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Lecture: THE KEYNESIAN MODEL IN THE SHORT AND LONG RUN
In the short run actual GDP, Y, may be lower or higher or equal to full-employment
GDP, Y . The aim of the Keynesian model in the short run is to explain short-run
fluctuations in production around a long-run trend.
The reason why actual GDP may deviate from full-employment GDP in the short run, is
that prices and nominal wages are assumed to be not fully flexible in the short run.
We start by assuming that P and W are fixed in the short run. In this case aggregate
demand determines output at a fixed price level. Thus, we assume that the short-run
supply curve (the MC-curve) is horizontal. A flat MC-curve is not unreasonable as when
firms increase output they in reality increase both K and L as some part of the stock of
physical capital is often unused in a recession. In a recession firms close production
plants, which makes both machines and workers unemployed. When firms expand
production they open up closed plants and employ workers. So MC needs not increase a
lot because diminishing MPL.
Lecture: BUILDING THE KEYNESIAN MODEL:
The simple Keynesian model for a closed economy without its own currency:
Assumption: The short-run supply curve is horizontal (= P is fixed), which implies that
aggregate demand alone determines output.
The model also assumes that the real interest rate is fixed; and that planned investment is
an exogenous variable. The money market plays no explicit role here.
The model is thus relevant for small economies without monetary authorities that are not
or far from full-employment. If economies are at full-employment government spending
cannot increase aggregate production. For example: the model is relevant for small
municipalities within Sweden or small countries within the Euro-area or small states
within the US states.
If they are big, expansionary fiscal policies might increase the real interest rate.
The model how income Y is determined for given levels of the exogenous variables:
government purchases (G), net taxes (T) and planned investment, I (planned). Actual
expenditure (Y) is the amount households, firms, and the government spends on newly
produced goods and services (GDP).
Planned expeditures is the amount households, firms and the government would like to
spend on newly produced goods and services. The economy is in equilibrium when
Actual expenditures (Y) = Planned expeditures (E)
NOTE: AGGREGATE DEMAND (AD) = PLANNED EXPENDITURES (E)
Actual Expenditure, Y=Y
Y, E
Planned Expenditure,
E = C(Y-T)+ I(pl.) + G
Y2 Y* Y1
Income, Output, Y
Actual expenditures (Y) = Planned expenditures (E) + involuntary inventory investment
(positive or negative).
Actual investment = I(planned) + involuntary inventory investment
(which is zero, negative or positive).
Planned Expenditure (E) = AD =
C(Y T )  I ( pl.)  G  C  MPC  (Y  t Y )  I ( pl.)  G
Note that: I ( pl.)  I ( planned ) . We could add NX as an exogenous variable.
If we rewrite the equation above:
E
AD  C  I ( pl.)  G  MPC  1  t Y , where 0<MPC<1.
Intercept
Slope
How is the equilibrium achieved?
At Y2 planned expenditures (E) > actual expenditures (Y)
 involuntary depletion of inventories,
I ( pl.) > I (actual)
 firms increase production, Y
At Y1 planned expenditures (E) < actual expenditures (Y)
 involuntary inventory build-up,
 firms decrease production, Y
I ( pl.) < I (actual)
The goods market Equilibrium implies: Y = E (=AD)
Y
 E  AD  C  I ( pl.)  G  MPC  (1 t) Y
The effect on Y of increased government spending (G):
Actual Expenditure, Y=E
Y, E
B
G
Planned Expenditure,
E = C(Y-T) + I(pl.) + G0
A
Y
Y1
Income, Output, Y
E  AD  C  I ( pl.)  G  MPC  1  t Y
Intercept
Slope
An increase in government purchases of G raises planned expenditures (E) = Aggregate
Demand (AD) by that amount for any given level of income (Y): the E-schedule shifts
up. The equilibrium moves from A to B and income rises. Note that the increase in
income Y exceeds the increase in government purchases G. Thus, fiscal policy has a
multiplied effect on income. This is because a higher income increases private
consumption, C(Y*(1-t)).
Y=C + G.
The multiplier process:
If government spending (G) increase by 1 $, you might expect equilibrium output (Y*) to
also rise by 1$. But it does not:
Initially planned expenditures (E) increases by G, and income increases by the same
amount. A higher income increases consumption (and thereby planned expenditures/AD)
by MPC*(1-t)*G, which raises Y again.
This second increase in income of MPC*(1-t)*G again raises consumption: by
(MPC*(1-t))*(MPC*(1-t)*G), which raises income and so on.
The change in equilibrium Y is:
Y * G (1 MPC (1 t)  MPC (1 t) MPC (1 t) ....)
Using the expression for the sum of an infinite series:
 Y * 
 Y
*
G
1
 G , 0<MPC<1. E.g., MPC=0.8
1  MPC 1  t 
1
 1 MPC
1 t


1
The multiplier effect operates fully if the factors of production are not fully utilized; that
is, when the short-run aggregate supply curve is horizontal.
Lecture: Solving for equilibrium Y mathematically and deriving multipliers:
Goods market Equilibrium: Y = E=AD 
Y  E  AD  C(Y  tY )  I ( pl.)  G  NX
Y
 E  AD  C  MPC  (1 t ) Y  I ( pl.)  G  NX
This is one equation with one unknown variable (one endogenous variable): Y.
 Y  MPC  1  t Y
 C  I ( pl.)  G  NX
 Y (1 MPC  1  t )  C  I ( pl.)  G  NX
 Y *  C  I ( pl.)  G  NX
1 MPC 1  t 
Y * is equilibrium Y, the value of Y which implies equilibrium in the goods market.
The solution implies that the unknown/endogenous variable, Y, is expressed as a function
of the exogenous variables; the variables that are determined outside the model.
What happens to equilibrium Y when the exogenous variables change?
 Y *  C  I ( pl.) G NX
1 MPC  1  t 
The government spending multiplier
If

C  t  I ( pl.)  0
G
Y *  1 MPC
 1 t



Y * 
1
1
G 1 MPC  1  t 
Summary: Factors that increase AD and thereby the equilibrium income (Y):
Increased
I ( pl.) , C , G , MPC, and NX, and lower t.
The saving function:
Households use their disposable income to saving and consumption:
Y T  Y  t Y  S  C  S  C  MPC Y  (1 t)
Thus, the private-saving function (S) is
S  C  (1 MPC)  (Y  tY )
A LESSON IN THIS MODEL: If government spending increases by 1 dollar, aggregate
demand and output may increase by more than 1 dollar. Of course if Y is at fullemployment there is complete crowding-out.
Leftist parties talk often about multipliers, when they want a larger government sector.
They rarely mention that increased G may crowd out I and NX, as well as create
inflation.
THE KEYNESIAN MODEL IN THE SHORT RUN CONTINUED:
INTRODUCING THE MONEY AND BOND MARKET INTO THE MODEL
THE IS-LM-MODEL
If the closed economy has its own currency and a central bank, the model below is
relevant. Now we have 2 markets: the goods market and the money (and bond) market,
which interact: For example:
A higher income (Y) increases the real money demand which results in a higher interest
rate (= real interest rate) when M/P is fixed, which lowers I(planned): Our equilibrium
requires both these markets to be in equilibrium.
As the bond market is in equilibrium when the money market is in equilibrium it is
sufficient that we only explicitly study the money market.
Assumptions: Short run: P is fixed. 2 markets:
Equilibrium in the goods market: Y=E=C(Y-T)+I(r)+G..
Equilibrium in the money market: M/P = L(r,Y)
Real interest rate (r)=nominal interest rate (i) – inflation rate = nominal interest rate
Note: since P is assumed to be constant, the inflation rate is 0, and the real interest rate
equals the nominal interest rate.
Equation system with the endogenous variables: Y, r, I(r), C(Y-T).
Exogenous variables determined outside the model:
M determined by the central bank.G, t are determined by the government.
P is fixed in the short run.
A simpler and more realistic model than IS-LM-model would
be to assume that the Central Bank sets the nominal interest
rate instead of chooses nominal money supply (M). That is, the
central bank chooses the nominal interest rate and provides
whatever money supply that is consistent with the chosen
interest rate. Such a model is more realistic and another
advantage is that we do not assume that the P is constant.
Instead we assume that inflation is sticky.
THE IS-MP (=Monetary Policy)-model
In the short run: it ,  r  because  t sticky/constant AD 
it ,  r  because  t sticky/constant AD
t
t
THE IS-LM-model continued:
Lecture: Analysis of expansionary fiscal policy: a higher G.
Actual Expenditure, Y=E
Y, E
B
G+
A
Planned Expenditure,
E = C(Y-T) + I(r0) + G0
Y* Y1
Income, Output, Y
If G  AD= (C(Y-T) + I(r)+G)  at given level of Y
When AD   Y the real money demand, L(r,Y)  r I.
In the new short run equilibrium (B): r is higher, I is lower, G, C, and Y higher than
before.
Y increases by less than
Y 
G
because private investment falls (“is
1 MPC  (1 t )
crowded out”) due to a higher interest rate.
i
M/P
i
i
M/p
PPP
/PP
Variable
G
Y
Interest rate
I
C
P
National saving
L(i,Y1
L(i,Y0
))'
)
((r,Y)
M/p
PPP
Old short-and long-run
Equilibrium (A)
G0
Y0
R0
I0
C(Y0-T)
P0
S0=I0
New short-run
Equilibrium (B)
<G1
< Y1
<R1
>I1
<C(Y1-T)
=P1
>S1=I1
Lecture: Short run effects of expansionary monetary policy
Assume that nominal money supply (M) is increased:
Note that the picture shows the opposite, a lower nominal money supply.
Recall that the price level (P) is assumed to be constant in the short run.
r
Supply' Supply
Demand, L (r,Y)
M/P
M/P
If M  (M/P)   nominal interest (=real interest rate when P is constant)   I(r) ,
AD= (C(Y-T) + I(r)+G) at a given level of P, which increases Y, which increases real
money demand; which pushes up the interest somewhat.
Actual Expenditure, Y=E
Y, E
B
A
Planned Expenditure,
E = C(Y-T) + I(r0) + G
Y* Y1
Income, Output, Y
+
Variable
Y
Interest rate
I
C
P
M/P
Old short-and long-run
Equilibrium (A)
Y0
R0
I0
C(Y0-T)
P0
M0/P0
New short-run
Equilibrium (B)
< Y1
>R1
<I1
<C(Y1-T)
=P1
<M1/P0
A MORE FORMAL APPROACH TO THE KEYNESIAN MODEL IN THE
SHORT RUN FOR A CLOSED ECONOMY: THE IS-LM-MODEL.
2 markets:
Equilibrium in the goods market: Y=C(Y-T)+I(r)+G
Equilibrium in the money market: M/P=L(i,Y)
Real interest rate(r) =nominal interest rate (i)-inflation rate=i
Note: since P is assumed to be constant, the inflation rate is 0, and the real interest rate
equals the nominal interest rate.
Assume now: planned investment depends on the real interest rate: I(r).
An increase in the interest
rate (in graph a), lowers
planned investment,
which shifts planned
expenditure downward (in
graph b) and lowers
income (in graph c).
(a)
r
(b)
E
Y=E
Planned Expenditure,
E=C+I+G
Income, Output, Y
(c)
r
The IS curve shows the equilibriums in the goods market.
I(r)
Investment, I
IS
Income, Output, Y
If r I(r)  so that AD (= planned expenditures)  at the old equilibrium Y AD<Y at
the old equilibrium  Y
Lecture: Mathematical Derivation of IS-curve:
Equilibrium in the goods market:
Before:
Y  E  AD  C  MPC  (Y  t Y )  I ( pl.)  G  NX
Now if I depends on r:
Y  E  AD  C  MPC  (Y  t Y )  I  d  r  G  NX
where d>0.
d  r  G  NX  C  I  G  NX 
d
Y *  C  1I MPC
r
 1  t 
1 MPC  1  t  1 MPC  1  t 
The equation above is the EQUATION FOR THE IS-CURVE:
When r=0, then Y *  C  I
 G  NX
1 MPC  1  t 
If
C , or I , or G , or t  or NX this intercept increases.
When Y=0, then r  C  I
 G  NX
d
Real money demand:
( M / P)d  L(r,Y )
The quantity of real money demanded is negatively related to the nominal interest rate
(because it is the opportunity cost of holding money) and positively related to income
(because of transactions demand).
Along a LM-curve real money supply,
M / P  L(r,Y )
M / P , equals real money demand:
The LM-curve has a positive slope as an increase in Y increases Real money demand,
which means that the interest rate has to increase to lower real money demand to the
same extent so that it continues to be equal to the real money supply ( M / P ), which is
fixed along a given LM-curve.
Nominal money supply ( M ) is assumed to be exogenous as it is determined by the
Central Bank. The price level is also assumed to be fixed. Thus, the supply of real money
balances, M / P , is assumed to be exogenously given; that is, determined outside the
model. The cost of holding real money is actually the nominal interest rate and not the
real interest rate. However, as the price level is fixed in the model, the real interest rate
equals the nominal interest rate.
Note: i = r (=real interest rate) as
If
P
=0 as P is assumed to be fixed.
P
M / P , LM-curve shifts to the right.
Mathematical derivation of the LM-curve:
Assume: L(r,Y )  e Y  f  r , where e> 0 and f > 0.
In equilibrium; that is, along the LM-curve:
M / P  L(r,Y )  e Y  f  r
Solving for r:
r   1  ( M / P )  e Y
f
Intercept
f
Slope
The equation above is the equation for the LM-curve. If M / P  , the intercept
becomes more negative. Thus, the LM-curve shifts to the right.
r IS
LM(P0)
r0
Y0
Y
The
Theintersection
intersectionof
ofthe
theIS
IScurve/equation,
curve/equation,Y=
Y=CC(Y-T)
(Y-T)++I(r)
I(r)++GGand
and
the
theLM
LMcurve/equation
curve/equationM/P
M/P==L(r,
L(r,Y)
Y)determines
determinesthe
thelevel
levelof
of
aggregate
demand.
The
intersection
of
the
IS
and
LM
curves
aggregate demand. The intersection of the IS and LM curves
If C(Y-T)  at a given level of Y, e.g. if T , or if I(r)  at a given r, or if G 
represents
representssimultaneous
simultaneousequilibrium
equilibriumin
inthe
themarket
marketfor
forgoods
goodsand
and
services
servicesand
andin
inthe
themarket
marketfor
forreal
realmoney
moneybalances
balancesfor
forgiven
givenvalues
valuesof
of
AD
at
a
given
level
of
Y:
the
IS-curve
shifts
to
the
right.
government
governmentspending,
spending,taxes,
taxes,the
themoney
moneysupply,
supply,and
andthe
theprice
pricelevel.
level.
A change in the exogenous variables and parameters: government (G), Money supply
(M), the price level (P), the tax rate (t), the autonomous level of investment ( I ),
MPC changes the short run equilibrium.
C
and
+G
Consider an increase in government purchases.
This will raise the level of income by G/(1- MPC)
r
IS IS´
A
LM
B
Y
The IS curve shifts to the right by G/(1- MPC) which raises income
and the interest rate.
Y increases by less than
G
Y  1 MPC
because private investment falls (“is crowded
out”) due to a higher interest rate. Here we assume fixed T; that is, a T that does not
depend on Y.
The economic mechanism:
If G  aggregate demand  at given level of Y  Y  real money demand  r
 investment 
Comparing equilibrium A with equilibrium B:
Y0 < Y1
C(Y0-T) < C(Y1-T)
R0 < r1
I(r0) > I(r1)
National saving0 > national saving1
Note that national saving=Y-C-G=I
+M
Consider an increase in the money supply.
r IS
LM
LM
A
B
Y
The LM curve shifts downward and lowers the interest rate which raises
income. Why? Because when the Fed increases the supply of money, people
have more money than they want to hold at the prevailing interest rate. As a
result, they start depositing this extra money in banks or use it to buy bonds.
The interest rate r then falls until people are willing to hold all the extra
money that the Fed has created; this brings the money market to a new
equilibrium. The lower interest rate, in turn has ramifications for the goods
market. A lower interest rate stimulates planned investment, which increases
planned expenditure, production, and income Y.
If M / P  r  so that real money demand  and becomes equal to
aggregate demand  at a given level of Y Y ..
Comparing equilibrium A with equilibrium B:
Y0 < Y1;
C(Y0-T) < C(Y1-T)
R0 > r1;
I(r0) < I(r1)
National saving0 < national saving1
DO EXERCISE 11.3
M /P
 I(r) ,
THE KEYNESIAN MODEL IN THE SHORT RUN: FROM IS-LM-curve to the
AD-curve in the PY-diagram. We use the PY-diagram to analyze long-run effects:
You probably noticed from the IS and LM diagrams that r and Y were on
the two axes. Now we’re going to bring a third variable, the price level
(P) into the analysis. We can accomplish this by linking both twodimensional graphs.
LM(P2)
To derive AD, start at point A in the top
r IS
LM(P1) graph. Now increase the price level from P1
to P2.
B
An increase in P lowers the value of real money
A
balances, and Y, shifting LM leftward to point B.
Notice that r increased. Since r increased, we know
Y
P
that investment will decrease as it just got more
costly to take on various investment projects. This
B
P2
sets off a multiplier process since -I causes a –Y.
A
P1
The - Y triggers -C as we move up the IS curve.
AD The +P triggers a sequence of events that end
Y with a -Y, the inverse relationship that defines
the downward slope of AD.
Lecture: The Short run equilibrium in the IS-LM-model in one equation:
Equilibrium in the goods market; that is, along the IS-curve:
d  r  G  NX  C  I  G  NX 
d
Y *  C  1I MPC
r
 1  t 
1 MPC  1  t  1 MPC  1  t 
In equilibrium; that is, along the LM-curve:
M / P  L(r,Y )  e Y  f  r
Solving for r:
r   1  ( M / P )  e Y
f
Intercept
f
Slope
Now substitute the LM-curve into the IS-curve to solve for equilibrium Y as a function of
the exogenous variables and parameters:


Y  1
*


Y
*





Y
*

d e
(1 MPC (1 t))  f
 C  I  G  NX



1

MPC

(1

t
)

d M / P
(1 MPC  (1 t ))  f
d  (M / P)
f  (1 MPC )  d  e   C  I  G  NX 

f  (1 MPC  1  t )  1 MPC  (1 t ) (1 MPC  (1 t ))  f
f  (C  I  G  NX ) 
f  (1 MPC  (1 t ))  d  e
d M / P
f  (1 MPC  1  t )  d  e
This is the “AD-curve” in the PY-diagram.
 If C , or MPC, or t, or I , or G , or NX or M  equilibrium Y increases.
“The AD-curve in the PY diagram shifts out”.
If P  equilibrium Y : Movement along the “AD-curve in the PY-diagram”.
Solving for equilibrium r by inserting the expression for equilibrium Y into the equation
for the equation that shows equilibrium in the money market:

r   1  M / P  e  f  (C  I  G  NX )
f
f f  (1 MPC  (1 t ))  d  e



d M / P

f  (1 MPC )  d  e 

which can be simplified:
THE LONG RUN EQUILIBRIUM
IN THE LONG RUN PRICES AND WAGES ARE FLEXIBLE
The Keynesian model in the long run = classical model see ch. 3
When Y is larger (lower) than the full-employment Y, the nominal wages increase
(decrease) which shifts the MC-curve/SRAS-curve upwards (downwards), which
increases (decreases) the price level.
A higher (lower) price lowers (increases) M/P which increases
(decreases) the real interest rate, and thereby lowers (increases) private investment.
Short and long run effects of less thriftiness: of
r
IS
C :
LM(P2)
LM(P0)
IS'
C 


Short
Run:
Y
P
r
C
I
Y
P
P2
C 
P0
 
LRAS
SRAS
Long
Run:
+
0
+
+
-
0
+
++
+
--
Short and long run effects of expansionary monetary policy
If M :  (M/P)   nominal interest (=real interest rate when P is constant)   I(r)
, AD= (C(Y-T) + I(r)+G) at a given level of P, which increases Y, which increases
In the short run: movement from A to B.
Y, C(Y-T), and I(r)=S increase, and r decreases in the short run.
Remember that LR is the movement from A to C.
For the variables Y, P and r, you can read the effects right off the diagrams.
Y 0, because rising P shifts LM to left, returning
r
Y to Y* as required by LRAS.
P +, in order to eliminate the excess demand at P .
0
r 0, reflecting the leftward shift in LM due
to +P, restoring r to its original level.
C 0, since both Y and T are back to their initial
levels (C=C(Y-T)).
I 0, since Y or r has not changed.
P
Notice that the only LR impact of an
increase in the money supply was an
increase in the price level.
P2
P0
IS
A= C
LM(P0)
LM
B
LRAS Y
C
A
B SRAS
AD´
AD
Y* Y´ Y
Variable
Y
Interest rate
I
C
P
M/P
Old short-and long- New short-run
run
Equilibrium (B)
Equilibrium (A)
Y0
< Y1
R0
>R1
I0
<I1
C(Y0-T)
<C(Y1-T)
P0
=P1
M0/P0
<M1/P0
New
long-run
equilibrium (C)
Y2=Y0
r2=r0
I2=I0
C(Y0-T)
<P2
M0/P0
In the long run P increases until M/P becomes identical to M0/P0. Thus,
An increased nominal money supply has no effect on real variables in the long run
Lecture: Analysis of expansionary fiscal policy: a higher G.
The short and long-run effects on increased government spending (G)
LRAS
P
C
B
P0
A
SRAS
AD=C(Y-T)+I(r)+G1
AD=C(Y-T)+I(r)+G0
Y
Y
Y = F (K,L)
Variable
G
Y
Interest rate
I
C
P
National saving
Old short-and long- New short-run
run
Equilibrium (B)
Equilibrium (A)
G0
<G1
Y0
< Y1
R0
<R1
I0
>I1
C(Y0-T)
<C(Y1-T)
P0
=P1
S0=I0
>S1=I1
New
long-run
equilibrium (C)
= G1
Y2=Y0
<r2
>I2
C(Y0-T)
<P2
>S2=I2
In the long run there is no effect on Y. The increase in G is completely offset by a
decrease in I. See chapter 3.
Read by yourselves: The short and long-run effects of lower net taxes (t):
If t  AD= (C(Y*(1-t)) + I(r)+G)  at given level of Y
When AD   Y the real money demand, L(r,Y)  r I.
In the new short run equilibrium (B):
r is higher, I is lower, C, and Y are higher than before.
LRAS
P
C
B
P0
A
SRAS
AD=C(Y-T1)+I(r)+G
AD=C(Y-T0)+I(r)+G
Y
Y
Y = F (K,L)
Variable
t
Y
Interest rate
I
C
P
National saving
Old short-and long- New short-run
run
Equilibrium (B)
Equilibrium (A)
t0
>t1
Y0
< Y1
R0
<R1
I0
>I1
C(Y0*(1-t0))
<C(Y1*(1-t1))
P0
=P1
S0=I0
>S1=I1
New
long-run
equilibrium (C)
= t1
Y2=Y0
<r2
>I2
>C(Y0*(1-t1))
<P2
>S2=I2
In the long run there is no effect on Y. The increase in C is completely offset by a
decrease in I. See ch. 3
Lecture: THE SMALL OPEN ECONOMY (r= r * ) with its own currency:
THE MUNDELL-FLEMMING MODEL, CH. 12.
Short-run effect:
2 equations: Equilibrium in the goods market: Y = C(Y-T) + I(r*) + G + NX (e)
Equilibrium in the money market: M/P = L(r*,Y)
Assumption 1: r = r*. The small economy assumption.
Assumption 2: P($) and
changes in e change
P*(Yen)
are assumed to be constant, which means that only
  e(Yen* /$)  P($)  Yen
P (Yen)
Yen
Thus, e   , e  
‘e=yen/dollar:  e ()  appreciation (depreciation) of dollar 
Domestic goods become more expensive (cheaper) in foreign currency (Yen) and foreign
goods become cheaper (more expensive) in domestic currency (dollar).  Exports,
Imports NX
M / P  L(r* ,Y ) , determines the
M , P and r* are exogenously given in the model. The
The money market equilibrium condition:
equilibrium level of output (Y).
only endogenous variable in the LM-equation is Y, which then is determined by the
exogenous variables
M / P , and r* : M / P  L(r* ,Yeq )
If:
M / P  L(r*,Y )  e Y  fr *
M / e  P  ( f / e)  r *  Y
Since M and P determine Y, fiscal policy (changes in G and T) has no effect on Y.
M / P  L(r* ,Y )
L(r* ,Y )  Y  100  r* , where r* =0.04
Ex.: The money market equilibrium condition:
If M=1000 and P=1, and
 1000=Y-100*0.04  Y = 1000 + 4 = 1004
If M=1100  Y = 1100 + 4 = 1104
 Given P and r * , M determines Y.
The economics of a monetary expansion in the standard model above:
If M / P r : r < r*  not profitable with financial investments in our country: 
the demand for our currency   the currency depreciates: e NX
 Monetary policy has a larger impact on Y in small open economy compared to the
effect in a closed economy because there is no crowding-out of private investment in the
open economy model.
Fiscal Policy(G,T):
Changes in G and T do not impact equilibrium Y
(because eqb. Y is determined by the equation: M s / P  L(r* ,Yeq ) :
Yeq  C (Yeq  T )  I (r* )  G  NX ( )
Aggregate Demand
If e.g. G   aggregate demand  at a given level of Y.
But AD must be unchanged as Yeq is fixed.
C(Yeq  T ) and I (r* ) also are fixed, e must increase so that NX  by the same
amount that G . That is, AD  G  NX  0
As
Why does a fiscal expansion increase e?
If G  aggregate demand  at a given exchange rate.
When aggregate demand   Y 
real money demand  domestic interest rate, r :
r > r*  profitable with financial investments in our country  the demand for our
currency   the currency appreciates  NX 
Thus: Increased G or increased C(Y-T) due to lower net taxes crowds out net exports
completely even in the short run.
(In a richer model, fiscal policy impacts Y in the short run:
A currency appreciation (e) tends to make the price on imported goods and services
cheaper in the domestic currency P because prices on imported goods are included in
the consumer price index  M / P : Fiscal policy has an effect on Y.)
Read by yourselves: The short and long run effect of monetary policy
If M   (M/P)   r so that r<r* financial investments in domestic country turns
less profitable  demand for the domestic currency   the nominal exchange rate, e,
depreciates (e) (e  P) / P*  NX,
AD = (C(Y-T)+I(r*) + G + NX(( (e  P) / P* ))
Variable
Y
Interest rate
I
E
C
NX
P
M/P
Old short-and long- New short-run
run
Equilibrium (B)
Equilibrium (A)
Y0
< Y1
R0
=R1
I0
=I1
E0
>e1
C(Y0-T)
<C(Y1-T)
NX0
<nx1
P0
=P1
M0/P0
<M1/P0
New
long-run
equilibrium (C)
>Y2=Y0
=r2=r0
=I2=i0
<e2=e0
>C(Y0-T)
>Nx2=nx0
<P2
>M1/P2=M0/P0
Notes:
*Fixed exchange rates are not included in the course
*The large open economy is an average of the closed economy and the small open
economy. To find how any policy will impact any variable, find the answer in the 2
extreme cases and take an average.