself cannot be credible: After private agents
have formed their expectations of inflation, the CB has the incentive to
renege on its announcement in order to decrease unemployment
[optimal policy is to set inflation to "=)/(2*)]
! Private agents understand the incentive to renege and therefore do not
believe the announcement in the first place
o BUT if the CB dislikes inflation much more than it dislikes unemployment (so
that * is very large, inflation under discretion is near 0, because the CB has little
incentive to inflate
! HENCE: Alternative to imposing a fixed rule " appointing central
bankers with fervent distaste for inflation
 Peter C. May - 127 -

SUMMARY:

1. Advocates of active policy believe:

a. Frequent shocks lead to unnecessary fluctuations in output and
employment
b. Fiscal and monetary policy can stabilize the economy
2. Advocates of passive policy believe:
a. The long & variable lags associated with monetary (outside) and fiscal
(inside & outside) policy render them ineffective and possibly destabilizing
b. Present understanding of the economy is too limited to be useful in
formulating successful stabilization policy [Lucas: effect of expectations]
c. Inept policy increases volatility in output, employment
3. Advocates of discretionary policy believe:
a. Discretion gives more flexibility to policymakers in responding to various
unforeseen situations
4. Advocates of policy rules believe:
a. The political process cannot be trusted: politicians make policy mistakes
or use policy for their own interests
b. Commitment to a fixed policy is necessary to avoid time inconsistency
and maintain credibility
5. Inflation targeting:
a. Adopted since the late 1980s by many of the world’s central banks
b. Involves setting a target for inflation and changing interest rates from
time to time (according to inflation forecasts/expectations) in order to
achieve that target over the medium term of 1 or 2 years
- 128 - Peter C. May

- Chapter 15: Government Debt -

Debt = Accumulation of past borrowing

- In general: Borrowing ! when expenditure > income
o When a government spends more than it collects in taxes, it runs a budget
deficit, which it finances by borrowing from the private sector
o Accumulation of past borrowing = government debt (also known as public debt
or national debt)
o BUT: because the government debt represents the debt of the whole economy,
and since an economy in some sense lives for ever and never retires, there is no
reason why it should ever have to pay off its debts entirely

2 opposing views on government debt:

1) Traditional view of government debt: Government borrowing reduces national
saving & crowds out capital accumulation in the long-run
2) Ricardian equivalence: Government debt does not influence national saving and
capital accumulation
! Debate arises from disagreement over how consumers respond to the government’s
debt policy

15-1. THE SIZE OF THE GOVERNMENT DEBT

- 2005 figures for government debt as % of GDP:

o Japan: ~180%
o Germany: 67.7%
o US: ~60%
o UK: 42.6% [2003 " £420bn]
o Luxembourg: 6.2%

- Historically, the primary cause of increases in government debt is war

o Deficit financing of wars appears optimal for reasons of both tax smoothing and
inter-generational equity
o Demographic changes " will worsen budgetary positions in the next 50 years

15-2. PROBLEMS IN MEASUREMENT

- Government budget deficit = government spending – government revenue !

amount of new debt the government needs to issue to finance its operation
o BUT: 4 problems with the usual measure of the budget deficit
1) Inflation
2) Capital assets
3) Uncounted liabilities
4) Business cycle
 Peter C. May - 129 -

Measurement Problem 1: Inflation

- Almost all economists agree that the government’s indebtedness should be measured in
real terms, not in nominal terms
o Measured deficit should equal the change in the government’s real debt, not the
change in its nominal debt

- To see why inflation is a problem, suppose the real debt is constant, which implies a
zero real deficit
o In this case, the nominal debt (D) grows at the rate of inflation:
"D/D = #
"D = #D
o The reported deficit (nominal) is &D even though the real deficit is zero
o Hence, one should subtract &D from the reported deficit to correct for inflation
- Same
! argument in another way:
o Expenditure should include the real interest paid on the debt (rD), not the
nominal interest paid (iD)
o Difference between nominal and real interest payments: iD ' rD = &D

- Correcting the deficit for inflation can make a huge difference, especially when inflation
is high
o Example: US in 1979
! Nominal deficit = $28bn
! Inflation = 8.6%
! Debt = $495bn
! &D = 0.086 ( $495bn = $43bn
! Real deficit = $28bn ' $43bn = $15bn surplus
! surprise inflation can erode the real debt burden

Measurement Problem 2: Capital Assets

- Currently: deficit = change in debt " does not take into account government’s assets
and liabilities
o Better: Capital budgeting
! Deficit = (change in debt) ' (change in assets)

- Example: Suppose government sells an office building and uses the proceeds to pay
down the debt
o Under current system, deficit would fall
o Under capital budgeting, deficit unchanged, because fall in debt is offset by a fall
in assets

- Problem with capital budgeting: Determining which government expenditures count as

capital expenditures (e.g. motorway, teachers/human capital) as well as their value
- 130 - Peter C. May

Measurement Problem 3: Uncounted Liabilities

- Measured budget deficit is misleading because it excludes some important government

liabilities
o Future pension payments owed to current government workers
o Future social security payments [in pay-as-you-go pension]
! BUT: government could always choose not repay all of its liabilities

Measurement Problem 4: The Business Cycle

- The deficit varies over the business cycle due to automatic stabilizers
o When economy in recession:
! # Unemployment insurance
! % Income tax revenue

- These are not measurement errors, but do make it harder to judge & monitor fiscal
policy stance
o Is an observed increase in deficit due to a downturn or expansionary shift in
fiscal policy?

- Possible solution: Cyclically adjusted budget deficit ! full-employment deficit

o Based on estimates of what government spending & revenues would be if
economy were at the natural rates of output & unemployment

Rule: Measurement problems of the budget deficit & national indebtedness – including
inflation, capital assets, uncounted liabilities and the business cycle – mean that we must exercise
care when interpreting the reported deficit figures!

15-3. THE TRADITIONAL VIEW OF GOVERNMENT DEBT

- Accepted by most mainstream economists

Traditional view of impact of #G or %T (unaccompanied by #T or %G respectively)

1. SHORT-RUN: #Y & %u (probably also#")
2. LONG-RUN: Y & u back at their natural rates
a. Closed economy: #r & %I [crowding out of investment]
b. Open economy: #+ & %NX [crowding out of net exports]
3. VERY LONG-RUN: Slower growth until economy reaches new steady state with
lower income per capita (due to % national saving and thus % investment)
 Peter C. May - 131 -

- HENCE:
o Current generations would benefit from higher consumption and higher
employment, although inflation would likely to be higher as well
o Future generations would bear much of the burden of today’s budget deficits:
they would be born into a nation with a smaller capital stock and a larger foreign
debt

Note on taxes & incentives: Throughout the book, Mankiw assumes that ‘T’ is a lump-sum
payment. However, in practice, taxes are levied on some type of economic activity
- Result: taxes affect incentives (e.g. when people are taxed on labour earnings, they have
less incentive to work hard)
- Supply-side economists: Incentive effects of taxes are large!
o HENCE: Tax cuts can be self-financing " % tax rate " # incentives " #AS
" #Y " # total tax revenue [Laffer curve]

CASE-STUDY: The Laffer Curve and Supply-Side Economics

- Laffer curve: Traces out the relationship between the average rate of income tax in the
economy and the amount of income tax revenue raised by the government
o Suggests that, while increasing income tax rates may increase tax revenue at first,
there comes a point where tax rates are so high that people’s incentive to work is
severely diminished " tax revenue falls as tax rates fall further

- Reasoning:
o At an income tax rate of either 0 or 100%, income tax revenue must be zero (at
0% there is no tax at all, and at 100% there is no incentive whatsoever to work)!
o Raising the tax rate slightly above 0% clearly raises tax revenue from 0 to a
positive amount, so that the slope of the Laffer curve must initially be positive.

Total income
tax revenue At some point between 0% and
100% total tax revenue must
achieve a maximum and the slope
become negative: the disincentive
to work as a result of higher
income tax rates means that
people work a lot less and so the
total amount of income tax paid
begins to fall

0% 100% Income
tax rate

- BUT: Economists have found it hard to trace any strong incentive effects of these tax
cuts leading to increases in total tax revenue, as the Laffer curve would suggest
o Sensitivity of labour supply to the wage rate too low
- 132 - Peter C. May

15-4. THE RICARDIAN VIEW OF GOVERNMENT DEBT

- Traditional view of government debt presumes that if govt % taxes & runs a budget
deficit (i.e. not %G) consumers respond to their higher after-tax income by # spending
o BUT Ricardian equivalence: consumers who are forward-looking and,
therefore, base their spending decisions not only on their current income, but
also on their expected future income
o HENCE: A debt-financed tax cut has no effect on consumption, national
saving, the real interest rate, investment, net exports, or real GDP, even in the SR

- 2 assumptions
1) Perfectly rational & forward-looking consumers with an infinite time horizon
(e.g. Barro’s bequest motive) ! based on LCH & PIH
2) Perfectly working financial markets " no borrowing constraints

The Basic Logic of Ricardian Equivalence

- Reasoning 1: Government finances a tax cut by running a budget deficit

o At some point in the future, the government will have to raise taxes to pay off
the debt and accumulated interests
o HENCE: policy really represents a tax cut today coupled with tax hike in future
! Tax cut financed by government debt does not reduce the tax burden,
BUT merely reschedules it

- Reasoning 2: Suppose government borrows "1,000 from the typical citizen to give that
citizen a "1,000 tax cut
o In essence, this policy is the same as giving the citizen a "1,000 government
bond as a gift
! One side of the bond says ‘The government owes you, the bondholder,
"1,000 + interest’
! The other side says ‘You, the taxpayer, owe the government "1,000 +
interest’
o Overall, the gift of a bond from the government to the typical citizen does not
make the citizen richer or poorer, because the value of the bond is offset by the
value of the future tax liability

- Assuming that consumers are forward-looking & know that a debt-financed tax cut
today implies an increase in future taxes that is equal – in present value – to the tax cut
o Tax cut does not make consumers better off, so they do not raise consumption
o Consumers save the full tax cut in order to repay the future tax liability
o Result: # Private saving by amount % public saving " national saving unchanged

- BUT: Ricardian equivalence does not imply that fiscal policy is irrelevant: Increase in
government purchases will always affect consumer behaviour, regardless of what
happens to other variables
 Peter C. May - 133 -

Consumers and Future Taxes

- Defenders of the traditional view of government debt believe that the prospect of future
taxes does not have as large an influence on current consumption as the Ricardian view
assumes because of

1) Myopia " Not all consumers think that far ahead (short-sighted, perhaps
because they do not fully comprehend the implications of government budget
deficits), so they see the tax cut as a windfall
! Consumers regard %T as # in lifetime income " #C & %S

2) Borrowing constraints " Some consumers are not able to borrow enough to
achieve their optimal consumption, and would therefore spend a tax cut
[consumption smoothing not possible, so consumption depends only on current
income]
! C1 depends only on Y1: %T " #Y1 " #C1

C2

Although the tax cut leaves

the intertemporal budget
constraint unchanged (#Y1
BC2
offset by %Y2) the borrowing
BC1 constrained consumer who
would prefer to borrow in
C2=Y2 A period 1 will increase his
consumption in period 1
C2=Y2 B
because of the tax cut!
IC1 IC2

C1=Y1 C1=Y1 C1

3) Future generations " If consumers expect that the burden of repaying a tax
cut will fall on future generations, then a tax cut now makes them feel better off,
so they increase spending
! Response by Robert Barro: bequest motive " because future
generations are the children and grandchildren of the current generation,
we should not view them as independent actor
! Relevant decision-making unit is not the individual, whose life is fine,
but the family, which continues forever
! HENCE: a debt-financed tax cut may raise the income an individual
receives in his lifetime, but it does not raise his family’s overall resources
! no change in consumption
- 134 - Peter C. May

- Debate over government debt is really a debate over consumer behaviour

a) Ricardian debt assumes consumers have a long time horizon; Barro’s analysis of
the family implies that the consumer’s time horizon, like the government’s is
effectively infinite
b) YET, it is possible that consumers do not look ahead to the tax liabilities of
future generations
! Expect children to be richer and welcome the opportunity to consume at
their children’s expense " zero-bequest families [debt-financed tax cut
alters consumption by redistributing wealth among generations]

Making a Choice

- Evidence against Ricardian equivalence

o Early 1980s: Huge Reagan tax cuts
! # budget deficit " % National saving " # real interest rate & #
exchange rate " %NX [as predicted by traditional view]
o 1992: President George H.W. Bush reduced income tax withholding to stimulate
economy
! This merely delayed taxes but didn’t make consumers better off
! Yet, almost half of consumers used part of this extra take-home pay for
consumption

- Proponents of Ricardian equivalence argue that the Reagan tax cuts did not provide a
fair test of RE
o Consumers may have expected the debt to be repaid with future spending cuts
instead of future tax hikes
o Private saving may have fallen for reasons other than the tax cut, such as
optimism about the economy

Consensus view: While there may be some offsetting effects of tax changes due to the
perceived effect on future tax liabilities, a combination of myopia and borrowing
constraints is likely to prohibit full Ricardian equivalence

15-5. OTHER PERSPECTIVES ON GOVERNMENT DEBT

- According to the traditional view, a government budget deficit expands AD and

stimulates output in the SR, but crowds out capital/investment in the long-run and
depresses economic growth in the very long-run
- According to the Ricardian view, a government budget deficit has none of these
effects because consumers understand that a budget deficit represents merely the
postponement of a tax burden
 Peter C. May - 135 -

A) Balanced Budgets versus Optimal Fiscal Policies

- Some politicians argue that the government should run a balanced government budget
every year
- BUT many economists reject this proposal, arguing that deficits should be used to

1) Stabilization:
o Stabilize output & employment through both automatic stabilizers and
active policy intervention

2) Tax Smoothing
o Total social cost of taxes is minimized by keeping tax rates relatively stable,
rather than making them high in some years and low in others

3) Intergenerational Redistribution
o Redistribute income across generations when appropriate (e.g. wars,
motorways)
o For investment that will benefit future generations as well as the current
generation of taxpayers

B) Fiscal Effects on Monetary Policy

- Government deficits may be financed by printing money

o A high government debt may be an incentive for policymakers to create inflation
! to reduce real value of debt at expense of bondholders

- Fortunately:
o Little evidence that the link between fiscal and monetary policy is important
o Most governments can finance deficits by selling debt and do not need to rely
on seigniorage
o Most governments know the folly of creating inflation (i.e. inflationary spirals)
o Most central banks have (at least some) political independence from fiscal
policymakers

C) International Dimensions

- Government budget deficits can lead to trade deficits, which must be financed by
borrowing from abroad ! Twin deficit " S-I=net capital outflow [if %S " %NCO]
o Large government debt may increase the risk of capital flight, as foreign
investors may perceive a greater risk of default.
o Large debt may reduce a country’s political clout in international affairs (see B.
Friedman, 1988: Day of Reckoning)
- 136 - Peter C. May

15-6. FISCAL SUSTAINABILITY, BUDGET DEFICITS AND THE DEBT-TO-GDP RATIO

- Since an economy in some sense lives forever and never retires, there is no reason why
it should ever have to pay off its debts entirely
o More important: Fiscal sustainability " government is able to service its debt
[pay interests and honour capital repayments when they fall due]
o For this to be the case, the ratio of government debt to GDP must settle down
at some constant level
! Government debt & GDP must grow at the same rate
! If this is not the case, government debt will become a larger and larger
multiple of GDP, and there must come a point at which the government
is no longer able to service the debt

- 2 budget deficits:
1. Total budget deficit (B): B = iD + G ' T " includes nominal interest
payments
2. Primary budget deficit: G ' T " excludes nominal interest payments
! Total budget deficit = primary budget deficit + nominal interest payments

Long - run fiscal sustainability :

"D
= g +# (g = long - run growth rate, # = long - run inflation rate)
D
Since "D = iD + G - T = B (B = total budget deficit)
B
$ = g +#
D
Dividing by Y :
D 1 B
= %
Y g +# Y

- LHS of equation: D/H " equilibrium debt-to-GDP ratio

!
o Tells us the stable equilibrium level towards which the debt-to GDP ratio will
head for a given level of nominal GDP growth (g+") and a given total budget
deficit as a proportion of GDP (B/Y)
o BUT: formula does not allow for short-run shocks!
! Even if D/Y sustainable in the LR, a negative shock could greatly reduce
nominal GDP " government unable to service debt
! Prudent long-run debt-to-GDP ratio (d): Sustainable even in the
event of large negative supply shocks

B
= (g + ") # d
Y

!
 Peter C. May - 137 -

- For a given target long-run debt-to-GDP ratio (d), the total budget deficit may be higher
for higher rates of nominal GDP growth, since this will tend to increase the
denominator of the debt-to-GDP ratio, and so allow a higher accumulation of debt for a
given debt-to-GDP ratio

- Looking at primary budget deficit (G ' T = B ' iD)

iD + G - T D
= (g + ") #
Y Y
G-T D
= (g + " - i) #
Y Y
G-T D
= (g - r) #
Y Y
G-T
or for prudent level : = (g - r) # d
Y

- HENCE: for fiscal sustainability, the primary deficit as a proportion of GDP must be
!
equal to the excess of real GDP growth over the real interest rate times the equilibrium
debt-to-GDP ratio
o If g=r " G'T has to be 0
! Government is not adding to the stock of debt through its expenditure,
and the government can roll over its debt interest without the debt-to-
GDP ratio growing
o If g>r " G'T can be negative
! Real value of national income is growing faster than the real value of
public debt, so the government can afford to increase debt a little by
running a primary deficit
o If g<r " G'T must be positive
! Government must run a primary surplus for fiscal sustainability because
real value of debt will rise faster than real income unless the government
uses some of its tax revenue to pay the debt-service, rather than
spending it

CASE STUDY: The Stability and Growth Pact

- According to the Treaty of Maastricht, the prudent debt-to-GDP ratio is 60%

o Given long-run European growth rates of the order of 2.5-3% p.a., and allowing
for inflation of 2-2.5% p.a. ! long-run nominal GDP growth rate of 5%
o Using the formula for fiscal sustainability in terms of the total budget deficit,
(B/Y)=(g+")(d, we therefore have: B/Y=0.05(0.6=0.03
- This implies a maximum total budget deficit of 3% – exactly as laid down in the Stability
and Growth Pact
- 138 - Peter C. May

CASE STUDY: The ‘Golden Rule’ of UK Public Finance

- UK Code for Fiscal Stability:

o Golden Rule: Over the business cycle, the government will borrow only to
invest
! Cyclically adjusted budget deficit – not taking into account public
investment – must balance or be in surplus
o Sustainable Investment Rule: Public sector net debt as a proportion of GDP
will be held over the economic cycle at a stable and prudent level, which the
government has defined as ‘40% of GDP over the economic cycle’

Ponzi Finance

- Ponzi finance: Government issues public debt in order to service its debt (i.e. to pay
the interest on its debt and repay capital when bonds mature)
o This requires greater and greater amounts of debt to be issued & consequently
higher and higher debt-to-GDP ratios
o Eventually investors get worried about the size of the total public debt
outstanding and stop buying government bonds
o At this point, the government has no option but to default on its debt!

Vicious Cycle of Large Debt-to-GDP Ratios

- To have fiscal sustainability – i.e. non-accelerating public debt:

G-T D G-T D
= (g - r) " # + (r - g) " = 0
Y Y Y Y
- Suppose the real interest rate (r) is 3%, the long-term growth rate (g) 2% and the debt
ratio (D/Y) is high: 100%
! o For fiscal sustainability, the government needs to run a primary surplus of 1%
o Now suppose financial investors start requiring a higher interest rate of 6% to
hold government bonds, e.g. because they are not sure the government will be
able to keep the deficit under control and repay the bonds in the future
o Government must # primary surplus from 1% to 4% of GDP just to keep the
debt-to-GDP ratio constant
o If government debt is only 10%, in contrast, the primary surplus only has to
increase from 0.1% to 0.4%, which is much easier to deal with

- The higher the debt-to-GDP ratio, the larger the potential for explosive debt dynamics
o Even initially unfounded fears that the government may not fully repay the debt
can easily become self-fulfilling
o By #r the government must pay on its debt, these fears can lead the government
to lose control of its budget, and lead to an increase in debt to a level such that
the government is unable to repay the debt, validating the initial fears
 Peter C. May - 139 -

SUMMARY:

1. Standard figures on the deficit are imperfect measures of fiscal policy since they
a. Are not corrected for inflation
b. Do not account for changes in government assets
c. Omit some liabilities (e.g. future pension payments to current workers)
d. Do not account for effects of business cycles
2. In the traditional view, a debt-financed tax cut increases consumption and
reduces national saving. This increase in consumer spending leads to greater
aggregate demand and higher income in the short-run. BUT:
a. LR: In a closed economy, this leads to higher interest rates, lower
investment (& capital stock), and a lower long-run standard of living
b. LR: In an open economy, it causes an exchange rate appreciation and thus
a fall in net exports
3. According to the Ricardian view of government debt, a debt-financed tax cut
does not stimulate consumer spending because it does not raise consumers’
overall resources – it merely reschedules taxes from the present to the future
a. The debate between the traditional and Ricardian views of government
debts is ultimately a debate over how consumers behave
i. Do they face binding borrowing constraints?
ii. Are they economically linked to future generations through
altruistic bequests?
b. Economists’ views of government debt hinge on their answers to these
questions, but the consensus: full Ricardian equivalence does not hold
4. Most economists oppose a strict rule requiring a balanced budget. A budget
deficit can sometimes be justified on the basis of
a. Short-run stabilization
b. Tax smoothing
c. Intergenerational redistribution of the tax burden
5. Government debt can potentially have damaging effects:
a. Large government debt or budget deficits may encourage excessive
monetary expansion and, therefore, lead to greater inflation
b. The possibility of running budget deficits may encourage politicians to
unduly burden future generations when setting taxes & spending
c. A high level of government debt may risk capital flight and diminish a
nation’s influence around the world
6. Fiscal sustainability – the ability of a government to service its debt – requires
that the debt-to-GDP settle down at a constant equilibrium level
a. Equilibrium level should be set a prudent level to allow for shocks
b. B/Y = (g + ")(d
c. The higher the nominal growth rate, the greater the total budget deficit
that allows for fixed sustainability
- 140 - Peter C. May

- Chapter 16: Common Currency Areas and EMU -

16-1. COMMON CURRENCY AREAS

- Common currency area: Geographical area through which one currency circulates and
is accepted as the medium of exchange
o Also referred to as currency union or monetary union

- European Economic and Monetary Union (EMU): Common currency that is

formed by 16 European countries that have adopted the euro (") as their currency
o These countries make up the Euro Area
o Since the EMU countries have a single currency, they also have a single
monetary policy:
! The monetary policy of the Euro Area is formulated and implemented
by the European Central Bank (ECB), which – together with the
national central banks of the countries making up the EMU – forms the
European System of Central Banks (ESCB)

16-1. THE BENEFITS OF A SINGLE CURRENCY

- 3 main benefits:
1) Reduction in transactions costs in trade
o Paying a cost to convert currencies is a deadweight loss " companies pay the
transaction cost but get nothing tangible in return
o Benefits since elimination of transaction costs: ~0.25-0.5% of Euro Area
GDP [cumulative effect!]

2) Reduction in price discrimination

o Harder to disguise price differences across countries " % price
discrimination
o Transparency in prices that results form a common currency will lead to
arbitrage in goods across the currency, so that people will buy goods where
they are cheaper (" #P) and reduce their demand for goods where they
are more expensive (" %P)
o BUT: large transaction and transportation costs ! law of one price does not
hold
3) Reduction in foreign-exchange-rate variability
o Uncertainty about foreign exchange rate movements reduces overall trade
" countries forego gains from trade & reduce overall economic welfare
o Uncertainty could be reduced with forward foreign exchange contracts BUT
service charge " deadweight loss
o Common currency: less uncertainty concerning future cash flows " #I
 Peter C. May - 141 -

16-3. THE COSTS OF A SINGLE CURRENCY

- When a country joins a monetary union, it gives up its national currency and thereby
gives up
a) Its freedom to set its own monetary policy
b) The possibility of macroeconomic adjustment coming about through
movements in the external value of its currency

- Asymmetric demand shock: Raises aggregate demand in one country and lowers it in
another
o E.g. shift in consumer preferences: away from German goods and services
towards French goods and services

a) France
LRAS
P
SRAS

Both the French and German

economy begin at a full
AD2 employment level of income
1. A shift in consumer
AD1
preferences increases
demand for French
!F
Y Y1F goods and services
Y
3 2. BUT decreases the
demand for German
goods and services
b) Germany 3. As a result of the
LRAS asymmetric demand
P shock, French GDP
SRAS increases above the
natural rate (boom)
2 4. And German GDP falls
below the natural rate
(recession)

AD1

AD2

Y1G Y
!G Y

4
- 142 - Peter C. May

- As a result of the asymmetric demand shock, Germany moves into recession & France
moves into a boom
o France: P > Pe ! in LR: #Pe " upward shift of SRAS
o Germany: P < Pe ! in LR: %Pe " downward shift of SRAS

a) France
SRAS2
LRAS
P
SRAS1

P2

P1 In the longer-term, when

AD2
expected prices adjust, SRAS
AD1 will shift upwards in France,
creating inflationary
pressures. In Germany, the
!F
Y Y1F Y SRAS curve will shift
downwards, creating
deflationary pressures. Both
b) Germany
economies will return to the
LRAS natural level of output and
P unemployment!
SRAS1
SRAS2

P1

AD1
P2 AD2

Y1G Y
!G Y

- Because each of the 2 economies has a long-run vertical supply curve, output will
eventually return to the natural rate in response to demand shocks
o The only cost to the 2 economies is therefore in terms of the short-term
fluctuations in output
o While this may not seem problematic in theory, in practice the resulting
fluctuations in output and unemployment in each country will tend to create
tensions within the monetary union
! Unemployment rises in Germany (SR) ! needs %i
! Inflation rises in France (SR & LR) ! needs #i
o ECB will not be able to satisfy demands for both countries " one-size-fits-all
monetary policy
 Peter C. May - 143 -

- If each country had maintained their own currencies and a flexible foreign exchange rate
between them, the short-term fluctuations in aggregate demand would be alleviated by a
movement in the exchange rate
o % Demand for German exports ! % demand for German currency
! " real depreciation & # demand for German exports
o # Demand for French exports ! # demand for French currency
! ! real appreciation & % demand for French exports

Rule:
1) Having a flexible exchange rate means that the economies never move away from their
long-term natural level of output (Y! ) ! a flexible exchange rate system can insulate an
economy from asymmetric demand shocks
2) In a currency union, however, this automatic adjustment mechanism through the exchange
rate is not available ! the best that can be done is to wait for wages and prices to adjust fully
to the asymmetric demand shocks so that the SRAS curve shifts in each country

16-4. THE THEORY OF OPTIMUM CURRENCY AREAS

- Optimum currency area (by Mundell): A group of countries for which the benefits of
adopting a single currency heavily outweigh the costs

Characteristics that Reduce the Costs of a Single Currency

- Main costs in participating in a monetary union:

o Loss of monetary policy autonomy [one-size-fits-all monetary policy]
o Rules out possibility of macroeconomic adjustment through exchange-rate
movements

- Hence, costs are lower if economies in question

1) Move rapidly to long-run equilibrium following a macroeconomic shock

o The faster the speed of adjustment to long-run equilibrium the better
! Real wage flexibility
! Labour mobility
! Capital mobility

2) Are prone to the same kind of demand shocks [i.e. no asymmetric demand shocks]
- 144 - Peter C. May

REAL WAGE FLEXIBILITY

- If # real wage flexibility " adjustment to long-run equilibrium occurs very quickly
o Germany: % wages " downward/rightward shift of SRAS curve ! Y !
o France: # wages " upward/leftward shift of SRAS curve ! Y !
- Real not nominal wage important
o It is real wages that must adjust to affect the SRAS curve by making it more/less
profitable for firms to produce a given level of output at any given level of prices

LABOUR MOBILITY
- If labour is highly mobile:
o Unemployed workers simply migrate to France and find a job
o Macroeconomic imbalance is alleviated:
! Unemployment in Germany will fall as many of the unemployed have
left the country
! Inflationary wage pressures in France decline as the labour force expands
with the migrants from France
o Note: Labour mobility does affect the speed of adjustment of SRAS BUT it
actually shifts the LRAS (natural rate of output and unemployment)
! Germany: LRAS shifts leftwards
! France: LRAS shifts outwards
a) France
LRAS1 LRAS2
P
SRAS

If, following the positive

shock to French AD and the
AD2
negative shock to German
AD1 AD, labour migrates from
Germany to France, the effect
will be to raise the natural rate
! F1 Y
Y ! F2 Y
of output in France, and to
reduce the natural rate of
b) Germany output in Germany.
LRAS2 LRAS1 As a result, the depth of the
P recession in Germany (as
SRAS
measured by the output gap)
is reduced, and the strength
of the boom in France is
lessened!

AD1

AD2

Y ! G1
! G2 Y Y
 Peter C. May - 145 -

Rule: By making the output gaps smaller in absolute size, labour mobility means that there is
less fluctuation in output and unemployment in each country, and the adjustment to the
long-run equilibrium will be faster!

CAPITAL MOBILITY
- Physical capital mobility: Plant, machinery (factor of production) " helps by
expanding productive capacity in countries experiencing a boom as firms in other
member countries build factories there
o # physical capital " #K " #MPL " #Y ! [so Y>Y ! smaller]

- Financial capital mobility: Bonds, company shares & bank loans " helps in
cushioning economies from short-term output shocks
o Recession in Germany " Germans borrow from French to make up for their
temporary fall in income
o HENCE: financial capital market integration across countries allows households
to insure one another against asymmetric shocks so that the variability of
consumption over the economic cycle can be reduced

SYMMETRIC MACROECONOMIC SHOCKS

- If shocks were symmetric (the same in both countries) and not asymmetric, there would
be no policy problem across the monetary union
o Economic cycles of each of the countries making up the currency union should
be synchronized in the sense that the various economies tended to enter recession
at the same time and enter the recovery phase of the cycle at the same time !
disagreements about the best interest rate policy are less likely to occur!

Characteristics that Increase the Benefits of a Single Currency

- High degree of trade integration: The greater the amount of trade that is done
between a group of countries, the more they will benefit from adopting a common
currency
o The greater the amount of trade the greater the benefits from
! Reduction in transaction costs
! Reduction in exchange-rate volatility
- 146 - Peter C. May

16-5. IS EUROPE AN OPTIMUM CURRENCY AREA

- Trade integration
o Degree of trade integration is variable, but nevertheless high on average (with
the notable exception of Greece)
o Degree of European trade integration appears to have been rising over time in
nearly every country
! Some criteria – such as high degree of trade integration – endogenous?
! Actually being a member of a currency union may enhance the degree of
trade between members of the union, precisely because of the decline in
transactions costs in carrying out such trade [# integration " # benefits]

- Real wage flexibility

o Continental European labour markets highly inflexible
! High levels of union coverage
! Generous unemployment benefit systems & laws
o Introduction of single currency " # inflexibility
! Company with employees in several countries would find it hard to
reduce real wages in Germany while rising them in France
o On the whole, movements in real wages are unlikely to make a significant
contribution to the macroeconomic adjustment of Euro Area countries to
asymmetric shocks

- Labour mobility
o Labour is notoriously immobile across European countries
! Differences in language, culture and other social institutions make it
difficult for workers to migrate
o Europe therefore scores very low on this optimum currency area criterion

- Financial capital mobility

o Wholesale financial markets " capital markets in which only financial institutions
(banks, investment trusts, very large corporations)
! Integration of EMU wholesale financial markets increased dramatically
o Retail financial markets " High street banks etc. open to households, and to small
and medium-sized corporations
! Integration of EMU retail financial markets lagging behind

- Symmetric demand shocks

o Economic cycle across countries of Euro Area seems to be positively correlated
" timing of booms and recessions appear to very close
o Some countries, like Ireland, have persistently outstripped the performance of
the Euro Area as a whole, so that ECB monetary policy has arguably been far
too loose for the Irish economy
o On the whole, the problem of asymmetric demand shocks is not a great one for
the current member countries of EMU
 Peter C. May - 147 -

Summing Up: Is Europe an Optimum Currency Area?

- Overall, if very strong differences in the economic cycle were to emerge across the
Europe Area, the lack of independent monetary and exchange-rate policy would be felt
acutely
o For that reason, many economists argue that EMU is not an optimum currency
area
o Nevertheless, it is possible that some of the optimum currency area criteria may
be endogenous
! In the long-run, EMU might gradually become an optimum currency
area

16-6. FISCAL POLICY AND COMMON CURRENCY AREAS

- Even if France & Germany did not make up an optimal currency area because wages
were sticky and labour mobility was low between the countries, national fiscal policy
could, in principle, still be used to compensate for the loss of monetary policy autonomy

Fiscal Federalism

- Fiscal federalism: Fiscal system for a group of countries involving a common fiscal
budget and a system of taxes and fiscal transfers across countries
o Surplus of government tax revenue over government spending in one country
would be used to pay for a budget deficit in another country
o Alleviates problems of adjustments to short-term asymmetric shocks
o Problem: Taxpayers in one country may not be happy about paying for
government spending and transfer payments in another country

National Fiscal Policies in a Currency Union: The Free-Rider Problem

- If fiscal federalism is not an option " possibility of individual members of the union
using fiscal policy in order to offset asymmetric macroeconomic shocks that cannot be
dealt with by the common monetary policy

- Effect of # debt " # possibility of default

o Default in open economy with flexible exchange rate:
! Large government budget deficit " # debt " partial default by surprise
inflation: #P & %e " % in real value of government debt, both internally
(#P) and externally (%e)
o Default in currency union
- 148 - Peter C. May

! Only through outright default – stopping interest payments and/or

failing to honour capital repayments when they fall due
! Financial markets are good at disciplining governments that run up large
debts, by charging them high rates of interest on the debt that the
government issues (# spread)
! In the case of a monetary union, this means that excessive debt issuance
by one member country (e.g. Germany) will tend to force up interest
rates throughout the common currency area!
! Also, interest rates may not be raised enough to discipline properly the
high-borrowing government because markets feel that the other
members of EMU would not allow the country concerned actually to
default or ‘bail-out’ the country
! Free-rider problem: Germany is enjoying the benefits of a fiscal
expansion without paying the full costs " moral hazard
! to avoid free-rider problem: Stability & Growth Pact (SGP)

The Stability and Growth Pact

- Rationale: Rules out any free-rider or moral-hazard problems associated with excessive
spending and borrowing in any one member country
o Limits the amount of spending that can be done that is not financed by taxation
o Since B/Y=(g+")d=0.05(0.6=0.03 " government should aim to run a total
budget deficit of no more than 3% of GDP per year if it wants an equilibrium
debt-to-GDP ratio of 60%

- BUT: SGP flawed & arbitrary

o No economic rationale for a balanced budget (tax smoothing, stabilization, inter-
generational equity etc.)
o Having given up sovereignty over monetary policy, an EMU member is left with
only fiscal policy with which to attempt to counter any asymmetric shock
o Currency unions are, by definition, short on policy instruments – they require
flexibility rather than rigidity in the conduct of fiscal policy
! Having a system of rigid rule and draconian punishments and no
credible way of enforcing the sanctions is not the correct way to ensure
fiscal stability in the Euro Area
 Peter C. May - 149 -

16-6. SHOULD THE UK JOIN THE EUROPEAN ECONOMIC AND MONETARY UNION?

Case for UK membership of EMU Case against UK membership of EMU

1) Reduction in transactions costs in 1) UK has enjoyed low and stable inflation
international trade [UK very open combined with annual growth that has
economy & half of the trade is done been the envy of the Euro Area
with Europe] 2) One-size-fits-all monetary policy is not
2) Reduction in exchange-rate uncertainty tailored to suit the specific needs of the
would benefit a large amount of British UK economy ! UK short-term interest
industry that trades with Europe rates have consistently been 1 to 2
3) UK business cycle appears to be more percentage points higher than euro
or less synchronized with EMU interest rates
business cycle 3) Problems of fiscal policy (SGP)
4) Would lead to closer financial market
integration " stronger competition
among banks, leading to greater choice
and efficiency in financial services
5) UK benefits from a great deal of foreign
direct investment (e.g. Japanese &
Korean companies who want to build a
factory inside EMU to avoid transactions
costs etc.)
6) Exchange rate volatility can be a source
of shocks

UK Government’s 5 Tests of EMU Entrance

1. Convergence " compatible business cycles

2. Flexibility [if problems occur]
3. Investment " better incentives to invest in Britain
4. Financial services
5. Growth & stability
- 150 - Peter C. May

SUMMARY:

1. A common currency area (or currency/monetary union) is a geographical area

through which one currency circulates and is accepted as the medium of
exchange.
2. The formation of a common currency area can bring significant benefits to the
members of the currency union, particularly if there is already a high level of trade
integration, primarily because of the reductions in transactions costs and in
exchange-rate uncertainty.
3. The costs of joining a currency union include the loss of an independent
monetary policy and the loss of the exchange rate as a means of macroeconomic
adjustment. Given a long-run vertical supply curve, this will affect mainly short-
run macroeconomic adjustments.
4. Short-run adjustment problems will be reduced by greater degrees of real-wage
flexibility, labour mobility and capital market integration across the currency
union. They will also be less important, the fewer members of the currency union
suffering from asymmetric demand shocks.
5. A group of countries with a high level of trade integration, high labour mobility
and real-wage flexibility, a high level of capital market integration and that does
not suffer asymmetric demand shocks across the different members of the group,
is termed an optimum currency area. An optimum currency area is most likely to
benefit from currency union.
6. It is possible that a group of countries may become an optimum currency area
after forming a currency union, since this may enhance trade integration and help
to synchronize members’ economic cycles, and a single currency may also
encourage labour mobility and capital market integration.
7. While the current Euro Area displays, overall, a high degree of trade integration
and does not appear to be plagued by asymmetric demand shocks, real-wage
flexibility and labour mobility both appear to be low. And while the introduction
of the " has led to a high degree of EMU financial market integration at the
wholesale level, retail financial markets remain nationally segregated. Overall,
therefore, the Euro Area is probably not at present an optimum currency area,
although it may eventually become one.
8. The problems of adjustment within a currency union that is not an optimum
currency area may be alleviated by fiscal federalism – a common fiscal budget and
a system of taxes and fiscal transfers across member countries. In practice,
however, fiscal federalism may be difficult to implement for political reasons.
9. The national fiscal policies of the countries making up a currency union may be
subject to a free-rider problem, with one member country issuing a large amount
of government debt at a lower interest rate than it might otherwise have paid,
leading to other member countries having to pay higher interest rates. A currency
union may therefore wish to impose rules on the national fiscal policies of its
members.
 Peter C. May - 151 -

- Chapter 17: Consumption -

This chapter surveys the most prominent work on consumption:

1. John Maynard Keynes: Consumption & current income
2. Irving Fisher: Intertemporal Choice
3. Franco Modigliani: Life-Cycle Hypothesis
4. Milton Friedman: Permanent Income Hypothesis
5. Robert Hall: Random-Walk Hypothesis
6. David Laibson: Pull of Instant Gratification

17-1. JOHN MAYNARD KEYNES AND THE CONSUMPTION FUNCTION

- Keynes (1936): General Theory " consumption function central to his theory of
economic fluctuations

- 3 conjectures:

1) Marginal propensity to consume (MPC): the amount consumed out of an

additional unit of disposable income [where Y=disposable income]
• MPC = ,C/,Y = c
• 0 < MPC < 1

2) Average propensity to consume (APC): ratio of consumption to income

• APC = C/Y = C ! /Y + c
• Falls as income rises because saving = luxury " rich save a higher
proportion of income than poor

3) Disposable income: primary determinant of consumption, rather than the

interest rate

- HENCE:
C = C + cY, where C > 0 and 0 < (c = MPC) < 1

C
!
C=C
! +cY

As income rises, the APC

Slope: c=MPC [slope of ray from origin
to any point on curve]
falls " consumers save a
bigger fraction of their
Slope = APC " Decreasing income
C
! APC as Y increases

Y
- 152 - Peter C. May

Early Empirical Successes

- Results from early studies

o Households with higher incomes:
! Consume more ! MPC > 0
! Save more ! MPC < 1
! Save a larger fraction of their income ! %APC as #Y
! Very strong correlation between income and consumption ! income
seemed to be the main determinant of consumption

Two Anomalies

1) Secular stagnation: Long depression of indefinite duration caused by mismatch of

investment and savings
- #Y " # savings BUT not enough investment projects available "
insufficient demand for goods and services " recession
- Would have occurred in post-war period if %APC as #Y

2) Kuznets: Ratio of consumption to income remarkable steady since 1870s, despite large
increases in income
- HENCE: APC fairly constant over long periods of time in advanced
economies

Long-run consumption
C function " constant APC

Short-run consumption
function " falling APC

- Consumption puzzle:
o Studies of household data & short time-series found evidence for a negative
relationship between APC and income
o BUT: studies of long time-series found that APC does not vary systematically
with income!
 Peter C. May - 153 -

17-2. IRVING FISHER AND INTER-TEMPORAL CHOICE

- Basis for much subsequent work on consumption

o Developed model to analyse how rational, forward-looking consumers make
inter-temporal choices

- Inter-temporal budget constraint at present value

o The sum of discounted consumption over the lifetime has to equal the sum of
discounted income over the lifetime

C2 Y
C1 + = Y1 + 2
(1+ r) (1+ r)

C2
!

Y1(1+r)+Y2
Saving C2 = Y1(1+ r) + Y2 - C2 (1+ r)
(vertical intercept) (slope)
Slope: -(1+r)
A
Y2
Borrowing !

Y1 Y1+Y2/(1+r) C1

- Indifference curve: Shows all combinations of C1 and C2 that make the consumer
equally happy
o Higher indifference curves represent higher levels of utility/happiness

- Consumer’s optimum: Tangency condition

o Point on the budget constraint that touches the highest indifference curve
o Marginal rate of substitution (slope of indifference curve)=slope of budget
constraint
! MRS = 1+ r

C2

!
Since C1>Y1 ! Borrower!
BC

Y2
C2
IC

Y1 C1 C1
- 154 - Peter C. May

- Increase in income (Y1 or Y2) " parallel outward shift of the budget constraint
o If consumption period 1 and 2 are both normal goods, the increase in income
raises consumption in both periods
o Consumption smoothing: Regardless of whether the increase in income
occurs in period 1 or 2, the consumer spreads it over consumption in both
periods
o HENCE: consumption depends on the present value of current & future
income! [not just current, as Keynes proposed]
Y
PV of income = Y1 + 2
(1+ r)

Rule:
!
1) Keynes posited that a person’s current consumption depends largely on his current
income!
2) Fisher’s model says, instead, that consumption is based on the income the consumer
expects over his entire lifetime!

How Changes in the Interest Rate Affect Consumption

C2
Initially the person was a lender.
An increase in the interest rate
rotates the budget constraint
C2B around the point (Y1, Y2),
reducing consumption in period
1 and raising consumption in
C2A IC2
period 2! [Higher indifference
Y2 IC1 curve " better off]

BC1
BC2
C1B C1A Y1 C1

- 2 effects:

1) Income effect: Change in consumption that results from the movement to a higher
indifference curve (if lender: #r " #C1 & #C2)

2) Substitution effect: Change in consumption that results from the change in the
relative price of consumption in the two periods (if lender: #r " %C1 & #C2)

! Overall effect (if lender): #r " = ?C1 & #C2

 Peter C. May - 155 -

Rule:
Depending on the relative size of the income and substitution effects, an increase in the
interest rate could either stimulate or depress saving
E.g. for a lender:
1) When substitution effect > income effect " %C1 " #S1
2) When substitution effect < income effect " #C1 " %S1

Constraints on Borrowing

- Borrowing/Liquidity constraint: Inability to borrow ! C1 - Y1

a. Not binding: consumer’s optimal choice without borrowing constraint is lending,
not borrowing " Bc has no effect
b. Binding: consumer’s optimal choice without borrowing constraint would be to
borrow " Bc affects the optimal choice

a)
C2
Consumer’s optimal choice is
C1<Y1 even without the
borrowing constraint
! borrowing constraint not
binding
C2
IC
Y2
BC with borrowing constraint

C1 Y1 C1
b)
C2
Borrowing constraint is
binding: consumer would like
to borrow and choose point
A BUT because borrowing is
impossible, the best available
choice is point B
! When the borrowing
C2=Y2 B constraint is binding, C1=Y1
A
IC2 IC1

C1=Y1 C1

- HENCE: For those consumers who would like to borrow but cannot, consumption
depends only on current income (C1=Y1)
o Similar effect if rborrowing>>rsaving [budget line only kinked, not vertical at Y1]
- 156 - Peter C. May

- In Fisher’s theory, the timing of income is irrelevant because the consumer can borrow
and lend across periods
o E.g. if consumer learns that her future income will increase, she can spread the
extra consumption over both periods by borrowing in the current period
o HENCE: If consumer faces borrowing constraints then she may not be able to
increase current consumption and her consumption may behave as in the
Keynesian theory even though she is rational & forward-looking

17-3. FRANCO MODIGLIANI AND THE LIFE-CYCLE HYPOTHESIS

- Hypothesis:
o Income varies systematically over people’s lives due to retirement, so people must save during
their working years to maintain their level of consumption after retirement

The Model

- Variables:
o W = initial wealth
o R = years to retirement
o T = remaining years of life
o C = consumption
o Y = income per year
o Interest rate = 0

- To have constant consumption over the remaining life time (smoothing consumption):
W +R " Y 1 R
C= = "W+ "Y
T T T
- HENCE: Aggregate consumption depends on both wealth and income
o Consumption function
!
C = " # W +$ # Y

C
! C=)W+.Y

APC=C/Y=)W/Y+.
Slope: .

)W

Y
 Peter C. May - 157 -

- LCH can solve the consumption puzzle

o The APC implied by the LC consumption function is APC=C/Y=)W/Y+.
o Across households, wealth does not vary as much as income [as #Y, not
everything is saved to increase wealth]
! HENCE: High income households should have a lower APC than low
income households
o Over time, aggregate wealth and income grow together, causing APC to remain
stable

C2=)W2+.Y
C
B

C1=)W1+.Y

1) In the long-run, as wealth

)W2 increases, the consumption
function shifts upwards "
A prevents APC from falling as Y
increases!
)W1 2) Points A & B have the same
APC!
Y

Consumption, Income & Wealth over the Life-Cycle

Wealth
The LCH implies that saving
varies systematically over a
Income person’s lifetime!
SAVING Consumption
C
DISSAVING

Retirement T

- Why elderly do not dissave to the extent that the model predicts
1. Precautionary saving: Saving that arises from uncertainty
o Unexpected medical expenses
o Possibility of living longer than expected
2. Bequest motive: Want to leave bequests to their children
- 158 - Peter C. May

17-4. MILTON FRIEDMAN AND THE PERMANENT-INCOME HYPOTHESIS

- Hypothesis:
o People’s income consists of two components: permanent (average) income, which people expect to
persist into the future, and transitory income, which are temporary deviations from average
income

The Model

- Current income = sum of permanent income YP and transitory income YT

o Permanent income YP " average income that people expect to persist into the
future (e.g. arising from education)
! High APC & MPC, low MPS
o Transitory income YT " random deviation from average income that people
do not expect to persist (e.g. from weather conditions) [can be –ve or +ve]
! Low APC & MPC, high MPS

- Friedman (1957): Consumption depends primarily on permanent income because

consumers use saving & borrowing to smooth consumption in response to transitory
changes in income
o PIH consumption function:

C = " # YT
" where ) is the fraction of permanent income that people consume per year

- PIH can!solve the consumption puzzle:

o The PIH implies APC = C/Y = )Y P/Y
! High income households have higher proportion of transitory income
than low income households " APC will be lower in high income
households
! Over the long run, income variation is due mainly if not solely to
variation in permanent income, which implies a stable APC

Implication for government policy

- Tax cuts that are explicitly announced to be temporary will be regarded as only
increasing YT and therefore leave current consumption unchanged
- If you assume infinitely-long living, rational consumers and perfectly working capital
markets (i.e. no borrowing constraints) any tax cut will be ineffective
o Tax cut will have no effect because it has to be financed through future tax
increase " consumers regard %T as YT and do not change their current
consumption [#S to be able to pay future #T]
- Even if individual consumers are not infinitely-long living, Barro’s bequest motive
would imply that families act as infinitely-long living economic agents
 Peter C. May - 159 -

Friedman’s PIH vs. Modigliani’s LCH

1. In both, people try to achieve smooth consumption in the face of changing

current income
2. In the LCH, current income changes systematically as people move through their
life cycle
3. In the PIH, current income is subject to random, transitory fluctuations
4. Both hypotheses can explain the consumption puzzle

17-5. ROBERT HALL AND THE RANDOM-WALK HYPOTHESIS

The Model

- Random-Walk Hypothesis: Based on Fisher’s model & PIH, in which forward-

looking consumers base consumption on expected future income
o Hall (1978) adds the assumption of rational expectations: People use all
available information to forecast future variables like income

- If PIH is correct and consumers have rational expectations, then consumption should
follow a random walk: changes in consumption should be unpredictable
o According to PIH, consumers face fluctuating income and try their best to
smooth their consumption over time
! A change in income or wealth that was anticipated has already been
factored into expected permanent income, so it will not change
consumption.
! Only unanticipated changes in income or wealth that alter expected
permanent income will change consumption
o So if consumers are optimally using all available information, then they should
only be surprised by events that were entirely unpredictable
! RESULT: changes in consumption are unpredictable as well

Implication:
If consumers obey the PIH and have rational expectations, then
policy changes will affect consumption only if they are unanticipated.

2 Consequences for Government Policy

1) Only unanticipated government policies will have effects

o For example, a tax cut to stimulate aggregate demand only works if consumers
respond to the tax cut by increasing spending
- 160 - Peter C. May

o The R-W Hypothesis implies that consumption will respond only if consumers
had not anticipated the tax cut!

2) Impact of announcements
o Policy changes take effect at the point of time when they change expectations
[by changing individuals’ calculations of YP]

Empirical Research

- Studies reveal that current income has a larger role in determining consumer spending
than the R-W hypothesis suggests
o Lack of rational expectations
o Borrowing constraints
! Result: Keynes’ original consumption function more attractive

17-6. DAVID LAIBSON AND THE PULL OF INSTANT GRATIFICATION

- Consumption decisions are not made by the ultra-rational homo economicus, BUT by
real human beings whose behaviour can be far from rational
o Theories from Fisher to Hall assumes that consumers are rational and act to
maximize lifetime utility
o Consumers consider themselves to be imperfect decision-makers.
! E.g. survey: 76% said they were not saving enough for retirement

- Laibson: The “pull of instant gratification” explains why people don’t save as much
as a perfectly rational lifetime utility maximizer would save
o Time-inconsistent behaviour

Laibson’s experiment
1. Would you prefer
(A) a candy today, or
(B) two candies tomorrow?
2. Would you prefer
(A) a candy in 100 days, or
(B) two candies in 101 days?
In studies, most people answered A to question 1, and B to question 2 [prefer 1 candy
today to 2 candies tomorrow, but 2 candies in 101 days to 1 candy in 100 days!]
" A person confronted with question 2 may choose B. 100 days later, when he
is confronted with question 1, the pull of instant gratification may induce him to
change his mind ! time-inconsistency!
 Peter C. May - 161 -

17-7. CONCLUSION

- Keynes:
o Consumption = ƒ(current income)
- Recent work:
o Consumption = ƒ(current income, wealth, expected future income, interest rate)

! Economists disagree over the relative importance of these factors and of borrowing
constraints and psychological factors

SUMMARY:

1. Keynesian consumption theory

a. Keynes’ conjectures
i. MPC is between 0 and 1
ii. APC falls as income rises
iii. Current income is the main determinant of current consumption
b. Empirical studies
i. In household data & short time series: confirmation of Keynes’
conjectures
ii. In long time series data: APC does not fall as income rises
2. Recent work builds on Irving Fisher’s model of intertemporal consumption
smoothing
a. Consumer chooses current & future consumption to maximize lifetime
satisfaction subject to an intertemporal budget constraint.
b. Current consumption depends on lifetime income, not current income,
provided consumer can borrow & save.
3. Modigliani’s Life-Cycle Hypothesis
a. Income varies systematically over a lifetime
b. Consumers use saving & borrowing to smooth consumption
c. Consumption depends on income & wealth
4. Friedman’s Permanent-Income Hypothesis
a. Consumption depends mainly on permanent income
b. Consumers use saving & borrowing to smooth consumption in the face
of transitory fluctuations in income.
5. Hall’s Random-Walk Hypothesis
a. Combines PIH with rational expectations
b. Main result: changes in consumption are unpredictable, occur only in
response to unanticipated changes in expected permanent income.
6. Laibson and the pull of instant gratification
a. Uses psychology to understand consumer behavior.
b. The desire for instant gratification causes people to save less than they
rationally know they should ! time-inconsistent behaviour!
- 162 - Peter C. May

- Chapter 18: Investment -

While spending on consumption goods provides utility to households today, spending on

investment goods is aimed at providing a higher standard of living at a later date
- Investment is the component of GDP that
o Links the present and the future
o Is the most volatile in the short-run

3 types of investments:
1) Business fixed investment: Equipment and structures that business buy to use in
production
2) Residential investment: New housing that people buy to live in and that landlords buy
to rent out
3) Inventory investment: Goods that business put aside in storage, incl. materials and
supplies, work in process and finished goods

18-1. BUSINESS FIXED INVESTMENT

- 75% of total investment

- Explanation of word:
o Business " investment goods that are bought by firms for use in future
production
o Fixed " spending for capital that will stay put for a while [i.e. not inventory]

- Neoclassical model of investment: Examines benefits and costs to firms of owning

capital goods " I(MPK, r, t)
o Key assumption: 2 kinds of firms
a) Production firms: Produce goods and services using capital they rent
b) Rental firms: Buy/own capital and rent it out to production firms
! Most firms in the real world perform both functions simultaneously!
o In this context, “investment” is the rental firms’ spending on new capital goods

Production Firm & the Real Rental Price of Capital

- Real cost of renting & using 1 unit of capital for one period:

Real rental cost = R/P, where R = rental rate, P = output price

- Real benefit of using 1 unit of capital for one period of time:

!
Real benifit of using capital = (P " MPK)/P = MPK
# MPK= Real value of extra output produced with 1 more unit of capital

!
 Peter C. May - 163 -

- To maximize profits, production firms hire capital until:

Marginal (real) revenue = Marginal (real) cost

" MPK = R/P

! R/P Capital supply

(fixed in SR)

R*/P
Capital demand=MPK

K
! K

- If Cobb-Douglas production function:

Y = A " K # " L1-#
$ L '1-#
MPK = # " A " & ) = R/P
%K(
! 3 variables that determine the equilibrium real rental price
1) The lower the stock capital (K), the higher R/P [%K " #R/P]
! 2) The greater the amount of labour employed (L), the higher R/P [#L " #R/P]
3) The better the technology (A), the higher R/ P [#A " #R/P]

Rental Firm & the Cost of Capital

- Real benefit of owning 1 unit of capital and renting it out

Real benefit from owning capital = R/P

- Real cost of owning 1 unit of capital:

!
o Nominal cost consists of 3 parts
1) Interest payments " iPK
2) Change in price/value " -$PK [if $PK -ve: loss in value, so cost (written as
a positive number) = -$PK]
3) Depreciation (Loss of value due to wear & tear) " /PK
! Total nominal cost of capital = iPK ' $PK + /PK = PK((i ' $PK/PK + /)
- 164 - Peter C. May

o If the price of capital goods rises with the prices of other goods:
! $PK/PK = &
! Hence, we can substitute i'&=r into the cost formula
! Total nominal cost of capital = PK((& + /)

PK
Real cost of capital = " (r + #)
P

o HENCE: The real cost of capital depends positively on:

!
! The relative price of capital (#PK " # cost)
! The real interest rate (#r " # cost)
! The depreciation rate (#/ " # cost)

- Real profit rate per unit of capital

Profit Rate = Revenue - Cost

= R/P - PK /P " (r + #)
= MPK - PK /P " (r + #)

Rule: !
1) If the MPK exceeds the cost of capital [profit rate is positive], firms will find it
profitable to add to their capital stock
2) If the MPK falls short of the cost of capital [profit rate is negative], firms will let
their capital stock shrink

- Net investment: Change in the capital stock ($K)

o Firms add to their capital stock if MPK > Real cost of capital
"K = IN [MPK - PK /P # (r + $)]
o IN is the function showing how much net investment responds to the incentive
to invest
!
- Gross investment = Net investment + replacement of depreciated capital

I = IN [MPK - PK /P " (r + #)] + #K

o HENCE: Total investment depends negatively on:

!! The relative price of capital (#PK " # cost " %I)
! The real interest rate (#r " # cost " %I)
o Effect of #/ (depreciation rate)
! If % net investment (due to # costs) > # replacement ! %I
! If % net investment (due to # costs) < # replacement ! #I
 Peter C. May - 165 -

r
1) Business fixed investment
increases as the real interest rate
falls
2) Outward shift of investment
function might be caused by:
- #MPK [#A (technological
innovation or #L]
I2 - %PK/P
- #/ [ only if %IN < #/K]

I1

- In the long-run, the capital stock reaches a steady-state level:

MPK = PK /P " (r + #)
o The speed of adjustment towards the steady-state depends on how quickly firms
adjust their capital stock, which in turn depends on how costly it is to build,
! deliver and install new capital
! If MPK begins above the real cost of capital, the capital stock will rise
and the MPK will fall
! If MPK begins below the real cost of capital, the capital stock will fall
and the MPK will rise

Taxes & Investment

- Two of the most important taxes affecting investment:

1. Corporate income tax " tax on corporate profits
2. Investment tax credit " tax provision

1. Corporate income tax

- Impact on investment depends on definition of “profits”
o If the law used the textbook definition of profits (rental price minus cost of
capital) and defined depreciation cost measuring the CURRENT price of capital,
then a tax on profits would not alter investment incentives
! Let 0 be the tax rate and - for this note only - let & denote the profit rate
as defined above ! After-tax profit rate: (1'0)&
! The firm’s investment decision depends on whether its profit rate is
positive
! As long as 0 < 1, then the sign of (1'0)& equals the sign of &. I.e., if
an investment project is profitable without the tax, it will be profitable
(though less so) with the tax
- 166 - Peter C. May

- BUT, legal definition uses the historical price of capital for measuring depreciation
o If #PK " legal definition understates the true cost of owning capital [actual
depreciation > legal measure of depreciation] " Overstates profit (firms could
be taxed even if their true economic profit is zero)
o HENCE, corporate income tax discourages investment!

2. Investment tax credit

- Tax provision that reduces a firm’s taxes for each $ spent on capital goods
o Thus, ITC effectively reduces PK, which reduces the real cost of capital and so
increases the profit rate and the incentive to invest! [%PK " % costs " # profit
rate " #I]

The Stock Market and Tobin’s q

- Tobin: Stock prices tend to be high when firms have opportunities for profitable
investment, because these profit opportunities mean higher future income for the
shareholders
! Stock prices reflect the incentives to invest

- Tobin’s q: Firms base their investment decisions on the following ratio:

Market Value of Installed Capital

q=
Replacement Cost of Installed Capital

o Numerator: Stock market value of the economy’s capital stock

o! Denominator: Actual cost to replace the capital goods today that were purchased
when the stock was issued
o Investment decision:
! If q > 1, firms buy more capital to raise the market value of their firms
[because stock market values capital at more than its replacement cost]
! If q < 1, firms do not replace capital as it wears out!
[because stock market values capital at less than its replacement cost]

- Closely related to neoclassical theory of investment

o Tobin’s q depends on current and future expected profits from installed capital
! If MPK > cost of capital ! Profit rate is high, which drives up the stock
market value of the firms, which implies a high value of q
! If MPK < cost of capital ! Firms are incurring losses on capital, so
their stock market value falls, and q is low!
o Advantage of Tobin’s q as a measure of the incentive to invest: Reflects
expected future profitability of capital as well as current profitability
! Example: % corporate income tax next year " # share prices (includes
future) " #q [now] " #I [now, not later]
 Peter C. May - 167 -

Why Do Stock Prices & Economic Activity Fluctuate Together?

- 3 reasons for positive a relationship between the stock market and GDP:

1) Fall in stock prices " %q " %I " %GDP

2) Stocks are part of household wealth and income; % stock prices " %C "
%GDP

3) Fall in stock prices might reflect bad news about technological progress and
long-run economic growth [implies that aggregate supply and full-employment
output will be expanding more slowly than people had expected]

Efficient Market Hypothesis vs. Keynes’ Beauty Contest

- Efficient Market Hypothesis (Fama, 1970): Market price of a company’s stock is the
fully rational valuation of the company’s value, given current information about the
company’s business prospects " Stock market = informationally efficient
o Implication: stock prices should follow a random walk
! Only unpredictable news can change the company’s valuation
! Impossible to predict changes in stock prices from available information

- BUT: some economists believe that many movements in stock prices are hard to
attribute to news; investors focus less on companies’ fundamentals and more on what
they expect other investors will pay later
o Keynes: Analogy of beauty contest in newspaper
! Because stock market investors will eventually sell their shares to others,
they are more concerned about other people’s valuation of a company
than the company’s true worth
! HENCE: best stock investors those who are good at outguessing mass
psychology
! Mass movements often represent irrational waves of optimism and
pessimism: Animal spirits of investors " herd behaviour

Financing Constraints

- Neoclassical theory assumes firms can borrow to buy capital whenever it is profitable
o BUT some firms face financing constraints: limits on the amounts they can
borrow (or otherwise raise in financial markets)
o Implication: FCs make investment more sensitive to firms’ current cash flow &
thus current economic conditions (i.e. credit crunch) because
! Recession + financing constraint: % current profits " if future profits
expected to be high, investment is still profitable, but no funds available
" unable to invest
- 168 - Peter C. May

18-2. RESIDENTIAL INVESTMENT

- Residential investment: Building and purchase of new housing, both by people who
want to live in it themselves and by landlords who plan to rent it to others
o For simplification: assume that all housing is owner-occupied
o Major factor driving residential investment by owner-occupiers: imputed rent that
owners expect to receive from owning their home (flow of ‘housing services’)

The Stock Equilibrium & Flow Supply

- 2 markets
1) Market for existing stock of houses determines the equilibrium housing price (PH)
2) Relative housing price determines the flow of new residential investment

- HENCE: residential investment depends on the relative price of housing (PH/P), which
depends on the imputed rent that individuals expect to receive from their housing (i.e.
demand for housing)

a) The Market for Housing b) The Supply of New Housing

PH/P Supply PH/P

Demand

PH*/P
Demand

K
!H Stock of housing IH* Flow of residential
capital, KH investment, IH

Explanation: The relative price of housing adjusts to equilibrate supply

and demand for the existing stock of capital. The relative price then
determines residential investment, the flow of new housing that
construction firms build!

- When the demand for housing shifts, PH*/P changes, which in turn affects IH*
[residential investment]
o Housing demand could increase because
! #Y
! # population
! %r (#& or %i)
 Peter C. May - 169 -

How Residential Investment Responds to a Fall in Interest Rates

a) The Market for Housing b) The Supply of New Housing

PH/P Supply PH/P

Demand

PH(r2)/P
2
PH(r1)/P
D(r2)
1
D(r1)

K
!H Stock of housing IH(r1) IH(r2) Flow of residen-
capital, KH 3 tial investment, IH

1) A decrease in the real interest rate increases the demand for

housing [by % mortgage payments & # maximum possible loan]
2) Which increases the equilibrium relative price of housing
3) And thus raises the flow of residential investment
! %r " #I

Tax Treatment of Housing

- The tax code, in effect, subsidizes home ownership by allowing people to deduct
mortgage interest
o The deduction applies to the nominal mortgage rate, so the subsidy is higher
when inflation and nominal mortgage rates are high than when they are low
o Some economists think this subsidy causes over-investment in housing relative
to other forms of capital
o BUT eliminating the mortgage interest deduction would be politically difficult

18-3. INVENTORY INVESTMENT

- Inventory investment is only 1% of GDP

o BUT: remarkable volatile: In the typical recession, more than half of the fall in
spending is due to a fall in inventory investment!

- 4 motives for holding inventory

1. Production smoothing – Sales fluctuate, but many firms find it cheaper to

produce at a steady rate than varying with the business cycle
o When sales < production, # inventories
o When sales > production, % inventories
- 170 - Peter C. May

2. Inventories as a factor of production – Operate more efficiently by protecting

production from temporary breakdowns
3. Stock-out avoidance – To avoid loss of sales and profits when demand is
unexpectedly high
4. Work in progress – Goods not yet completed are counted as part of inventory

Accelerator Model

- A simple theory that explains the behaviour of inventory investment, without endorsing
any particular motive

- Model:
o Notation
! N = stock of inventories
! $N = inventory investment
o Assumption
! Firms hold a stock of inventories that is proportional to the firms’ level
of output
! N = " # Y, where N is the economy's total stock of inventories
o Result:

II = "N = # $ "Y
!
! Inventory investment is proportional to the change in output!
a) When #Y " $N +ve: inventory investment
!
b) When %Y " $N 've: inventory disinvestment (by allowing existing
inventories to run down)
o The estimated relationship is I=0.2($Y

Inventories and the Real Interest Rate

- Holding inventory means selling something tomorrow rather than today, thus giving up
the real interest rate that could have been earned between today and tomorrow
o OR in other words: The opportunity cost of holding goods in inventory is the
interest that could have been earned on the revenue from selling those goods

- When #r " # cost of holding inventories " %II

o Example: High real interest rates in the 1980s motivated many firms to adopt
just-in-time production, which is designed to reduce inventories
 Peter C. May - 171 -

SUMMARY:

1. All three types of investment (business fixed, residential, inventory) depend

negatively on the real interest rate " if %r:
a. % Business fixed investment since # cost of holding capital
b. % Residential investment since # cost of buying houses (# mortgage
payments)
c. % Inventory investment since # opportunity cost of holding goods in
inventory (=interest that could have been earned on the revenue from
selling those goods)
2. Business fixed investment
a. MPK determines the real rental price
b. Real interest rate, depreciation rate and the relative price of capital goods
determine the cost of capital [(PK/P)((r+/)]
c. According to the neoclassical model, firms invest if R/P=MPK > costs,
and disinvest if R/P=MPK < costs
3. Tobin’s q
a. Alternative way of expressing neoclassical model of investment
b. Ratio of market value of installed capital to its replacement cost
c. Reflects current and expected future profitability of capital
d. The greater q, the greater the incentive to invest
4. Financing constraints: In contrast to the assumption of the neoclassical model,
firms cannot always raise funds to finance investment ! FCs make investment
more sensitive to firms’ current cash flow and thus economic conditions
5. Residential investment
a. Depends on relative price of housing [the greater PH/P, the greater RI]
b. Housing prices in turn depend on the demand for housing and the
current fixed supply
c. # Housing demand (e.g. because %r) " # relative price " #IR
6. Inventory investment
a. Motives: production smoothing, use as a factor of production (#
efficiency, %breakdowns), avoiding stock-out & storing work in process
b. Accelerator model: investment depends on change in GDP [II=.($Y]
7. Things that shift the investment function
a. Technological improvements: #MPK " # business fixed investment
b. Increase in population: # demand for, price of housing " # residential
investment
c. Economic policies (corporate income tax, investment tax credit) alter
incentives to invest
8. Investment is the most volatile component of GDP over the business cycle
a. Fluctuations in employment affect the MPK and the incentive for
business fixed investment.
b. Fluctuations in income affect demand for and thus price of housing and
the incentive for residential investment
c. Fluctuations in output affect planned & unplanned inventory investment
- 172 - Peter C. May

- Chapter 19: Money Supply and Money Demand -

19-1. MONEY SUPPLY

- Definition of money supply in Ch. 4: quantity of money = number of dollars held by the
public [controlled by CB by # or % the number of dollars in circulation through open-
market operations]
o BUT: very simplified version
o More complete explanation
! Money supply is not only determined by CB policy, but also by the
behaviour of
1. Households – which hold money
2. Banks – in which money is held

Money Supply = Currency + Demand Deposits

M = C + D

! Since the money supply includes demand deposits, the banking system
! plays an important role

100-Percent-Reserve Banking

- Reserves (R): Portion of deposits that banks have received but have not lent out
o Some reserves are held in the vaults of local banks throughout the country
o BUT: most are held at CB

- 100-percent-reserve banking: System in which banks hold all deposits as reserves &
give out no loans (so make no revenue)

- Bank’s balance sheet (with 100% reserve banking)

o Assets = Reserves
o Liabilities = Deposits
! e.g. 1,000" deposit " 1,000" assets (reserves) & 1,000" liabilities (deposits)

- Effect on money supply:

o Without a bank, the money supply would be 1,000" of currency
! [C=1,000, D=0, M=1,000]
o With a 100% reserve bank, the money supply is 1,000" of demand deposit
! [C=0, D=1,000, M=1,000]
o HENCE: A " deposited in a bank % currency by 1" and # demand deposits by
1" ! money supply remains the same
 Peter C. May - 173 -

Rule: If banks hold 100% of deposits in reserve, the banking system does not affect
the supply of money!

Fractional-Reserve Banking

- Fractional-reserve banking: System in which banks only hold a fraction (e.g. 20%) of
their deposits as reserves & make loans

- Banks’ balance sheet (with fractional-reserve banking – holding 20% as reserves)

o First bank [receives 1,000" deposit]
! Assets: 800" loan + 200" reserves
! Liabilities: 1,000" deposits
o Second bank [receives 800" deposit from loan]
! Assets: 640" loan + 160" reserves
! Liabilities: 800" deposits
o Third bank [receives 640" deposit from loan]
! Assets: 512" loan + 128" reserves
! Liabilities: 640" deposits
… other lending
! With each new deposit & loan, more money is created

- Effect on money supply

o Without a bank, the money supply would be 1,000" of currency
! [C=1,000, D=0, M=1,000]
o With fractional-reserve bank, the money supply increases
! [C=0, D=1,000+800+640+512…, M>1,000]
o If rr denotes the reserve-deposit ratio (e.g. 0.2), then the total money supply is:

1
Total money supply = " Initial money supply, where rr : reserve - deposit ratio
rr
1
e.g. M = " 1,000! = 5,000!
0.2

! Rule:
1) Banks not only act as financial intermediaries (transferring funds from savers to
borrowers), but also have the legal authority to create assets that are part of the money
supply (e.g. current accounts)
2) Banks are the only type of financial intermediary that creates money through making
loans
3) A fractional reserve banking system creates money & liquidity, BUT it does not create
wealth: Bank loans give borrowers some new money and an equal amount of new debt
- 174 - Peter C. May

A Model of the Money Supply (Under Fractional-Reserve Banking)

- 3 exogenous variables

1) Monetary base (B): Total number of "s held by the public as currency (C)
and by banks as reserves (R)
! Controlled by the central bank
! B=C+R

2) Reserve-deposit ratio (rr): Amount of reserves (R) banks hold as a fraction

of their holdings of demand deposits (D)
! Depends on regulations & bank policies
! rr=R/D

3) Currency-deposit ratio (cr): Amount of currency (C) people hold as a

fraction of their holdings of demand deposits (D)
! Depends on regulations & bank policies
! cr=C/D

- Solving for the money supply

(1) M = C + D
(2) B = C + R
B B (C/D + D/D) 1+ cr
" M = (C + D) # = (C + D) # = #B= #B
B (C + R) (C/D + R/D) cr + rr

- HENCE:
!
1+ cr
M= "B
cr + rr
1+ cr
or M = m " B, where m =
cr + rr

- Implications:
!
1. Money supply depends on the 3 exogenous variables (B, rr, cr)
2. If rr < 1, then m > 1 " m=money multiplier
! Since M=m(B, the monetary base has a multiplied effect on the money
supply ! High-powered money
3. M1B ! Money supply is proportional to the monetary base (B)
! %$B=%$M
4. Reserve-deposit ratio (rr) inversely proportional to M
! If rr% " #M [banks can lend more out of each unit of deposit]
5. Currency-deposit ratio (cr) inversely proportional to M
! If cr% " #M [More money in banks that can banks can lend out]
 Peter C. May - 175 -

- For a fixed money base

a) What happens if households hold more money in currency and less in
deposits?
! #cr " %m " %M
! $M=m($B " Banks have fewer deposits so cannot create as much
‘new money’ through lending
b) What happens if banks increase their reserves relative to deposits?
! #rr " %m " %M

Rule: Because the currency-deposit ratio (cr) and the reserve-deposit ratio (rr) can
vary, so can m & M " HENCE: monetary authority cannot precisely control the
money supply

Banks: Maturity Transformation

- Banks &c borrow short-term – depositors/lenders can get money out readily if they
need to
- But lend long-term – in assets such as business projects and housing loans that will take
a while to reach profitable maturity
o By itself this is efficient, not sinister
o It works fine if there is no rush to the exit and if the bank remains solvent – i.e.
if the assets if held to maturity are worth more than the bank’s obligations to
depositors/ lenders

Liquidity problem: efficient calm or bank run?

Others stay cool Others panic

Withdraw money only if needed Efficient investment & convenience Lose your money
Withdraw money anyways Efficient investment & inconvenience Chance of salvaging some of your money

Introduce 100% deposit insurance

Others stay cool Others panic

Withdraw money only if needed Efficient investment & convenience Inefficient investment but no loss to you
Withdraw money anyways Efficient investment & inconvenience Inefficiency & inconvenience

Solvency problem:
- The assets even if held to maturity are probably worth less than the bank’s obligations to
depositors/lenders
o For example, if the value of the housing collateral backing mortgage loans
slumps
o Or if the bank has mortgage-backed securities on its balance sheets
- Contagion risk as banks all try to dump their exposures, sending asset prices down
- Loss of trust even among banks
- 176 - Peter C. May

The 3 Instruments of Monetary Policy

1) Open-market operations
2) Reserve requirements
3) Refinancing rate

1) Open-market operations (most frequently used)

- Definition: The purchase or sale of government bonds by the central bank
o To #M, CB creates money & uses it to buy government bonds from the public
" extra money is in hands of public [#C " #B " #M]
o To %M, CB sells government bonds from its portfolio and destroys the money it
receives " less money in hands of public [%C " %B " %M]
- OMOs cause a change in (US) Federal Funds Rate 2 Discount Rate [Refinancing rate]
- Note: these transactions are outright OMOs because they each involve an outright sale or
purchase of non-monetary assets to or from the banking sector without a corresponding
agreement to reverse transaction at a later date [! OMOs differ from refinancing rate]

2) Reserve requirements (least frequently used)

- Definition: Regulations on the minimum amount of reserves that banks must hold
against deposits (rarely used!)
o If %rr " banks can make more loans and “create” more money from each
deposit " #M
o If #rr " banks can make less loans and “create” less money from each deposit
" %M
- Why not use reserve requirements more frequently?
o Making them too low creates a risk of bank runs & bank failures
o Making them too high makes banking unprofitable
o Banking would be difficult if the Fed changed reserve requirements frequently

3) Refinancing rate (largely symbolic)

- Definition: Interest rate at which the CB is willing to lend to commercial banks on a
short-term basis [usually higher than (US) Fed Funds Rate]
- When banks borrow from CB, their reserves increase, allowing them to make more
loans and “create” more money [banks have to balance their balance sheet at the end of
every working day]
o If CB #r " % borrowing from CB by banks " % reserves " %M
o If CB %r " # borrowing from CB by banks " # reserves " #M
- Setting the refinancing rate incorporates the use of a more sophisticated way of OMOs
o CB buys bonds or other assets from banks & at the same time agrees to sell
them back later
o HENCE: CB has effectively made a loan against a collateral
o The interest rate it charges on this is the refinancing rate
! called repurchase agreement (or repo)
- Largely symbolic because CB is a lender of last resort & thus does not usually make
loans to banks on demand
 Peter C. May - 177 -

The Central Bank’s Loss of Control over the Money Supply

- CB’s control over the money supply is not precise " 2 problems caused by the money
creation by banks in a fractional reserve system

1) CB cannot control the amount of money that households choose to hold as

deposits in bank
o If confidence in banking system falls " people withdraw money " #
currency & % demand deposits " #cr " %M
2) CB cannot control the amount that bankers choose to lend
o Banks can choose between holding excess reserves OR lending
o If banks become more cautious about economic conditions " % lending
" #rr "%m " %M

- HENCE: In a system of fractional-reserve banking, the money supply depends in part

on the behaviour of depositors & bankers

CASE STUDY: Bank Failures, Money Supply & the Great Depression

- 1929-1933: %M by 28% & over 9000 banks closed

o Caused by fall in money multiplier [m=(cr+1)/(cr+rr)]
! #cr because of reduced public confidence in banks
! #rr because bankers became more cautious
o CB should have prevented bank failures by acting as a lender of last resort & even
sharper increases in the monetary base
! This drop in the money supply may have caused the Great Depression
! It certainly contributed to the Depression’s severity

- Could this happen again?

o Many policies have been implemented since the 1930s to prevent such
widespread bank failures
o Example: Federal Deposit Insurance, to prevent bank runs and large swings in
the currency-deposit ratio
o In the current crisis, governments acted successfully as a lender of last resort for
many struggling banks (except for Lehman Brothers) & thereby avoided bank
runs
- 178 - Peter C. May

19-2. MONEY DEMAND

- General money demand function:

(M/P)d = L(i, Y)

- 2 types of theories
1) Portfolio theories
!
! Emphasize store of value function
! Relevant for M2 & M3 BUT not relevant for M1
2) Transactions theories
! Emphasize medium of exchange function
! Also relevant for M1

Portfolio Theories of Money Demand

- Emphasize the role of money as a store of value

o Key insight: Money offers a different combination of risk & return than other
assets (stocks, bonds)

- - - +
(M/P)d = L(rS , rB , " e , W )
- rS : Expected real return on stocks (if # rS $ %(M/P)d )
- rB : Expected real return on bonds (if # rB $ %(M/P)d )
- " e : Expected rate of inflation (if # " e $ %(M/P)d )
- W : Real wealth (if # W $ #(M/P)d )

- Intuition for the relationships:

! o Stocks and bonds are alternatives to money
! An increase in their expected returns makes money less attractive, and
thus reduces desired money holdings
o The real return to holding money is -&e
! An increase in &e is a decrease in the real return to holding money, which
would cause a decrease in desired money balances
o An increase in wealth causes an increase in the demand for all assets

- Portfolio theories useful for studying money demand?

o Depends on which measure of money we are considering
! More plausible if we adopt a broad measure of money (e.g. Euro-Area:
M3, UK: M4)
! REASON: Money (M1) is a dominated asset: as a store of value, it
exists alongside other assets that always have a better risk-return profile
! Optimal amount of M1 money in portfolio would be 0
 Peter C. May - 179 -

- NOTE: Most of the currency in an economy is hold by people in the black economy
o Economists: Large amount of currency in black economy = one reason that
some moderate inflation may be desirable
! Black economy is hit hardest by inflation tax

Transaction Theories of Money Demand

- Acknowledge that money is a dominated asset and stress that people hold money, unlike
other assets, to make purchases " money as medium of exchange
o Explain why people hold narrow measures of money, such as currency and bank
current accounts as opposed to holding assets that dominate them (savings
accounts, Treasury bills etc.)

Prominent Example: Baumol-Tobin Model of Cash Management

- Analyses costs and benefits of holding money

o Costs = foregone interest
o Benefits = convenience [people hold money to avoid making a trip to the bank
every time they wish to buy something]

- Notation:
o Y = total spending, done gradually over the year
o i = interest rate on savings account
o N = number of trips consumer makes to the bank to withdraw money from
savings account
o F = cost of a trip to the bank (e.g., if a trip takes 15 minutes and consumer’s
wage = $12/hour, then F = $3)

- Assumption:
o Consumer’s wealth is divided between cash on hand and savings account
deposits
! Savings account pays interest rate i, while cash pays no nominal interest
o Alternatively, we can think of money in the BT model as representing all
monetary assets, including some that pay interest
! Then, i in the model would be the interest rate on non-monetary assets
(e.g. stocks & bonds) minus the interest rate on monetary assets
(interest-bearing checking & money market deposit accounts)
! F would be the cost of converting non-monetary assets into monetary
ones, such as a brokerage fee
! The decision about how often to pay the brokerage fee is analogous to
the decision about how often to make a trip to the bank
- 180 - Peter C. May

- If an individual makes N trips to the bank over the course of a year, his average money
holding is:

Y
Avg. money holding =
2N

Money
!
holding Example: N=3
Y

Avg. money holding=Y/6

Y/3

1/3 2/3 1 T

- Average foregone interest is i((Y/2N) so total cost of holding money is:

Total costs = Foregone Interest + Cost of Trips

C = iY/2N + FN
"C iY
= - 2 +F = 0
"N 2N
iY
# N* =
2F
Costs

!
Total cost

Cost of trips to bank = FN

Foregone interest = iY/2N

N* N (no. of trips)
(No. of trips that
minimizes total cost)

- Avg. money holding at N*:

Y YF
Avg. money holding = =
2N * 2i

!
 Peter C. May - 181 -

- HENCE: Individuals hold more currency if

1) Fixed cost of going to the bank is higher: #F
2) Income is higher: #Y
o B-T implies that income elasticity of money demand = 0.5
ln(avg. MH) = 0.5ln(Y) + 0.5ln(F) - 0.5ln - 0.5ln(i)
"ln(avg. MH)
YED = = 0.5
"ln(Y)
3) Interest rate is lower: %i
o B-T implies that interest elasticity of money demand = '0.5
! ln(avg. MH) = 0.5ln(Y) + 0.5ln(F) - 0.5ln - 0.5ln(i)
"ln(avg. MH)
IED = = -0.5
"ln(i)

- Implication: Any change in the fixed cost F (trip to bank OR brokerage fee) alters the
money demand! function:
o E.g. ATMs " %F " % Avg. money holdings " %(M/P)d " %k " #V " #(?)P

Financial Innovation, Near Money & the Demise of Monetary Aggregates

- Traditional macroeconomic analysis groups assets into 2 categories

1) Those used as a medium of exchange & store of value (currency, current accounts)
2) Those used only as a store of value (stocks, bonds, saving accounts) ! no money

- HOWEVER: financial innovation makes this distinction increasingly difficult in practice

o Examples of financial innovation:
! Many checking accounts now pay interest
! Very easy to buy and sell assets
! Mutual funds are baskets of stocks that are easy to redeem - just write a
check
o Near money: Non-monetary assets that have acquired some of the liquidity of
money
! E.g. investment trusts allow depositors to hold stocks & bonds and to
make withdrawals of cash on demand

- Implication
o Complicates monetary policy by making demand for money unstable
(households can switch between money and near money for minor reasons "
close substitutes)
! CB switched from controlling the money supply to setting the
refinancing rate & simply supply whatever money is necessary through
OMOs in order to achieve that interest rate
! HENCE: money supply becomes endogenous: it is allowed to adjust to
whatever level is necessary to keep the interest rate on target
- 182 - Peter C. May

Why Bond Prices are Negatively Related to the Interest Rate

- Consider zero-coupon bonds, which don’t pay coupons but derive their value from the
difference between the purchase price and the par value paid at maturity
o For instance, if a zero-coupon bond is trading at $950 and has a par value of
$1,000 (paid at maturity in one year), the bond’s rate of return at the present
time is approximately 5.26% [(1000-950)/950 = 5.26%]
o For a person to pay $950 for this bond, he or she must be happy with receiving
a 5.26% return
o BUT his or her satisfaction with this return depends on what else is happening
in the bond market (Bond investors, like all investors, typically try to get the best
return possible)

- If current interest rates were to rise, giving newly issued bonds a yield of 10%, then the
zero-coupon bond yielding 5.26% would not only be less attractive, it wouldn’t be in
demand at all. Who wants a 5.26% yield when they can get 10%?
o HENCE: To attract demand, the price of the pre-existing zero-coupon bond
would have to decrease enough to match the same return yielded by prevailing
interest rates
o In this instance, the bond’s price would drop from $950 (which gives a 5.26%
yield) to $909 (which gives a 10% yield)

- If current interest rates were to drop to 3%, our zero-coupon bond – with its yield of
5.26% – would suddenly look very attractive
o More people would buy the bond, which would push the price up until the
bond’s yield matched the prevailing 3% rate
o In this instance, the price of the bond would increase to approximately $970
o Given this increase in price, you can see why bond-holders (the investors selling
their bonds) benefit from a decrease in prevailing interest rates

Bond Price

Interest rate (on

newly issued bonds)
 Peter C. May - 183 -

SUMMARY:

1. Fractional-reserve banking (in contrast to 100%-reserve banking) creates money

because each dollar of reserves generates many dollars of demand deposits
a. CB can control the monetary base (C+R) but not the money supply
2. The money supply depends on the
a. Monetary base " B=C+R
b. Currency-deposit ratio " cr=C/D
c. Reserve-deposit ratio " rr=R/D
! M=[(cr+1)/(cr+rr)](B
3. The CB can control the money supply with
a. Open market operations [#M by # buying of government bonds]
! changes US Fed Funds rate, UK base rate
b. Refinancing rate [#M by % discount rate which # bank lending by CB]
! changes US discount rate, UK refinancing rate
c. Reserve requirements [#M by % reserve requirements]
4. Portfolio theories of money demand
a. Stress the store of value function
b. Posit that money demand depends on risk/return of money & alternative
assets
c. BUT M1-money is a dominated asset " optimal amount in portfolio 0
5. Baumol-Tobin model
a. Is an example of the transactions theories of money demand, stresses
medium of exchange function
b. Money demand depends positively on spending, negatively on the interest
rate, and positively on the cost of converting non-monetary assets to
money
6. Financial innovation has led to the creation of assets with many of the attributes
of money (especially its liquidity)
a. This near monies makes the demand for money less stable, which
complicates the conduct of monetary policy
- 184 - Peter C. May

- Chapter 20: Advances in Business Cycle Theory -

- 2 recent strands of research on short-run fluctuations in output and unemployment

1) Real Business Cycle Theory: Believe that one can explain SR economic
fluctuations while maintaining the assumptions of the classical model (i.e.
flexible prices & classical dichotomy)
o Only changes in real variables affect output, so economic fluctuations
are explained by changes in real variables & not nominal variables
2) New Keynesian Economics: Sticky wages and prices in SR cause output to
deviate from Y ! [natural level of output & unemployment]

20-1. THE THEORY OF REAL BUSINESS CYCLES

- All prices flexible, even in short run

o Implies money is neutral, even in short run
o Classical dichotomy holds at all times

- Productivity shocks the primary cause of SR economic fluctuations

o Technological progress and economic growth occur unevenly
o Shocks induce SR fluctuations in the natural levels of output and employment
o Fluctuations in output, employment, and other variables are the optimal
responses to exogenous changes in the economic environment

The Economics of Robinson Crusoe

- Economy consists of a single producer-consumer, like Robinson Crusoe on a desert

island
o Assume Crusoe divides his time between 3 activities
1. Leisure: swimming & consuming fish
2. Working
o Production: catching fish for consumption
o Investment: making fishing nets
o Assume Crusoe optimizes given the constraints he faces

- Economy’s GDP = Number of fish caught + Number of fishing nets made [weighted
by some prices to reflect relative valuation]

- Evaluating impact of 3 shocks:

1. Large school of fish passes by the island
2. Big storm hits the island
3. Attack by natives (war)
 Peter C. May - 185 -

Shock I: Large school of fish passes by the island

- #GDP because
o # Productivity (Crusoe catches more fish per hour)
o # Employment (Crusoe decides to shift some time from leisure to fishing to
take advantage of the temporary high productivity)

Shock II: Big storm hits the island

- %GDP because:
o % Productivity (Crusoe catches more fish per hour)
o % Employment (Crusoe spends less time fishing for consumption & more time
on leisure)
o % Investment (Easy to postpone making nets until storm passes)

Shock III: Attack by natives (war)

- #GDP (war-time boom) because
o # Employment (# production for defence industry & % leisure)
o % Production of fish & % investment as more time spent on defence "
crowding out
o BUT: in total he spends more time working, so #GDP

Rule:
Shocks aren’t always desirable BUT once they occur, fluctuations in output, employment,
consumption and productivity are all the natural, desirable and optimal response to the
inevitable change in environment
! SR fluctuations have nothing to do with monetary policy, sticky prices or any type of
market failure!

- At the heart of the debate about the validity of RBC theory are 4 issues:

1. Interpretation of the labour market: Do fluctuations in employment reflect

voluntary changes in QLS? [like Crusoe # leisure & % employment when %
productivity]

2. Importance of technology shocks: Does the economy’s production function

experience large, exogenous shifts in the SR?

3. Neutrality of money: Do changes in the money supply have only nominal or

also real effects (i.e. classical dichotomy or not)?

4. Flexibility of wages & prices: Do wages & prices adjust quickly and
completely to always balance demand & supply?
- 186 - Peter C. May

1. Interpretation of the Labour Market

- RBC: QLS depends on the incentives workers face

o Workers reallocate labour over time in response to changes in the reward to
working now versus later ! intertemporal substitution of labour
! Work more when well rewarded, but less when poorly rewarded
! Sometimes, if the reward for working is sufficiently small, workers
choose to forego working altogether (at least temporarily)

- Intertemporal relative wage: Relative reward for work of present vs. future
o W1: Real wage in period 1
o W2: Real wage in period 2

(1+ r)W1
Intertemporal Relative Wage =
W2
(1+ r)W1
- if > 1 " work in period 1
W2
(1+ r)W1
- if < 1 " work in period 2
W2

- In RBC!theory:
o Shocks cause fluctuations in the intertemporal wage
o Workers respond by adjusting labour supply ! most unemployment is voluntary,
involuntary does not exist
o This causes employment and output to fluctuate (if #i " #IRW " #E " #Y)
o Interest rates are important as they represent the relative price of labour and
determine agents’ choices between labour and leisure

- Critics argue that:

o Labour supply is not very sensitive to the intertemporal real wage
o High unemployment observed in recessions is mainly involuntary [If workers
were choosing not to working, they would not call themselves unemployed] "
wages do not adjust to equilibrate the labour market
! Reply by advocates of RBC: People call themselves unemployed to collect
unemployment benefits

- Empirical research:
o Most studies of labour supply find that expected changes in the real wage lead to
only small changes in hours worked
! BUT: data does not include wages that unemployed could have earned by
taking a job
o HENCE: Although most studies of labour supply find little evidence for
intertemporal substitution, they do not end the debate over RBC theory
 Peter C. May - 187 -

2. Importance of Technology Shocks

- RBC assumes that economy experiences fluctuations in technology

o Technology: Economy’s ability to turn inputs (capital & labour) into output
(goods and services)
o In CD production function: F(K, L)=A(K)(L(1-)) " A changes
! When technology improves: #Y ! " # employment & #(W/P)
! Recession ! periods of technological regress

- BUT critics argue that technological progress is a gradual process

o Response by RBC:
! Bad weather, the passage of strict environmental laws or increases in
world oil prices have effects similar to adverse changes in technology:
they reduce the economy’s ability to turn capital & labour into goods and services!

- Solow residual: Measure of productivity shocks & of the rate of technological progress
" shows the change in output that cannot be explained by changes in capital and labour

Solow Residual = %" Output - %" Inputs

(different inputs weighted by their factor shares)

- RBC theory implies that the Solow residual should be highly correlated with output
o Empirical research by Prescott:
!
a) Solow residual varies substantially over time (-1 to +3)
b) High correlation between Solow residual and growth in GDP per worker
c) HENCE: Technology shocks are an important source of economic
fluctuations
o BUT controversial
! Many economists do not believe that the Solow residual accurately
represents changes in technology over short periods of time because of

1. Labour hoarding: Firms may continue to employ workers when

they do not need them (e.g. in recessions), so that they have the
workers on hand when the economy recovers
! Solow residual overestimates labour input during
recession [in a recession, total factor productivity falls
even if technology has not changed]

2. Immeasurable activities: When demand is low, firms may

produce things that are not easily measured (e.g. clean the
facture, organize inventory)
! Solow residual underestimates output during
recession
- 188 - Peter C. May

3. The Neutrality of Money

- RBC assumes money neutrality in SR (most radical assumption)

o BUT RBC critics note that reductions in money growth and inflation are almost
always associated with periods of high unemployment and low output
! %M & %& " %Y & # unemployment
o RBC proponents respond by claiming that money supply is endogenous
[Confusion of direction of causation between money & output]
! Suppose output is expected to fall ! CB reduces money supply in
response to an expected fall in money demand
! HENCE: changes in Y cause changes in M, not the other way round!

4. The Flexibility of Wages & Prices

- RBC theory assumes that wages and prices are completely flexible " no market
imperfections " markets always clear
o RBC proponents argue that the extent to which wages or prices may be sticky in
the real world is not important for understanding economic fluctuations
o Flexible prices are consistent with microeconomic theory
- Critics believe that wage and price stickiness explains involuntary unemployment and
the non-neutrality of money

20-2. NEW KEYNESIAN ECONOMICS

- Most economists believe that SR fluctuations in output & employment represent

deviations from the natural rate
o These deviations occur because wages & prices are sticky
o Price/wage stickiness makes SRAS upward sloping rather than vertical
o HENCE: fluctuations in AD cause SR fluctuations in Y & u

- New Keynesian Economics research: Attempts to explain the stickiness of wages and
prices by examining the microeconomics of price adjustment
o Why are prices sticky?
1) Small menu costs and AD externalities
2) Coordination failures
3) Staggering of wages & prices
4) Implicit contracts
 Peter C. May - 189 -

1) Small Menu Costs & AD Externalities

- Menu costs = costs to adjust prices

o E.g. costs of printing new menus or mailing new catalogs
o Causes firms to change prices intermittently rather than continuously

- There are also externalities to price adjustment: Macroeconomic impact of one firm’s
price adjustment on the demand for all other firms’ products
o A price reduction by one firm causes the overall price level to fall (albeit slightly)
o This raises real money balances and increases aggregate demand, which benefits
other firms
o %Pown " %Ptotal " #(M/P) " rightward shift of LM " #AD " # demand for
the products of all firms
! explains why even small menu costs can cause a large cost to society!

Rule: In the presence of menu costs, sticky prices may be optimal for the firms setting
them even though they are undesirable for the economy as a whole!

2) Recessions as Coordination Failure

- In booms, almost everyone is better of than in recessions, so there must be a

coordination failure that explains why society fails to reach an outcome that is feasible
& that everyone prefers
o Failure arises in the setting of wages & prices because those who set them must
anticipate the actions of other wage & price setters [but imperfect information]

- Can be seen as game between different firms

o Recession " if all firms and workers would reduce their prices, then economy
would return to full employment
o BUT: no individual firm or worker would be willing to cut his price without
knowing that others will cut their prices
o HENCE: prices remain high and the recession continues

- Example: CB %M " firms face decision: keep high price or %p

Firm 2
Cut price Keep high price
Cut price F1: 30", F2: 30" F1: 5", F2: 15"
Firm 1
Keep high price F1: 15", F2: 5" F1: 15", F2: 15"
Recession

- Multiple equilibria: Both firms cut prices OR both firms keep prices high (" recession)
o If firms could coordinate, they would both cut prices & thus avoid recession,
but if n large, coordination difficult ! underemployment equilibrium
- 190 - Peter C. May

Rule: Prices can be sticky simply because people (i.e. firms) expect them to be sticky,
even though stickiness is in no one’s interest

3) Staggering of Wages & Prices

- Wages & prices are not simultaneously

o Staggering makes the overall level of wages & prices adjust gradually, even when
individual wages & prices change frequently

- If all firms’ price setting process was synchronized, relative prices would be unchanged
o BUT: if price setting is staggered, firms that raise prices have a relative
disadvantage
o HENCE: disincentive to raise prices " price level adjusts sluggishly

- NOTE: If all wages were set simultaneously, workers might be willing to accept a lower
wage because relative wage would be unchanged

4) Implicit Contracts

- Implicit contract " firms want to form long-term relationships with their customers
to make sales more predictable
o Customer provides loyalty & firm provides stable prices
o Other reason: cost of negotiating may be sufficiently high that buyers and sellers
agree to a contract that fixes the price for the duration of the contract’s life

CASE STUDY: Sticky Prices in the EU & the US

- Blinder " Inflation Persistence Network (IPN)

o Avg. time between price changes for any one product
! EU: 13 months
! US: 6.7 months
o Top reasons for price stickiness
! EU: implicit & explicit contracts
! US: Coordination failure
- Blinder: “If it proves difficult or impossible to remove or reduce greatly this price stickiness, the door is
opened to activist monetary policy to cure recessions”
 Peter C. May - 191 -

20-3. SUMMARY & CONCLUSION

- Policy implications
o RBC: supply-side measures (limited government influence in SR)
o New Keynesian: Monetary & fiscal policy = important stabilizers for the
economy in SR
! Not all economists fall entirely into one camp or the other!

Hot Issue RBC Proponents RBC Critics

1. Intertemporal YES! N O!
substitution of - Shock " fluctuations in - Labour supply is not very
intertemporal wage " workers sensitive to intertemporal real
labour & existence wage [confirmed by empirical
adjust labour supply "
of only voluntary employment & output to research]
unemployment? fluctuations - High unemployment observed
in recessions is mainly
involuntary unemployment

2. Technology shocks YES! N O!

important for - Technology shocks " change
in economy’s ability to turn
explaining SR
capital & labour into goods and
fluctuations? services " change in Y ! and
thus in Y & unemployment
- High correlation between
Solow residual and growth in
GDP per worker
- Solow residual does not
accurately represent changes in
technology over short periods
of time because of labour
hoarding & immeasurable
activities during recessions
[overestimates relationship]

3. Are nominal NO! YES!

variables important - Money is neutral even in SR - Reductions in money growth
- Money supply is endogenous and inflation are almost always
for explaining SR - Confusion of direction of associated with periods of high
fluctuations? Is causation between Y & M unemployment and low output
money non-neutral? o %M & %& " %Y & #u

4. Are inflexible NO! YES!

- Wages and prices are - Wage and price stickiness
wages & prices
completely flexible " no explains involuntary
important for unemployment and the non-
market imperfections "
explaining SR markets always clear neutrality of money
fluctuations? - Extent to which wages or
prices may be sticky in the real
world not important for
understanding economic
fluctuations
- 192 - Peter C. May

SUMMARY:

1. Real Business Cycle theory

a. Builds on the assumptions of classical model (i.e. perfect flexibility of
wages and prices, classical dichotomy)
b. Shows how fluctuations arise in response to productivity shocks
c. Economic fluctuations are the natural & efficient response to changing
economic circumstances, especially changes in technology
2. Points of controversy in RBC theory
a. Intertemporal substitution of labor
b. Importance of technology shocks
c. Neutrality of money
d. Flexibility of prices & wages
3. New Keynesian economics
a. Accepts the traditional model of aggregate demand and supply
b. Attempts to explain the stickiness of wages and prices with
microeconomic analysis, including
i. Menu costs & AD externalities [even small menu costs can have
large macroeconomic affects because of AD externalities (i.e.
effect on real money balances and total demand for products)]
ii. Coordination failure
iii. Staggering of wages & prices
iv. Implicit contracts
 Peter C. May - 193 -

- Epilogue -

E-1. THE FOUR MOST IMPORTANT LESSONS OF MACROECONOMICS

Lesson 1

In the long-run, a country’s capacity to produce goods and services determines the
standard of living of its residents!

- Real GDP measures the economy’s total output of goods and services, and, therefore, a
country’s ability to satisfy the needs and desires of its residents
o In the long-run, GDP depends on the factors of production – capital and labour
– and on the technology for turning capital and labour into output
o GDP grows when the factors of production increase or when the economy
becomes better at turning these inputs into an output of goods and services

- Corollary for policy: Public policy can raise GDP in the long-run only by improving the productive
capability of the economy
o Policies that raise national saving – either through higher public saving or higher
private saving – eventually lead to a larger capital stock
o Policies that raise the efficiency of labour – such as those that improve
education or increase technological progress – lead to a more productive use of
capital and labour
o Policies that improve a nation’s institutions – such as crackdowns on official
corruption – lead to both greater capital accumulation and a more efficient use
of the economy’s resources

Lesson 2

In the short-run, aggregate demand influences the amount of goods and services that a
country produces

- Although the economy’s ability to supply goods and services is the sole determinant of
GDP in the long-run, in the short-run GDP depends also on the AD for goods and
services
o AD is of key importance because prices are sticky in the short-run
o HENCE: All the variables that affect AD can influence economic fluctuations
! Monetary policy
! Fiscal policy
! Shocks to the money and goods market
! responsible for year-to-year changes in output and employment
- 194 - Peter C. May

- Because changes in AD are crucial to short-run fluctuations, policy makers monitor the
economy closely
o Before making any change in monetary or fiscal policy, they want to know
whether the economy is booming or heading into a recession ! output gap

Lesson 3

In the long-run, the rate of money growth determines the rate of inflation, but it does
not affect the rate of unemployment

- The long-run analysis stresses that the growth in the money supply is the ultimate
determinant of inflation
o HENCE: In the long-run, a currency loses real value over time if, and only if,
the central bank prints more and more of it

- Long-run effects of high money growth and high inflation

o According to the Fisher effect, high inflation raises the nominal interest rate (so
that the real interest rate remains unaffected)
o High inflation leads to a depreciation of the currency in the market for foreign
exchange

- The long-run determinants of unemployment are very different

o According to the classical dichotomy – the irrelevance of nominal variables in
the determination of real variables – growth in the money supply does not affect
unemployment in the long-run
o The natural rate of unemployment is determined by the rates of job separation
and job finding, which in turn are determined by the process of job search and
by the rigidity of the real wage

- Thus we concluded that persistent inflation and persistent unemployment are unrelated
problems
o To combat inflation, in the long-run, policy makers must reduce the growth in
the money supply
o To combat unemployment, they must alter the structure of labour markets

- In the long-run, there is no trade-off between inflation and unemployment (vertical

Phillips curve)
 Peter C. May - 195 -

Lesson 4

In the short-run, policy makers who control monetary and fiscal policy face a trade-off
between inflation and unemployment

- Although inflation and unemployment are not related in the long-run, in the short-run
there is a trade-off between these 2 variables ! illustrated by the short-run Phillips
curve
o Policy makers can use monetary and fiscal policies to expand AD, which lowers
unemployment and raises inflation
o OR they can use these policies to contract AD, which raises unemployment and
lowers inflation

- Policy makers face a fixed trade-off between inflation and unemployment only in the
short-run
o Over time, the short-run Phillips curve shifts for two reasons
! Firstly, supply shocks, such as changes in the price of oil, change the
short-run trade-off: An adverse supply shock offers policy makers the
difficult choice of higher inflation or higher unemployment (or a bit of
both)
! Second, when people change their expectations of inflation, the short-
run trade-off between inflation and unemployment changes

- The adjustment of expectations ensures that the trade-off exists only in the short-run
- 196 - Peter C. May

E-2. SUMMARY OF IMPACTS OF MONETARY, FISCAL AND TRADE POLICIES

1. Classical Closed Economy

Equations:
1) MV=PY
2) Y! =F(K
!, L!)
3) S=I(r)
4) P flexible (P=Pe)

Policies:
1) Monetary policy: #M " V ! " #P [if V variable: #M " #"e " #i " %(M/P)d " #V
!, Y
" ##P]
2) Fiscal policy:
a) #G " %S (Y ! , so C
! ) " #r " %I ! crowding out of investment & change in
composition of GDP: #G, %I [might lead to lower growth rate in the very long-
run due to lower capital-labour ratio]
b) %T " #C by -$T(MPC " % S (Y ! ) " #r " %I ! crowding out of investment &
change in composition of GDP: #C, %I [might lead to lower growth rate in the
very long-run due to lower capital-labour ratio]

2. Classical Open Economy

Equations:
1) MV=PY
2) Y! =F(K
!, L!)
3) S-I(r*)=NX(+(
4) P flexible (P=Pe)

Policies:
1) Monetary policy: #M " V !, Y
! " #P ! #P " %e but PPP: + unchanged so NX
unchanged
2) Fiscal policy:
a) #G " %S (Y ! , so C
! ) " r* but %(S-I)=net capital outflow " % net supply of
domestic currency " #+ [disregarding PPP] " %NX ! crowding out of net
exports & change in composition of GDP: #G, %NX
b) %T " #C by -$T(MPC " % S (Y ! ) " r* but %(S-I)=net capital outflow " %
net supply of domestic currency " #+ [disregarding PPP] " %NX ! crowding
out of net exports & change in composition of GDP: #G, %NX
3) Trade policy (e.g. quota): % imports & upward shift of NX(+) schedule " #+ " %X "
NX constant ! no change in trade deficit/surplus, merely a reduction in trade [might
lead to lower growth rate in the very long-run due to loss of gains from trade
(competitive advantage theory)]
 Peter C. May - 197 -

3. IS-LM Model Closed

Equations:
1) IS: Y=C(Y-T
! )+I(r)+G!
2) LM: M/P=L(i (or r), Y)
3) P fixed

Policies:
1) Monetary policy: #M " # supply of real money balances " %r for every given level of
Y ! rightward/downward shift of LM curve " #I " #Y
2) Fiscal policy:
a) #G " #E & #Y (Keynesian cross) by $G/(1-MPC) [$Y=$G+$C=
$G+($G(MPC)/(1-MPC)] " #Y for every level of r ! rightward shift of IS
curve " #r " %I [only partially crowds out I] ! #Y
b) %T " #E & #Y (Keynesian cross) by (-$T(MPC)/(1-MPC) [$Y=$C=(-
$T(MPC)/(1-MPC)] " #Y for every level of r ! rightward shift of IS curve
" #r " %I [only partially crowds out I] ! #Y
BUT: %T might have no effect when Ricardian equivalence holds

4. Mundell-Fleming Model (Fixed exchange rate)

Equations:
1) IS*: Y=C(Y-T ! )+I(r*)+G
! +NX(ePd/Pf)
2) LM: M/P=L(r*, Y) [vertical in Y-e space]
3) r=r* [perfect capital mobility]
4) e=e*
5) P fixed

Policies:
1) Monetary policy: #M " # supply of domestic currency in the FX market " downward
pressure on e " %M to keep at e at e* ! no effect because monetary policy is sacrificed
to keep e at e*
2) Fiscal policy:
a) #G " #E & #Y (Keynesian cross) by $G/(1-MPC) [$Y=$G+$C=
$G+($G(MPC)/(1-MPC)] " #Y for every level of e ! rightward shift of IS*
curve " upward pressure on r " # net capital inflow " # demand for currency
" upward pressure on e " CB has to #M to keep e at e* (#M until upward
pressure on r subsides] ! #Y
b) %T " #E & #Y (Keynesian cross) by (-$T(MPC)/(1-MPC) [$Y=$C=
(-$T(MPC)/(1-MPC)] " #Y for every level of e ! rightward shift of IS*
curve " upward pressure on r " # net capital inflow " # demand for currency
" upward pressure on e " CB has to #M to keep e at e* (#M until upward
pressure on r subsides] ! #Y
BUT: %T might have no effect when Ricardian equivalence holds
- 198 - Peter C. May

3) Trade policy (e.g. quota): % imports " upward shift of IS* curve " upward pressure on
e " CB has to increase M to keep e at e* " outward shift of LM* curve ! Y (but
decreasing Y for trading partners!)

5. Mundell-Fleming Model (Floating exchange rate)

Equations:
1) IS*: Y=C(Y-T ! )+I(r*)+G
! +NX(ePd/Pf)
2) LM: M/P=L(r*, Y) [vertical in Y-e space]
3) r=r* [perfect capital mobility]
4) P fixed

Policies:
1) Monetary policy: #M " # supply of domestic currency in the FX market " downward
pressure on e " %e " #NX ! #Y
2) Fiscal policy:
a) #G " #E & #Y (Keynesian cross) by $G/(1-MPC) [$Y=$G+$C=
$G+($G(MPC)/(1-MPC)] " #Y for every level of e ! rightward shift of IS*
curve " upward pressure on r " # net capital inflow " # demand for currency
" upward pressure on e " #e " %NX until upward pressure subside (when
r=r*, i.e. when $Y=0) " Y !
b) %T " #E & #Y (Keynesian cross) by (-$T(MPC)/(1-MPC) [$Y=$C=
(-$T(MPC)/(1-MPC)] " #Y for every level of e ! rightward shift of IS*
curve " upward pressure on r " # net capital inflow " # demand for currency
" upward pressure on e " #e " %NX until upward pressure subside (when
r=r*, i.e. when $Y=0) " Y !
BUT: %T might have no effect when Ricardian equivalence holds
3) Trade policy (e.g. quota): % imports " upward shift of IS* curve " upward pressure on
e " #e " %NX until upward pressure subside (when r=r*, i.e. when $Y=0) " Y !