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International Finance
Lecture 2
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Economics are divided into two most
general branches:
Microeconomics
(from Greek word "mikros-" meaning "small" +
"economics") is 'the behaviour of individual consumers and firms in an
attempt to understand the decision-making process of firms and
households. Microeconomics looks at the smaller picture and focuses more
on basic theories of supply and demand and how individual businesses
decide. Microeconomics focuses on the tree not in the forest.
Macroeconomics
(from Greek word "makros-" meaning "large" +
"economics") studies the behaviour, structure and decision-making of the
economy as whole and not just on particular companies, but entire
industries and economies. This includes national and global economies.
Macroeconomists study aggregated indicators such as GDP, national
income, , consumption, investment, international trade ,unemployment
rates, and price indicators to understand how the whole economy functions.
Macroeconomics focuses on the forest not in the tree.
International Finance is a macroeconomic field
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Objectives of the Lecture
What is the definition of the two markets of an economy?
When is equilibrium occur in goods market?
When is equilibrium occur in money market?
When does equilibrium exist at the same time in the two
markets : goods market and money market?
The ISLM graphical model illustrating the behavior of the
two markets.
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Aggregate Demand in the Goods and
Money Markets

Goods market The market in which goods and
services are exchanged and in which the equilibrium
level of aggregate output (amount produced) is
determined.

Money market The market in which financial
instruments are exchanged and in which the
equilibrium level of the interest rate is determined.
Issue: Where does these two markets cross/meet so as
to create equilibrium/balance in the economy?
ISLM model answers this matter.
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Equilibrium at the same time in the goods market and the
money market by combining the IS and LM curves.



The IS/LM model (Investment – Saving /Liquidity preference –
Money Supply is a macroeconomic tool that demonstrates the
relationship between interest rates and real output in the goods
and services market and the money market. The intersection of
the IS and LM curves is the "general equilibrium" where there is
equilibrium at the same time in both markets.
IS curve represents the equilibrium
in the goods market
LM curve represents the equilibrium
in the money market
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A ) Goods Market
 The value of production of goods and services is the economy’s real
GDP. Because the production activity creates income , in the form of
wages , profits , other returns to capital and rents to landowners,
real GDP is nearly the same thing as real national income (Y).
GDP= (Y)
 In the short run domestic production is determined by aggregate
demand (AD) for the country’s products. Therefore if someone
demand a product , manufacturers will produce it. Hence equilibrium
occurs when domestic production (Y,GDP) equals desired demand
for domestically produced goods and services.
Y=AD
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AD has 4 components
C household consumption for goods & services
I domestic investment in new real assets like machinery,
buildings, software , housing and inventories
G government spending on goods and services
X-M net exports on goods and services
X is the foreign demand for our exports
M (imports) must be deducted because is the demand
for the products of other countries and also these
imports are already included in other kinds of spending
Y=GDP=AD=C+I+G+(X-M)
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Interest Rates
Interest Rates set the cost of borrowing to finance the purchase of
items like automobiles, household wealth and consumer approach of
the future.
Real domestic Investment I is negatively related to the level of interest
rates in the economy. Higher interest rates increase the cost of
financing the capital assets, thus reducing the amount of real
investment undertaken.
The effects of a change in the interest rate therefore include:
Planned investment is a part of aggregate demand (AD). Thus,
when the interest rate rises, aggregate demand (AD) at every level
of income falls.
A decrease in aggregate demand (AD) lowers equilibrium output
(income) (Y) by a multiple of the initial decrease in planned
investment.
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Aggregate Demand and the Interest Rates
r
r
I
I
AD
AD
Y
Y
Investment has a positive relationship with output and negative
relationship with the interest rate. Investments are strongly affected
by interest rates because they state the cost of borrowing money.
For example, a rise in the interest rate will cause less private
investments to be made, causing aggregate demand to decline. If
interest rates were rather to decrease, lowering the cost of
borrowing, investment would increase.
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Planned Investment and the Interest Rate
FIGURE 1 Planned
Investment Schedule
Planned investment spending is a negative function of the interest rate.
An increase in the interest rate from 3 percent to 6 percent reduces planned
investment from I0 to I1.
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Other Determinants of Planned Investment
The assumption that planned investment depends only
on the interest rate is obviously a simplification, just
as is the assumption that consumption depends only
on income. In practice, the decision of a firm on how
much to invest depends on, among other things, its
expectation of future sales.
The optimism or pessimism of entrepreneurs about the
future course of the economy can have an important
effect on current planned investment. Keynes used the
phrase animal spirits to describe the feelings of
entrepreneurs, and he argued that these feelings
affect investment decisions.
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Planned Aggregate Demand and the Interest Rate graph
Equilibrium occurs
initially at point 1
and then at point 2
FIGURE 2 : An increase in the interest rate from 3 percent
to 6 percent lowers the investment and consequently
the planned aggregate demand and as a result also
reduces equilibrium income from Y0 to Y1.
Aggregate
Demand AD/
Investment I
AD=Y
1
AD=Yo=Co+ Io +Go+(X-M)
Rate3%
AD=Y1=C1+I1+G1+(X-M)
Rate 6%
Io
2
Io-I1
I1
) 45°
Y1
Y0
Output / Income
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Observation points in the graph:
Line of 45° is a supporting (secondary in order to help) line which is
equidistant from the two axes. This means that for every level of
income/output Y the aggregate demand AD equals the income/output
Y.
The above graph is also labeled as Keynesian cross diagram :
A desired total demand curve is drawn as a rising line since
consumers will have a larger demand with a rise in Income which
increases with total national output. This increase is due to the
positive relationship between consumption and consumers'
disposable income.
The most important use of the 45-degree is the Keynesian model,
which identifies equilibrium equality between aggregate demand and
aggregate production. In particular, the intersection (meeting point)
between the 45-degree line and the aggregate demand line indicates
the equilibrium level of aggregate production. Thus the 45 decree line
is also called AD=Y.
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How IS curve created
FIGURE 3 An IS curve illustrates
the negative relationship between
the equilibrium value of aggregate
output (income) (Y) and the interest
rate in the goods market.
Interest Rates (r)
Each point on the IS curve
corresponds to the
equilibrium point in the
goods market for the given
interest rate.
r2
r1
IS
Output / Income (Y)
Y2
Y1
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B ) Money Market



According to macroeconomic theory money market is in balance when
money supply equals money demand.
What is “the Supply of Money”?
M s is the quantity of money that the Central Bank of a nation set as
available to the consumers.
What is “the Demand for Money”? How much money would you like to
have? A billion or two?
Of course, that is not what we mean by your demand for money! What
we do mean by your demand for money is this: how much of your wealth do
you wish to keep in the form of money, that is, currency and bank deposits?
For example, suppose that family F have € 50,000 in financial assets which
they divide between investment in bonds and holding money. How are they
going to decide how much of their € 50,000 to invest in bonds and how much to hold
in the form of money?
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1 Money is held to carry out transactions and the value of transactions
should be similar with the value of income or output (Y). The largest
the domestic product is the greater the amount of money that firms
and households will want to keep on hand to carry out their larger
spending.
2 However there is a cost of holding money to finance your
transactions, the opportunity cost. The opportunity cost is the
interest that the holder of money could earn if his money were
instead in other financial assets such as bonds. This cost leads us to
attempt to save our money and especially when the interest rate
available on other financial assets rises!
A higher interest rate
makes people want to hold bonds rather than money and thus the
money demand lowers.
Conclusion form points 1 & 2 :
The demand for money is positively related to GDP and negatively
to the level of interest rates available on other financial assets.
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Economists have identified three primary motives for
holding money:
• To
settle transactions, since money is the medium of exchange.
• As a protective store of liquidity, in the event of unexpected need.
• To reduce the riskiness of a portfolio of assets by including some money in
the portfolio, since the value of money is very stable compared with that of
stocks, bonds, or real estate.
These three motives for holding money are often referred to as the
transactions motive, the protective motive, and the portfolio motive
respectively. Together they provide good reasons for the family F to hold
some money in their portfolio in spite of the opportunity cost of foregone
interest.
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Aggregate Money Demand M d
It is determined by 3 main factors:
 Interest Rate (r): It reduces the demand for money
 Price Level (P): It raises the demand for money
 Real National Income (Y): It raises the demand for money
M d = P x L (R,Y)
Price Level
Real National Income
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FIGURE 4: Aggregate Real Money Demand and the Interest Rate
Downward slope because of the negative relationship between interest rates
And Aggregate Demand for Money: If r L(R,Y)
Interest
rate, R
L(R,Y)
Aggregate real
money demand
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FIGURE 5: Effect of a Rise in Real Income on the Aggregate Real Money Demand.
An Increase in Real Income from Y1 to Y2 raises the demand for real money
balances at every level of the interest rate and causes the whole demand curve to
shift upward right.
Interest
rate, R
Increase in
real income
L(R,Y2)
L(R,Y1)
Aggregate real
money demand
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The Equilibrium Interest Rate:
The Interaction of Money Supply and Demand
Equilibrium in the Money Market:

The condition for equilibrium in the money market is:
Ms=Md

The money market equilibrium condition can be expressed
in terms of aggregate real money demand as:
M d = M s = P x L(R,Y)
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How the Supply of Money and the Demand for
Money Determine the Interest Rate
Interest
rate, R
Real money supply
2
R2
1
R1=10%
3
R3
Q2
MS( = Q1)
P
Q3
FIGURE 6: Determination of the
Equilibrium Interest Rate with
the
supply
of
money
unchanged,
market
money
equilibrium is at point 1
Aggregate real
money demand,
L(R,Y)
Real money
holdings
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In Figure 6 the supply of money is a vertical line at the quantity Q1
indicating that in this hypothetical economy the Central Bank has
set the supply of money at Q1. The supply of money is fixed at that
quantity, and it will remain there until the Central Bank decides to
change it. The quantity of money demanded is equal to the quantity
supplied, Q1, at an interest rate of 10%. At that interest rate, people
are happy to hold the quantity of money that is supplied by the
Central Bank
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How LM curve created FIGURE 7 An LM curve illustrates
Interest
rate, R
Interest
rate, R
Real money supply
the positive relationship between the
equilibrium value of the interest rate
and aggregate output (income) (Y) in
the money market.
LM
CURVE
R1
R0
L(R,Y2)
L(R,Y1)
MS ( = Q 1 )
Aggregate real
P
money demand
INCOME INCREASED FROM Yo TO Y1
Y0
Y1
Y output / income
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
In the money market, on the left, the real money supply is the red
vertical line. When the demand for money curve crosses it the
equilibrium interest rate is found. For a higher level of national
income (Y1), the equilibrium interest rate is higher. These points
create the LM curve.
Y  M d  r 
Y  M  r 
d

The LM curve shows combinations of interest rates and levels of
real output-income for which money supply equals money
demand, that is for which money market is in equilibrium.
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THE IS-LM DIAGRAM
The IS-LM diagram is a way to show graphically
the determination of aggregate output (income)
and the interest rate in the goods and money
markets.
The IS curve describes the combination of interest rates and output
that clear the goods and services market in the short run. The goods
and services market is said to clear when spending by consumers,
firms, the government (and foreigners if an open economy) on
goods and services equals the production of goods and services.
The LM curve summarizes all the combinations of income and
interest rates that equate/link money demand and money supply.
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Is and Lm
Goods Market
Money Market
Interest
rate, R
Interest
rate, R
LM
CURVE
r2
r1
IS
Y2
Y1
Output /
Income (Y)
Y1
Y2
Y output /
income
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THE IS-LM DIAGRAM
Figure 8 : The point at which the IS and LM curves cross corresponds to
the point at which both the goods market and the money market are in
equilibrium. The equilibrium values of aggregate output and the interest rate
are Y0 and r0.
Interest
rate, R
LM
CURVE
Ro
IS
Yo
Y output /
income
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The two dimensions of Macroeconomics:
The ‘Real’ Economy and the ‘Monetary’ economy



The Real Economy and the Goods market
The Monetary Economy and the Money Market
The linkages between the two markets:
1. the overall price levels and wage levels
2.the interest rates
3.the foreign exchange rate (through its impact
on balance of payments)
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The central Role of Interest Rates



It plays a central role in the goods market as the
price of capital – a determinant of investment
It is the price of money in the money market
It is an important factor in determining the
exchange rate, especially in the short run
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The link:

Given price level and the exchange rate
Y=C+I+G+(X-M)
Md=M(i)
I=I(i)
i
i
IS
0
Md
Q
0
Q
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A P P E N D I X A:
The Price Level
 The development of the framework so far has ignored the factor Price Level
(P), as we supposed that the price level is constant. This may be
reasonable for most short-run analysis but in fact this state is not correct
generally.
 The Price Level change over time for three basic reasons: 1. Most countries
have an amount of constant inflation. Inflation is a rise in the general level of
prices of goods and services in an economy over a period of time. 2. Strong
or weak aggregate demand can put pressure on the country’s price level. If
aggregate demand increases, while aggregate supply remain stable, then
the price of market products increases. On the other hand if aggregate
demand is weak is creating downward pressure in the price level. 3. Shocks
occasionally can cause large changes in the price level. E.g. an oil price
huge increase as happened in the mid-2000 created rise in inflation in the
countries that were importing oil. Also a large change in the exchange rate
value of a country’s currency. A significant devaluation increases the price
level because imports are becoming more expensive.
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 A change in the price level changes money demand and if we take as
granted that money supply is stable then the LM Curve will shift over time.
 Fundamental changes that shift the LM curve down or to the right are:
Increase in the money supply (expansionary monetary policy)
Decrease in the average price level of a country’s
Decrease in money demand: for example because of the use of credit
cards.
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APPENDIXB
Other factors, than I,
that affect IS curve
 The development of the framework has also ignored the factors
consumption, government spending and trade considering only investment.
In fact the above factors also affect the IS curve.
 For example trade (X-M) is depended on the income of foreign countries
and if this income is higher then foreigners tend to buy more of our exports
and this shift IS curve to the right( or up). Also the price level we saw in
appendix A influences trade and consequently IS curve. For instance if a
country has an advantage in price competitiveness then aggregate demand
on exports increases and IS curve shift to the right( or up).
 Other fundamental changes that shifts IS curve to the right are:
Increase in consumption
Decrease in imports
Increase in domestic Investment
Increase in government spending or tax cut (expansionary fiscal policy)
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