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Macroeconomics MGMT 510
FOREWARD
“LECTURE NOTES” for “Macroeconomics for Managers” course have been
prepared primarily to assist the MBA students in following my in – class lectures as
well as the main and supplementary text books that I use for this course. However,
it is important for the students to bear in mind that these lecture notes are not a
perfect substitute neither for the actual lectures that I give in class nor for the actual
text book. Rather, they are designed to help the students to understand some of the
technically more challenging material better. Students should keep in mind that
actual lectures can sometimes analyze material which may not be covered by these
“Lectures Notes” in hand. In addition, the material that we discuss in relation to
articles that are on the reading list of MGMT 510 Course, are not covered by these
“Lecture Notes”.
Assoc. Prof. Dr. Serhan Çiftçioglu.
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Macroeconomics MGMT 510
AN OVERVIEW OF KEYNESIAN MACROECONOMICS
The basic features of Keynesian Macroeconomics can be best understood by imagining
the conditions under which National Income (or GNP) and the levels of employment are
determined in Keynesian Model:
First of all, Keynesian Model attempts to explain the determination of Y (GNP) and
employment in the short-run in Keynesian Model. Short-run follows from the assumption
of price and wage stickiness. In other words, producers do not change prices even when
the aggregate demand increases or decreases. Well, is this assumption realistic or not?
Yes, it is realistic. If we look around, especially for countries which are not described by
wage price spirals (leading to high rates of price and wage inflation) this assumption
seems to be validated by the empirical evidence.
But you may ask why shouldn’t a firm increase its price immediately when the demand
for its product increases. One answer is that it may not know whether this increase in its
sales is permanent or transitory. So, it may prefer to wait and see whether this higher
demand will continue into future. Secondly, producers work on explicit or implicit
contracts with their customers. Explicit contracts are written contracts, whereas implicit
contracts are unwritten contracts based on the mutual trust between the producers and its
customers. Such contracts usually imply that producers agree to supply any amount
demanded by the customers at a previously agreed price. So, in order not to lose the trust
of customers, producers will supply any amount at a fixed price. They will change their
prices when, for example, a new contract is negotiated between themselves, and the
customers.
Second basic feature of Keynesian Model is the assumption that the economy in question
is already operating bellow full-employment level of output. In other words, there are
idle (unemployed) resources such as labor and physical capital which can be put into
production process if necessary.
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Keynesian Model describes an economy where, not only prices (P) are sticky (fixed) but
also Nominal wages and therefore real wages (w/p) are fixed as well. Again this follows
from the short-run considerations of the model; just like producers, labor unions usually
work on explicit or implicit contracts. In other words, wages are fixed for the duration of
contracts which may last a year or even longer. This means that, workers agree to supply
any amount of labor demanded by the producers at the wage predetermined by the
conditions of the contract. In addition, the presence of unemployed workers in the
economy means that there are workers in the economy, who are willing to work at the
current wage rate but are unable to find jobs. So, if demand increases, firms can easily
expand production either by making the existing workers work longer hours at the
prevailing wage rate or by hiring additional labor force again at the current wage rate or
by doing both.
The assumption of wage stickiness is another reason as to why producers in Keynesian
model are willing to supply any amount demanded at the same price level. Because the
fact that wages are fixed means that labor costs per unit of output are fixed as well. (For
this assumption we need to assume that technology is described by constant returns to
scale).
After going over the basic features of Keynesian Model and finding out that:
1. National Income (output = Y) is purely and solely determined by the level of
aggregate demand.
2. Prices and wages are fixed because of the short-run nature of the model;
We can now go over the determinants of aggregate demand first for a closed economy
and then for an open economy and see how in each case changes in any of the
components of aggregated demand affects the (equilibrium) level of National Income.
Closed economy is an economy which does not engage in trade with the rest of the world.
On the other hand, an open economy is the one which exports to and imports goods and
services from the rest of the world.
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In a closed economy, the basic components of aggregate demand are:
1) Consumption expenditures (C) of consumers).
2) Investment expenditures (I) of firms on plants, tools and equipment and buildings.
3) Government spending on various goods and services (G)
So, total spending (aggregate demand) for a closed economy is given by
Spending = C + I +G
Since in Keynesian model, fluctuation in spending are the main cause of the changes in
national output and therefore the level of employment we have to analyze each
component of total spending separately and find out what may cause changes in each one
of them;
For the time being, for keeping our analysis simple, we will assume that spending by
firms on new plants, equipment, machinery are determined by the beginning of each
period regardless of the conditions that may prevail during the course of this period. In
other words, I (Investment spending) is assumed to be fixed; is this realistic? Maybe not
because Investment spending may depend upon the level of economic activity (Y) which
affects the level of sales. But for the time being, we assume that
I = I . I means some
fixed amount. Similarly, we assume that at the beginning of each period government
determines its spending on goods and services (G). In other words, no matter what
happens over the course of the period under consideration, government does not change
its level of spending. In other words G = G. Is this a realistic assumption? Probably
not. Why? Because, usually movements will follow and activist policy. An activist
policy means that government will intervene the economy by altering its level of
spending (or by changing taxes) anytime it deems necessary.
For example, if
unemployment increases, we can reasonably expect the government to increase its
spending (or decrease taxes) to stimulate demand. Similarly, when inflation is getting out
of control a government may intervene to the economy and reduce the level of
government spending. However, right now, for simplicity we assume that G = G and
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stays intact (unchanged) no matter what happens during the time period we are looking
into.
Consumption Expenditures of a consumers, on the other hand are assumed to positively
depend on their level of disposable income (Yd). As Yd increases so does C. In other
words, consumption (C) be described by the following functional relationship:
(1) C = a + bYd
consumption Function
a is a constant which reflects that part of total consumer spending which is determined by
other factors such as interest rates, wealth of consumers, expectations of consumers about
future state of the economy, their preferences over time regarding present and future
consumption. (This last factor means the following: people at any point in time, have
preferences about how much they like to consume in future as opposed to now. This
affects their saving decisions. If they prefer to consume more in future, they will save
more now and invest it, so that they will have larger amount of wealth in the future which
they can consume. But saving money now means they have to consume less now). So
assuming that “a” is a constant amount means that all these factors which can affect C
stay same in the course of the period we are considering.
How about the second part of consumption? bYd
b is > 0 and < 1
It is MPC (marginal propensity to consume)
For example if b = 0.9, this means that for every $1 increase in Yd, consumer spending
(C) will increase by $0.9 (The remaining $0.1 goes to savings). Therefore, b is the slope
of the consumption function.
Now we can define Yd:
(2) Yd = Y – T where T =Tax payments
(3) T =tY where t is the income tax rate
Substituting (3) into (2) we get:
(4) Yd = Y - tY
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And substituting (4) into (1) we get
C = a + bYd
C = a + b(Y –tY)
(5) C = a + b(1-t)Y
The above equation means that, if the marginal propensity to consume b is 0.9 and the tax
rate t is 0.3 then b(1-t) = 0.63. An increase in income (Y) of TL 100 billion will increase
consumption by TL 6.3 billion.
So, in this simple model of income determination, we will assume that G and I are
exogenous variables but C and Y are endogenous variables. In other words, G and I will
be given from outside the model. But C and Y will be determined by the model. If we
combine what we have so far, we get the following:
Spending = C + I + G
Spending = a+ b(1-t)Y + I +G
Consumption
Exogenous
Components
Of Spending
Why is consumption endogenous? Because it’s value depends on Y. If Y changes C
changes as well. But Y depends on the value of C as well. That’s why the value of C
and Y are both determined within the model.
Spending balance occurs when the level of Y that consumers base their consumption
decision (through Consumption function) is the same as Y = C + I + G (6)
Equation (6) is called Income identity.
So if
Y>C+I+G
Or
Y < C + I + G; we won’t have spending balance in the economy.
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If Y > C + I + G, National Income (GNP) is greater than total spending. In other words,
total output is more than aggregate demand. Therefore, there is excess aggregate supply
of goods in the economy. On the other hand, if Y < C + I + G, there is excess aggregate
demand because private and public spending is more than the current level of income.
In each case, there is disequilibrium in the economy.
Since we assumed that in
Keynesian model output will adjust passively to the conditions of demand in the
economy, then
Y will increase anytime Y < C + I + G
And
Y will decrease anytime Y > C + I + G. That’s why we say that in Keynesian model
output (Y) is purely and solely determined by the condition of demand.
GRAPHICAL AND ALGEBRAIC ANALYSIS OF SPENDING BALANCE AND
THE DETERMINATION OF NATIONAL INCOME (OUTPUT) IN KEYNESIAN
MODEL
Spending
45o line
Spending line
Spending = a+b(1-t)Y+I+G
S1
SE
S2
Y2
YE
Y1
Income (Y)
Spending line shows the level of aggregate spending in the economy for each and every
level of Y. As you can see spending will increase as Y increases. Why? Because, as Y
increases C increases and since C is a component of spending, so does spending!
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The slope of spending line is given by b(1-t). In other words, as Y increase by (1$)
spending will increase by b(1-t)x$1. Since both b and t are less than 1, then a given
increase in Y leads to a smaller increase in spending.
Along the 45o line, spending and Income are equal. Therefore, Income identity Y = C + I
+ G is satisfied only at points along 45o line.
So, for the economy to settle for
equilibrium, it must end up at a point somewhere along the 45o line.
There is only one level of Y at which spending will equal to national income (Y). And
that is given by YE. At income levels higher than YE, such as Y1, spending that will
emerge is given by YE. At income levels higher than YE, such as Y1, spending that will
emerge is given by S1. But S1 is < Y1. So at Y1, there will be excess supply and output
will decrease due to insufficient demand and therefore unemployment will increase.
Similarly, when Y is less than YE, such as at Y2 spending is S2. But S2 > Y2. So there is
excess demand which will lead to an increase in output.
ALGEBRAIC ANALYSIS
Y = a +b (1-t)Y + I + G (Income identity)
Spending balance requires that the income identity, given in the above, is satisfied. In
other words, for the economy to be in equilibrium, economy has to produce that level of
Y which generates spending ( =C + I + G) level exactly same as itself. To find this
equilibrium level of Y we can solve the above equation for Y.
To do this, take all the terms involving Y to the left-hand side to obtain:
Y=
a +I + G
(7)
1-b(1-t)
Equation (7) tells us that given the values of I, G, a, b and t, we can obtain the value of Y
that will satisfy spending balance in the economy.
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Example: Suppose that I = $650, G = $750 and b = 0.9, a = 80 and t = 0.3. Then
according to the formula in equation (7)
Y=
80 + 650 + 750
1 – 0.9 (1 – 0.3)
=
1380
Hence Y = $4000
0.37
Using consumption function we can find the resulting value of C with the level of Y
C = a + bYd
C = 80 + 0.9 (1 – 0.3) (4000)
C = $2600
HOW IS SPENDING BALANCE AND EQUILIBRIUM MAINTAINED IN THIS
MODEL
Now we attempt to show how change in either one of the exogenous components of
aggregate spending such as C (Consumption), I or G, will lead to a change in the
equilibrium level of national income (Y) and how the adjustment takes place as the
economy evolves from a position of disequilibrium to a new equilibrium.
Disequilibrium in Keynesian model simply means an imbalance between national income
(Y and aggregate spending (C + I + G). And the main mechanism in adjustment is the
multiplier mechanism. As the name implies, a given increase (or decrease) in aggregate
spending will lead to an increase (decrease) in Y and the amount of the change in Y will
be a multiple amount of the original change in the exogenous component of aggregate
spending which stared the whole process.
For example: Let’s say that I decreases because of changes in the expected future
profitability of investment products.
In other words, businessmen may become
pessimistic about the future condition of the economy and reduce their Investment
spending.
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Macroeconomics MGMT 510
In what follows, we first analyze the effects of this change in I on Y graphically and then
algebraically.
Spending
45o line
New spending line
(1)
OldSpending line
Spending = a+b(1-t)Y+I+G
S1
SE
Change in I
S2
(2)
Y1
Yo
Income (Y)
(1) Spending line shifts down by the amount of change in I
(2) Income is reduced by
1
I
1 – b(1 – t)
Y1 is the new level of income
Yo is the old level of income
A decrease in investment demand (I) shifts the spending line down. The amount of
vertical shift is equal to the change in I (I). The decrease in I means that at the original
level of Yo, aggregate spending will be less than income:
Yo > C + I + G (after the decrease in Investment)
Initially economy moves down from A to C. but at C Yo > A.S so output starts falling
until we reach point B. At point income is same as aggregate spending. So B is the new
point of equilibrium. However, the decrease in Y is a multiple of the initial decrease in I.
The value of the multiplier determines the exact amount of decrease in Y.
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Multiplier =
1
.
>1
1 – b (1-t)
We note that since both b and t are < 1, multiplier has to be >. Therefore;
Y =
1
I
1 – (1 – t)
Example: If the m.p.c (b) is equal to 0.9 and the tax rate t, is 0.3, then the multiplier is
equal to 1/0.37 or abut 2.7. A $10 decrease in I results in a $ 27 decrease in income or
GNP.
Exercise: Show graphically and algebraically the effects of a $50 increase in G or Y.
Assume that b = 0.8 and t = 0.2.
SPENDING BALANCE WITH FOREIGN TRADE
So far, we have analyzed Keynesian model in the context of a closed economy. We have
ignored the influence of foreign trade and the value of domestic currency (exchange rate)
on the macroeconmy. Now, we will bring these crucial variables into the model.
EXPORT AND IMPORTS
When Exports > Imports, we say that there is a trade surplus. When Exports < Imports,
we say that there is a trade deficit. We define net exports as follows;
X = Net Exports = Exports – Imports
The first step is to incorporate foreign trade into our macroeconomic model. To do this;
we add Export to, and subtract imports from, the Income identity;
Y = C + I + G + Exports – Imports
Since Exports – Imports = Net Exports = X
Y=C+I+G+X
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What is the logic of adding X to Aggregate Spending? An increase in Exports means an
increase in aggregate demand for domestic products. But an increase in imports means
an increase in the flow of income spending on foreign goods. So it represents a decrease
in aggregate spending for domestic products.
So, if X (Net Exports) increases, then
aggregate spending for domestic products increases.
We will assume that our exports to the rest of world are exogenously given. So it is a
constant amount (let’s call this amount g) during the time period under consideration.
But how about our impr0ots from the rest of the world? Imports means purchases of
consumer and Investment goods from the rest of the world. And since consumption
increases as Y increases, naturally spending for imported goods will increase as Y
increases. So there is a positive relationship between import spending and Y (Income).
Let’s say that this positive relationship is given by:
Imports = mY where 0<m
Where m is called: m = marginal propensity to import
Recalling that Exports = g (some fixed amount.
Then X = Net Exports = g – mY
Now we can use the above equation to solve for the open-economy multiplier;
Y=C+I+G+X
Y = a + b (1 – t) Y + I + G + g – mY
Rearranging we get:
Y=a+I+G+g
(1 – b(1 – t) + m
Open-Economy Multiplier =
1
.
1 – b(1 – t) + m
So when our economy is open to foreign trade multiplier is given by the above formula.
In other words, the impact of a given change in I or G or a (exogenous component of C)
or g (Exports) can be found by suing the above multiplier as follows:
Y =
1
I
1 – b(1 – t) + m
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or
Y =
1
G
1 – b(1 – t) + m
INJECTIONS – LEAKAGES (OR WITHDRAWALS) APPROACH TO THE
DETERMINATION OF EQUILIBRIUM LEVEL OF INCOME
According to income –expenditure approach an economy will be in equilibrium only if
Income = Expenditures (on domestic production)
This was algebraically expressed as:
Y
=
C+I+G+X
Income
Expenditure (AD)
In this approach; disequilibrium arises where Y > or < C + I + G + X. Then Y will adjust
passively until Y = C + I+ G + X.
However; the condition for equilibrium given by Y = C + I + G + X also implies
S+T+M=I+G+E
S:
Private savings
T:
Tax revenues
M:
Imports
I:
Private investment
G:
Government spending
E:
Export
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Macroeconomics MGMT 510
S + T + M  Leakages (or withdrawals) from the spending stream of the economy.
I + G + X  Injections
Note: Read from any textbook to understand why
(or total withdrawals) and why
S + T + M = Total Leakages
I + G + X = Total injections.
To see that if Y = C + I + G + X, then
S+T+M=I+G+E
Substitute in the above equation for Y,
Y=C+S+T
and
X=E–M
C+S+T=C+I+G+E–M

S+T+M=I+G+E
So when the economy is in equilibrium,
Total leakages = Total injections
If S + T + M > I + G + E
<
Then the economy will in disequilibrium and Y will change until the equality is obtained.
Remember that
S = f(Y)
T = f(Y)
M = f(Y)
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Macroeconomics MGMT 510
S
So as Y
T
S
and as Y 
M
T
M
However I, G and E are all autonomous of Y.
There are some interesting insights that one can obtain by analyzing the equilibrium
condition be given by:
S+T+M=I+G+E
To see this, we rearrange the above condition and rewrite as follows:
M – E = (I – S) + (G – T)
M – E = Trade deficit if M > E
Trade Surplus if M < E
I – S  If I > S we call I – S  Private sector’s resource deficit.
I – S  If I < S we call I – S  Private sector’s resource surplus
G – T  Budget Deficit if G > T (Public sectors’ resource deficit
G – T  budget surplus if G < T (Public sector’s resource surplus)
So, in equilibrium
M – E = (I – S) + (G – T)
M – E:
External resource deficit (surplus)
(I – S) + (G – T):
Internal resource deficit (surplus)
Let’s see what the above condition implies for Turkey;
M – E > 0 Turkey has trade deficit. This means more resources are coming in Turkey
through imports than the amount of resources going out of Turkey though exports. This
resource deficit on external account is due to net internal resource deficit of the economy.
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In case of Turkey where I is close to S, the main reason for internal resource deficit is
high public sector’s resource deficit given by G > T
EXTENSION OF THE BASIC MODEL
In this part of our lectures, we will extend our model in a way which will take into
account of the
1. Negative relationship between interest rtes and investment.
2. Negative relationship between interest rates and net exports.
3. And finally, because of the fact that interest rate is a financial variable we have to
introduce financial markets in order to see how interest rates are determined. To
do this, we will have to introduce the concept of money market equilibrium,
demand for money and supply of money.
1. INVESTMENT FUNCTION
Previously, we assumed that Investment spending (I) was exogenously given to our
model. But now, we will assume that Investment depends negatively on interest rates.
And since interest rate are determined in the money market (which we will analyze later
on), anything that causes disequilibrium in the money market and changes interest rates
will naturally lead to a change in I. Therefore, I will become endogenous. In other
words, it will be determined within our extended model.
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Macroeconomics MGMT 510
Investment Function
I = e – dR where e is a positive constant and d is also > 0 and it is the coefficient of R
(interest rate). In this sense, d is a measure of responsiveness of I to changes in R
As R  I
R
Ro
R1
Io
I1
Investment
2. NET EXPORTS AND INTEREST RATES
You will remember that net exports (X) was negatively related to Y from the equation X
= g – mY. The reason for this was related to the fact that as Y increases, imports would
increase (mY increases) and given that exports were exogenously by given at some
constant amount (g), net exports (X) would decrease as Y increases. Now we will make
X a function of not only Y but also a function of R. Again, we will intuitively show that
X will negatively depend on R prevailing at home.
Relationship between interest rate and exchange rate is the key to understanding the
relationship between interest rate and net export. Exchange rate is defined as the amount
of foreign currency (in units) that you can buy with 1 unit of domestic currency. For
example if US is the domestic economy and England is the foreign country, then
exchange rate is the units of British pounds (£) that one can buy with 1 US $. Let’s say
that exchange rate is such that $ 1 US = £ 0.5. If exchange rate increases above £ 0.5
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Macroeconomics MGMT 510
(such as £ 0.60) we say that US dollar (domestic currency) has appreciated vis-à-vis
British pound.
Exchange rate plays a very important role in affecting foreign trade because when
exchange rate increases (US$ appreciates) American products become more expensive
for British consumers.
However, British products become cheaper for American
consumers. So an increase in the exchange rate of US dollar will increase imports of US
from the rest of the world and at the same time decrease US exports to the rest of the
world.
Why this happens? Example: If the price of a British good is £ 10; when the exchange
rate is $ 1 US = £ 0.5, the price in terms of US dollar is given by 10/0.5 = $20. so for
Americans the price was $20. Let’s say exchange rate increases from $1 = £ 0.5 to $ 1 =
£ 1. Now, the price of this British good for Americans is now 10/1 = $ 10. so there is a
decrease in the price of British goods (in terms of US dollars) when US dollar gains in
value vis-à-vis British pound.
On the other hand, American goods become more expensive in terms of their pound
prices for British consumers.
So, as exchange rate increases, net export will decrease. But what is the relationship
between exchange rate and interest rate? As interest rate (R) increases at home, exchange
rate increases (gains in value). In other words, domestic currency (Let’s say US $)
appreciates if interest rate in US rises relative to the interest rate prevailing in the rest of
the world. Why? As R increases in US, demand for dollars in the foreign exchange
markets will increase which increases the price of US dollar (exchange rate) in terms of
other currencies. Why? To understand this, we have to give an example about US and
England. Let’s say that in US interest rate increases (while there is no change in R in
England). Now, it will become attractive for English residents to buy American bonds or
deposit their savings into American banks. But to do this, they have to withdraw their
deposits from English banks and buy $ with their £ (pounds). So there will be an
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Macroeconomics MGMT 510
increased demand for dollars and an increased supply of British pounds in foreign
exchange markets.
Why? Because English investors are trying to convert their £ into $
so that they can buy American Bonds or deposit their money into American banks which
offer higher rate of return compared to British bonds and banks. So this increased
demand for $ leads to an increase in the price of US dollar in terms of pounds. In other
words, exchange rate of US $ vis-à-vis British £ increases; US $ appreciates. So in
Summary:
As R increase, increased demand for US dollar in foreign exchange markets, which leads
to an increase in the price of US $ (increase in the exchange rate).
But we know that as Exchange rate increase, this leads to a decrease in X (Net exports)
for that country. So as R increases, this should lead to a decrease in X. Hence, as interest
rate rises relative to the rates in the rest of the world, this will negatively affect net
exports because of its appreciation effect on domestic currency.
Given the above result, we extend our net export function in a way which will reflect this
negative relationship between (X) and exports and interest rate (R)
X = g – mY – nR
Where n>0
So, n is a coefficient which measures the responsiveness of net exports in relationship to
changes in R. If n is relatively large, a given change in R leads to relatively large change
in X. Now we will analyze the factors which influence interest rates.
3. MONEY MARKET
Money market and the way it functions are key to understanding the main variables
which can influence interest rates.
Money market, just like any other market has demand side as well as supply side. Supply
of money can be assumed to be under the control of government. In other words, Ms
(Money supply) is exogenously given by the government.
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How about demand for Money? Md is assumed to be a function of Y (National income)
and R (interest rates). In other words, the amount of money demanded by people and
firms are likely to depend positively on the level of national income (Y) and negatively
on the level of interest rate (R). In order to understand this assumption, we have to define
what we mean by Money. Money here refers to the sum of Currency in circulation +
Demand deposits. So, Ms = C.C + D.D
Demand deposits are those deposits of people and firms with the banks, which do not
earn any interest and are kept as checking balances. Similarly currency held in our
deposits or in the firms’ vaults do not earn any interest.
But why should firms and people increase the amount of money they like to hold (in the
form of CC + DD) as Y increases and decrease their demand for such money when R
increases? Why does Demand for money increase when income increases? At higher
levels of Y, people spend more on goods and services because they need larger amount of
money to finance larger volume of transactions at higher levels of Y. On the other hand,
the negative relationship between demand for money and the interest rate R is studied
under “Speculative demand for money”. According to this idea, at higher rates of interest
people and firms would like to reduce the amount of money they hold for speculative
purposes. This is simply because higher interest rate means higher opportunity cost of
holding money for speculative purpose. So as Y increases, Md increases but as R
increases, Md decreases.
Demand Function for Money
We can express the positive relationship between Y and Md and negative relationship
between R and Md as follows:
M = (kY – hR)P
M: Total demand for money
Y: Income
P: Price level
K and h are > 0 and they are coefficients of Y and R variable.
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DEMAND FUNCTION FOR MONEY
We can express the positive relationship between Y and Md and negative relationship
between R and Md as follows:
M = (kY – hR)P
M: Total demand for money
Y: Income
P: Price level
k and h are > 0 and they are coefficients of Y and R variable. So total amount of money
demanded depends on three variables: Y, R and P. why is P in this function? Think
about it, this way: if P doubles, people and firms will need twice as much money as
before to finance their existing transactions.
So demand for moony is directly
proportional to the level of P.
THE MONEY SUPPLY
Right now, we will assume that the government determines the supply of money. And it
is equal to demand for money. In other words M represents both supply of money and
demand for money. But what happens if money supply is increased or decreased? How
will the money demand adjust to the new level of money supply. Essentially all three
variables, Y, R and P will change to bring money demand to the new level of money
supply. However, the adjustment in P is relatively slow. So usually it is the changes in Y
and R that will ensure the equality of money demand with the new level of money
supply.
Now we are ready to put everything together and introduce IS-LM model of an economy.
Our objective is to use the economic relationships introduced until now to determine
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GNP, Investment, consumption Net exports, the interest rate and the price level. There
are five economic relationships:
1) Income identity
2) The consumption function
3) The investment demand function
4) The net export function
5) The money demand function.
We will assume that P is predetermined. In other firms, at the beginning of each year
firms adjust P by looking at the conditions of demand in the previous year. As we
assumed before, P is sticky (fixed) during the year.
For this reason P is called
predetermined variable. There are also two exogenous variables of the model. G and M
(Money supply), these are determined by the government. Our job is to develop a model,
by using all these five relationships to determine the level of Y and R (interest rate)
which (1) generate spending balance in the goods market and (2) at the same time
generate equilibrium in the money market. In other words, we are thinking of the
economy consisting of two markets:
1) Goods market
2) Money market
For the economy to be in equilibrium, both goods and money markets have to be in
equilibrium. The variables that will adjust to bring the overall economy and therefore
each one of these markets into equilibrium are Y and R.
Goods market equilibrium requires that Y = C + I + G + X
In other words, total spending on goods has to be equal to GNP (Y). So we will try to
find the values of Y and R which will generate goods market equilibrium.
Four of the five economic relationships are the elements of goods market equilibrium:
(1) Y = C + I + G + X
(Income Identity)
(2) C = a + b(1 – t)Y
(Consumption function)
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Macroeconomics MGMT 510
(3) I = e – dR
(Investment function)
(4) X = g – mY – nR
(Net export function)
For the money market to be in equilibrium we require that
(5) M = (kY – hR)P
So our job is to develop a graphical method to find the value of Y and R which generate
equilibrium in both goods market and money market at the same time.
So the
endogenous variables are Y and R. Exogenous variables are G and M. Predetermined
variable is P.
Question is: What will we do after developing such a model? We will be able to analyze
how changes in exogenous variables such as G and M and a change in predetermined
variable P will affect output (Y), interest rate (R) in the economy. And naturally, we can
use these to see how C, I and X will change as a result of changes in G, M or P.
But why should C, I and X change as G, M or P changes? Remember that:
(1) C is a function of Y
(2) I is a function of R
(3) X is a function of Y and R.
So, if Y and R change as a result of a change in G or M or P, all these will change. By
this model, we will be able to analyze the effects of monetary policy which is performed
by changes in M and the effects of fiscal policy which is performed by changes in G. At
the same time, we will be able to see the effects of a change in P (if firms change their
prices) on Y and R. And we will be able to see the conditions under which monetary
policy will be more or less effective than fiscal policy in affecting Y (GNP).
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Macroeconomics MGMT 510
GRAPHICAL REPRESENTATION OF IS-LM MODEL
We will develop two curves on R – Y space. On the vertical axis we will measure
interest rate (R) and on the horizontal axis we will measure Income (Y).
R
RB
B
RA
A
IS
YA
Y
1st curve is called IS-curve. IS-curve gives us all combination of Y and R which generate
equilibrium in the goods market. It is negatively sloped. Why? To see this, remember
that for goods market equilibrium we want Y = C + I +G + X. Start with point A where
R = RA and Y – YA and the goods market is in equilibrium. Now, suppose that R is
increased to RB. What happens? Assume that initially there is no change in Y.
Question is: What must happen to Y (income) for the goods market to return back to
equilibrium? As R increases from RA to RB, aggregate spending falls. Why? Remember
that I and X negatively depend on R.
In other words, as R increases, Investment
spending and net exports fall. This means that at the initial level of Y which is YA we
have disequilibrium in the goods market.
YA > C + IB + G + VB
(Because IB and XB are lower now).
So, for the goods market to return back to equilibrium, YA (output) should fall to the new
level of spending. So as R increases, for the goods market to return back to equilibrium
Y should decrease. That’s why IS-curve is negatively sloped.
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R
RB
C
RA
B
A
IS
YA
YB
Y
After RA increases to RB we will initially be at point B. But at B,
YA > C + IB + G + VB
So at B there is excess supply of goods. That is why Y should fall until
Y=C+I+G+X
once again so that goods-market equilibrium is restored. This happens when Y decreases
to Ye and goods market is again in equilibrium.
How about Money market? The LM curve shows all the combinations of Y and R for
which money market will be in equilibrium.
Money market will in equilibrium when
M = (kv – hR)P
What does this mean? This condition means that money market will be in equilibrium
when money supply (M) is exactly same as money demand given by (kY – hR)P. We
can express this equation in a different way.
M = (kY – hR)P
M/P = (kY – hR)
M: Nominal money supply
M/P: Real money supply
So, when M is divided by the price level P we obtain what we call real money supply. So
kY – hR gives us demand for real money.
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From now on we will use this equation for money market equilibrium
M/P = kY – hR
Since M and P are fixed, let’s try to see what happens to equilibrium in the money market
if R is increased? Let’s say that initially Y = Y A and R = RA and money market is in
equilibrium.
M/P - k YA – hRA
What happens if RA increases to RB? We know that R is the opportunity cost of holding
money and as R increases, demand for money will decrease. We can see from the righthand side or equation (1) that (kY – hR) will be smaller for higher values of R. But M/P
is fixed. So as RA increases to RB, we will have excess supply of money. Why? Because
M/P > k YA – hRB.
Since M/P is fixed, the only variable that can change to bring the money market back into
equilibrium is Y. what must happen to YA for demand for real money to increase back to
the level of M/P (Real money supply)? It must increase. Because as Y increases,
transactions demanded for real money will increase. This tells us that for money market
to be in equilibrium an increase in R requires an increase in Y. So LM curve is positively
sloped;
Spending
B
C
LM Curve
RB
RA
B
YA
YC
Income (Y)
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At point B, R is higher so demand for money decreases. There is excess supply of
money. To eliminate this, Y has to increase to YC
DETERMINATION OF EQUILIBRIUM LEVELS OF Y AND R FOR THE
WHOLE ECONOMY
R
R
Is curve
Is curve
Y
Y
Equilibrium condition in the
goods market
Equilibrium condition in the money
market
Y=C+I+G+X
(M/P)d=(M/P)s
Output=aggregate spending
Demand for
supply of real
Real money balance=money balance
G=Exogenous variable
=g-mY-nR
=e-dR
=a+bYd
d=(1-t)y
(M/P) s
=
kY-hR
Supply of real = demand for real
money balance
money balance
M=Exogenous variable
P=Predetermined variable
R and Y are endogenous variables.
They will change if an exogenous or
predetermined variable change.
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We have said that IS curve is negatively sloped: economic meaning of this was that
starting from a point of equilibrium in goods market where by Y=C+I+G+X
A given increase in Y means that Y>C+I+G+X → Excess supply of goods
So, R has to be lower so that I and X increase until this excess supply is eliminated and
once again Y= Aggregate spending in the economy. So, higher levels of Y are associated
with lower levels of R (interest rate) along the IS curve. We should keep in mind that a
given IS curve is drawn for a given value of G (government spending).
Question is: what happens if G increase?
Answer: IS curve will shift to the right
Why?
IS1
An increase in G means that
at the initial level of R0 and
Y0, (where the goods market
was in equilibrium before the
increase in G)
IS0
R0
Y0
Y1
Goods market will no longer be in equilibrium. Why? Because additional government
spending means new level of aggregate spending becomes higher than the level of output
(Y0).
So Y0< C0+I0+G1+X0
Excess demand
(Initially before the changes in G) we had Y0=C0+I0+G1+X0, but now increase in G to
G1>G0, so goods market can be in equilibrium only if increase Y at every level of R
(interest rate) to match up the new level of aggregate spending so that Y= C+I+G+X once
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Macroeconomics MGMT 510
again. That is why an increase in G will lead to a shift in IS curve to the right. In other
words, higher G means each level of R is now associated with a higher level of Y.
HOW ABOUT A DECREASE IN G?
In this case IS curve will shift to the left. Why?
IS1
IS0
Because, a decrease in G will
create decreasing aggregate
spending.
R0
Y1
Y0
But lower level of aggregate spending means, the initial level of Y0 becomes more
than the new level of aggregate spending. So, for the goods market to be in equilibrium
Y0 should fall until Y is again equal with (C+I+G+X) which are lower than before. So
lower levels of G means each levels of R is xxxxx page 68 with a lower level of Y for
equilibrium in goods market.
On the other hand LM curve is positively sloped. In other words, the
combinations of R and Y which generate equilibrium in money market are such that,
higher level of Y require higher level of R for the money market to stay in equilibrium.
WHY?
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R
LM curve
Y
Money market will be in equilibrium when (M) s = kY-he
P
Supply of money = Demand for money
M is exogenously fixed by the government
P is predetermined by firms for this period
(M/P)S is fixed. In other words, real money supply is fixed. Let’s see what happens to
money market equilibrium if Y increases?
C
R1
A
B
R0
Y0
A is initial combination of
R and Y which create
equilibrium in the money
market.
Y1
if Y increases from Y0 to Y1 (while R0,Y0) is the initial combination generating
equilibrium in money market then point B (R0,Y1) combination of R and Y can not be a
combination which generates equilibrium in money market WHY? Well, (M/P) S is fixed.
At point A:
(M/P) S = (kY0-hR0)
but now, Y is higher Y1>Y0 but we know that if Y is higher kY1 is bigger than kY0. So,
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kY1-hR0 > kY0-hR0
New level of money demand > Original money demand
Since, (M/P) S is fixed, the only way far the money market to be in equilibrium
again is that the interest rate (R) rises by a sufficient amount so that demand for money is
being reduced to its original level (which is equal to (M/P) S).
But why should money demand decreases if R increases? REMEMBER that R
(interest rate) is the opportunity cost of holding money. So, if R increases, people and
firms would like to hold less money in the form of cash and demand deposits (both of
which earns 0 interest). That is why we say that demand for money will decrease if R
increases.
So, if we start from a combination of (R0 Y0) which generate equilibrium in
money market, such as point A, and if Y increases to Y1 (point B), we will have excess
demand for money. So, point B can not be an equilibrium point for money market. The
only way we can have equilibrium in the money market is if R increases by a sufficient
amount (such as R1) so that this excess demand for money (caused by the increase in Y
from Y0 to Y1) is eliminated. So, at point A (M/P)
S
= kY0-hR0 and point K (M/P)
S
=
kY1-hR1
Both A and C are points of equilibrium in money market but point B is not.
Now we can ask the question “WHAT WILL HAPPEN TO LM CURVE IF M
OR P CHANGES?” It will shift to the right if (M/P) S increases and LM curve will shift
to the left if (M/P) S decreases.
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LM0
A
B
R0
LM1
Increase in
(M/P) S
Y0
Y1
It is important to note that (M/P) S can increase in two ways:
(1) M can be increased by government
(2) P can be decreased by the firms
Lets say that (M/P) S increases as a result of deliberate expansionary monetary policy of
government which increases M.
Lets say that before the increase in M we were at point A where money market
was in equilibrium and R=R0 and Y=Y0 so, (R0, Y0) generating the original equilibrium
higher money supply. We can think of this as follows:
Money demand increases as Y increases so since (M/P) S is higher than before, at each
level of Y has to increase until money demand rises by a sufficient amount until it is
equal to the new higher level of money supply.
So point A shifts to point B. actually every point on the original LM curve (LM0)
will shift to the right. So, LM curve will shift from LM0 to LM1. In other words, if (M/P)
increases for each level of R, money market can be satisfied only at higher level of Y.
LM curve will shift to the right when:
(1)M increased by government or
(2)P is decreased by firms
LM curve will shift to the left when:
(1)M is decreased by government
(2)P is increased by firms
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There is only one level of Y at which spending will be equal to national
income(Y). And that is given by YE. At income levels higher than YE, such as Y1,
spending that will emerge is given by S1. But S1 is smaller than Y1, there will be excess
supply and output will decrease due to insufficient demand and therefore unemployment
will increase. Similarly, when Y is less than YE, such as Y2 spending is S2. But S2>Y2 so
there is excess demand which will lead to an increase in output.
Previously we have shown that the entire economy will be in equilibrium only
when both good market and the money market are in equilibrium at the same time. In our
IS-LM model, the variables that will adjust so as to generate equilibrium in the economy
are R (interest rate) and Y (national income). Graphically speaking, values of R and Y
that will generate equilibrium in both goods market and money market are given by the
intersection point of IS and LM curve.
LM
E
RE
IS
YE
So, the above diagram suggest that when R=RE and Y=YE our economy will be in
equilibrium both money market and goods market are in equilibrium. In other words,
(1)MS/P= kY-hR money market
(2)Y=C+I+G+X
Agg. Supply=Agg. Demand
And given the equilibrium values of R and Y (RE, YE) we can find the values of
C, I and X which depend Y and R.
Now we are ready to analyze the affects of MONETARY AND FISCAL POLICY
and change in P (by the firms) and equilibrium value of R and Y and trough them on C, I
and X.
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POLICY IN THE IS-LM MODEL
A) MONETARY POLICY
OLD LM
NEW LM
R0
R1
IS
Y0
Y1
INCREASE IN MONEY SUPPLY
IS-LM model products that increase in MS will reduce the equilibrium level of R
and leads to an increase in the equilibrium level of income.
First of all, we know that an increase in R, MS will lead to excess supply of
money leading to an immediate drop in R to point B.
Intersection of LM curve with the IS curve will be at E1 whereby R is lower at R1
and Y is higher at Y1.
WHAT IS THE DYNAMICS OF THIS RESULT?
As MS is being increased, the first impact is in the money market. At the initial
value of R and Y (at R0 and Y0), after the increase in MS we will have excess supply of
money. (Ie. MS/P > kY0-hR0).
Excess supply of money will put a downward pressure on R and R will decrease
to oint B. As R decreases two things will happen simultaneously:
(1) Md will star increasing
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(2)I and X will start increasing
As I and X   AD  which eliminates some part of the  in Md when we reach pint
C, R has increased form point B to R1. But overall R falls from Ro to R1. Exchange rate
depreciates since R is lower. And I is higher at point C relative to A. But what happens
to X is ambiguous because as R  X but as Y  X due to higher imports. So the
net effect of  in Md on X is ambiguous. But as Y, C, S, and T. So BD and I.
And exchange rate depreciates.
The increase in investment will start increasing income Y through the multiplier
process. In addition, this increase in Y will start increasing Md through its effect on
transaction demand for money.
Therefore, the process will continue until R has fallen and Y has risen by an
amount sufficient enough to increase Md to the new level of Ms. At this point money
market will be in equilibrium. Since, in IS-LM model output will adjust passively to the
level of demand, whatever the increase in aggregate demand caused by the decrease in R
will be output will increase to eliminate any excess demand for goods caused by the
increase in investment spending. So, at the new equilibrium level R is lower and Y is
higher.
HOW ABOUT C, I AND X? Well, we know that C depends positively on Y. therefore at
the new equilibrium point; C will be higher than before. I will be higher as well, due to
lower R.
On the other hand, since X(net exports) depends on Y and X we can not tell whether X
will increase or decrease WHY? As Y increases, net exports will decrease. Because,
imports will increase as Y increases. However, as R decreases (due to depreciation of the
exchange rate), X will increase. Because, our exports will increase as TL loses its value
which we call depreciation. So, the net effect of this increasing in MS on X is ambiguous
(uncertain).
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SUMMARY
1) MS increase LM curve shifts to the right, R decreases (due to excess supply of
money), investment increases, Y increases (through multiplier process), Md
increases, ( C, S, T, M, as Y). But what happens to X is ambiguous since
depreciation of the exchange rate (due to lower R) leads to an increase in X. But
an increase in Y, by increasing M leads to a decrease in X.
The effects of a decrease in P are similar to those of an increase MS. WHY? Because
decrease in P, increase in MS/P. so, decrease in P leads to rightward shift in LM
curve. As an exercise analyze the effects of a decrease in MS (or an increase in P) on
R,Y,C,I and X.
FISCAL POLICY EFFECT OF A CHANGE IN G
OLD IS CURVE
LM
E1
R1
E0
A
R0
NEW IS CURVE
Y0
Y1
YA
We know that increase in G (government spending) will shift IS curve to the right. And
the equilibrium point will move from E0 to E1. as you can see, at the new equilibrium
point, both R and Y are higher.
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WHAT IS THE DYNAMICS OF THIS RESULT? As G increase, aggregate demand will
first increase from Y0 to YA, however the ultimate increase in output (Y) will be less than
this initial increase in aggregate demand and the economy will settle down at Y1. To
understand this result, we have to introduce the concept of “CROWDING-OUT”.
CROWDING-OUT takes place when the increase in R leads to a decrease in investment
which partly offsets the initial positive effect of the increase in G on aggregate demand.
Well, why does R increase? As G increases, aggregate spending increases, Y increases
(through multiplier process). However the increase in Y causes an increase in Md. WHY?
Because transaction demand for money will be higher due to larger economic
activity caused by the increase in Y. (in other words kY component of Md increases). The
increase in Md causes EXCESS DEMAND FOR MONEY since MS/P is fixed. The
excess demand for money leads to an increase in R. the increase in R will reduce
investment spending (I). So the net increase in Y will be smaller than what is would have
been in the absence of such an increase in R. this effect of increase in R on Y is called
CROWDINH-OUT. Because increase in R crowds-out, I which partly offsets the positive
impact of increase in G on Y. So the magnitude of the positive effect of an increase in G
on Y depends on the magnitude of the crowding-out effect.
Crowding-out effect will be larger when
(1) The increase in R is relatively larger
(2) Decrease in I and X for a give increase in R is relatively larger.
(1) R will increase relatively by a larger amount when the sensitivity of Md is R is
relatively smaller. This means that when Md increases kY a certain amount
(due to the initial positive effect of increase in G on Y), R will have to
increase a lot in order to reduce Md to its original level so that Ms /P=kY-hR
again
(2) On the other hand, if X and I decreases a lot for a given increase in R (in other
words d is relatively large in I=e-dR function and n is large in X function)
then crowding-out effect will be larger. So that the net increase in Y as a result
of an increase in G will be smaller
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****As an exercise analyze the effects of a decrease in G on (Y,R) and through changes
in Y and R on C,I and X.
THE RELATIVE EFFECTIVENESS OF MONETARY AND FISCAL POLICY
By “relative effectiveness” what we mean is their relative effects on Y. in other
words; under what conditions we should use monetary policy and fiscal policy to change
Y.
TWO IMPORTANT ISSUES must be faced in determining the relative
effectiveness of monetary and fiscal policy in affecting aggregate demand and therefore
in affecting Y.
(1) the sensitivity of investment demand and net exports to interest
(2) the sensitivity of money demand to interest rates
These issues can be given graphical interpretations in terms of the slopes of the IS
curve and the LM curve. But we will give an intuitive (logical) explanation.
WHEN IS FISCAL POLICY RELATIVELY WEAK?
An expansionary fiscal policy will have a relatively weak effect on aggregate
demand if interest rates raise a lot and have at large negative effect on investment and net
exports.
As we said earlier, the fall in investment and net exports will portly offset the
positive effect that government spending has an aggregate demand? The fall in
investment and net exports will be large.
Under two circumstances, corresponding to the two issues listed above.
(1) If the sensitivity of investment and net exports to the interest rate is very large.
Then a rise in interest rates will reduce investment and net exports by a considerable
amount
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(2) If the sensitivity of money demand to the interest rate is very small. Then the
increase in money demand that arises as a result of the increased government
expenditures will cause a big rise in the interest rates. WHY? Because, if Md is not
sensitive to R, R will have to increase a lot in order to eliminate the excess demand for
money caused by the increased in G.
Another property of our model that affects the strength of fiscal policy is the
spending multiplier. A high spending multiplier means more effective fiscal policy.
However, if the economy has high interest sensitivity of investment and net exports and
low interest sensitivity of money demand, even a very large multiplier will not result in
strong effects of fiscal policy.
WHEN IS FISCAL POLICY RELATIVELY STRONG?
An expansionary fiscal policy will have a relatively strong effect on aggregate
demand if interest rates don’t rise by much or have effect on investment and net export.
This occurs under circumstances opposite to those listed under weak fiscal policy.
WHEN IS MONETARY POLICY RELATIVELY WEAK?
An expansionary monetary policy will have a relatively weak effect on aggregate
demand if the drop in interest rates that occurs when the money supply is increased is
small or has little influence on investment and net exports. This occurs under two
circumstances
(1) If the sensitivity of investment demand and net exports to interest rates is very
small. Then investment (I) and net exports (X) are not stimulated much by the
decline in interest rates
(2) If the sensitivity of money demand to interest rates is very large. Then the
increase in the money supply doesn’t cause much of a drop in interest rates. In
other words, a small drop in R is sufficient to bring money demand up to the
higher level of money supply.
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WHEN IS MONETARY POLICY RELATIVELY STRONG?
An expansionary monetary policy will have a big effect if interest rates fall by a
large amount and stimulate investment and net exports in a big way. This occurs under
circumstances opposite to those listed under weak monetary policy.
DERIVATION OF AGGREGATE DEMAND CURVE FROM IS-LM MODEL
As we know, aggregate demand curve shows us the relationship between the
general price level (P) in the economy and the level of aggregate demand. Remember that
A.D= C+I+G+X.
So, we would like to show what happens to aggregate spending on domestic
goods as price level changes. We will find out that the mechanism through which
changes in the price level affect A.D is a little bit more complicated and it involves the
role of money market.
First we show graphically, how we can obtain the relations between P and the
level of A.D and later on, explain the economic logic behind such a relationship
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R
M1
(M
R1
0,
P0)
R0
E1
LM1 (M0, P1)
LM0 (M0, P0)
E0
IS(G0)
Y (SAME AS AD)
Y1=AD1
Y0=AD0
P
B
P1
A
P0
AD
AD (Y)
AD1
AD0
Before we explain what is going on in the above diagram, remember that in ISLM model, each equilibrium lead of output (Y) the level of A.D that occurs at that level
of Y1 since equilibrium requires that Y=A.D
Assume that the economy is initially in equilibrium at E0. And at E0, price level is
P0 and the resulting equilibrium values of R and Y are given by R0 and Y0. Therefore Y0
is also the level of A.D that exists when P=P0 and it is given by A.D0. so when P=P0,
AD=AD0=Y0 and this point is shown by point A. now, assume that firms increase their
prices raising the general price level from P0 to P1. This shifts the LM curve to the left
from LM0 to LM1, and a new equilibrium is reached at point E, whereby R is R 1 at the
new equilibrium, R1 is higher than R0 and Y1 is lower than Y0. Since Y1=AD1, this gives
us point B on AD curve and when we connect points A and B, we obtain the “negatively
sloped” AD curve. Negative slope means that as P increase, AD decrease. What is the
economic logic behind this?
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* As P increase, MS decrease, we will have Excess Demand for Moneyin the Money
Market;
P
This inturn will raise R; the increase in R causes a decrease in I and X which leads to a
fall in AD, thereby causing an eqivalent decrease in Y through the multiplier process.
That’s how we obtain the “negative relationship” between P and AD.
EFFECTS OF CHANGES IN MS AND G ON AD CURVE
We can show that an increase in MS or an increase in G will shift the AD curve out to the
right in other words, at each and every price level Total Spending on domestic goods will
be higher.
R
G1 > G0
LM (P0,MS0)
R1
R0
B
A
IS1 (G1)
IS0 (G0)
Y
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P
Y0
P0
Y1
AD = Y
D
C
AD1
AD0
AD0
AD1
AD (Y)
In the above diagram, we have shown that an increase in G will shift the AD
curve out to the right. Remember that price level is fixed at P0. So, as G increase, IS
curve shifts out from IS0 to I. Economy reaches a new point of equilibrium at point B,
where R and Y are both higher. Higher G increases AD(and therefore Y) through the
multiplier process (Keep in mind that some part of the initial positive effect on AD is
offset by the crowding-out effect of higher R on I&X).
Higher G means that at the given price level P0, AD is higher (C+I+G1+X) is now
higher that is why point C shifts to point D. Actually, every point on the original AD
curve shifts out to the right, giving us the new AD curve. What is important is the idea
that the level of AD at each level of P is now higher.
Exercise: Try to see what happens to AD curve when MS decrease or increase
using IS-LM Model.
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AGGREGATE SUPPLY AND PRICE ADJUSTMENT
What we have covered so far gave us an idea about the way output (Y) is
determined in the Short-Run. It was assumed that given fixed Wages and Price, changes
in AD are the only determinants of GNP (Y).
In other words, an increase in AD would lead to an increase in Y and a decrease in
AD would lead to a decrease in Y. Therefore a decrease in I or C or X or G could throw
the economy into a recession (decrease in GNP) and therefore cause an increase in
unemployment.
Now, in this section we will try t analyze what happens in the Long-Run.
Difference between Long-Run and Short-Run lies in the idea that in the Short-Run are
fixed while the Long-Run Prices can adjust depending upon the conditions of the
economy and this adjustment of prices will help the economy to return back to its
Potential Ouput(Y*).
So we will try to analyze, how changes in Y (caused by changes in AD) cause
changes in P which, in turn, bring economy back to its Long-Run equilibrium level of
output.
So we will show that, in the Long-Run, the level of output is given by potential
output. And potential output is purely determined by Aggregate Supply of the economy.
And Aggregate Supply is determined by the productive resource and the state of
Technology.
So; change in Y caused by change in AD are short-lived and once the price start
adjusting Y returns back to Y* which is determined by the level of AS. Therefore, in the
Long-Run the level of AD has no effect on Y.
So; our first job is to identify the determinants of AS which determine Y*
(potential GNP), which , in turn, is the Long-Run equilibrium level of output.
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And secondly we will try to analyze the process through which PRICE level
adjusts and how this adjustment in P brings the actual level of Y back to Y* in the LongRun. So adjustment of P is the key mechanism through which economy returns back to its
Long-Run equilibrium level of Y.
DETERMINANTS OF AGGREGATE SUPPLY
The economy’s capabilities for (proXXXp110) output are given by:
1. The number of people available for work (shown by N) (labor force)
2. The amount of equipment, structures, land and other types of capital (shown by
K) (capital stock)
3. The technology
1. LABOR:
We will define “Potential Employment” (sometimes called “Full-Employment”) (N*) as
that level of employment would emerge if everybody in the population who wanted to
work at existing real wage (W) could find a job and work. But remind yourself that even
P
when employment is at its potential level (N*), we have some positive unemployment
rate. Why? Because, at each point in time, some people are unemployed either voluntarily
or due to simple fact that they are in search of a new job. There are available jobsfor them
but it takes time to find those jobs. So the rate of unemployment that exists due to “job
search” and due to “voluntary choice” of some people is called Natural Rate of
Unemployment. So when N=N*, we still some unemployment given by Natural Rate.
2. CAPITAL:
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In a given year, the volume of physical capital is fixed. Even if there is positive
Investmentat taken sometime for those investment projects to be finished and add to the
existing capital stock. So K is fixed.
3. TECHNOLOGY:
Technology determines the amount of output(Y) that can be obtained by using a
given amount of K and N. And Y nature of technology is represented by the form of
production function. Here, we just use the general form of production function:
Y=F (K, N)
So if N=N* and all the existing capital stock (K) is used, technology determines
the maximum amount of output that can be produced. This level of Y is the potential
level of output given by Y*
===>Y*= F (K, N*)
Y*= Potential Output
N*= Potential Level of Employment
As we said before, Y* is sometimes called full-employment level of output
because it is produced when everybody who wanted to work at the existing Real Wage
(W) can find a job and work.
P
Notice that Y* does not depend on the price level P. So regardless of the price
level, Y* is fixed in a given year. Because it depends on the value of K and N* which
themselves do not depend on P. So, this means that Aggregate Supply Curve is a vertical
line fixed at Y* level of output as shown below:
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Y*
P
AS Curve
Y*
GNP(Y)
PRICE STICKINESS AND THE DETERMINATION OF OUTPUT AND
UNEMPLOYMENT IN THE SHORT-RUN
Let’s try to remember what we mean by price stickiness. Prices are sticky in the
sense that they are not adjusted quickly by firms in response to demand conditions. Firms
wait a while before adjusting their prices. For some period of time, therefore, the price
level is stick at a predetermined level. It is during this time that sellers are waiting to see
how demand conditions change before they adjust their price again. Prices eventually
adjust, of course, but not until the next time period – a year or quarter later, for example.
For the time being the price level is predetermined
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Determination of Output:
P
P
Figure-1
Predetermined Price
Line
P0
Figure-2
Predetermined
Price Line
P0
New AD
AD
Old AD
Y0
GNP (Y)
Y0
Y1
GNP (Y)
Figure 1, shows how aggregate demand determines output at some predetermined
price. The aggregate demand curve is the same one derived in the previous lectures. The
predetermined price is shown by the horizontal line drawn at P0. GNP is determined by
the point of intersection of the aggregate demand curve and the flat predetermined price
line.
Shifts in aggregate demand curve caused perhaps by changes in the money supply
or government spending will result in increase or decrease in output. A rightward shift in
the aggregate demand curve results in an expansion of output; a leftward shift, the
aggregate demand curve results in a contraction of output.
The price level inherited from last year when combined with the aggregate
demand curve, determine the level of output. If this level of output is below potential
output ten we will observe unemployment and other unused resources. Or actual output
can be greater than potential output. These two possibilities are shown in Figure 3 and 4,
where we have superimposed the vertical potential GNP line to indicate potential.
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P
Figure-3
P
Y*
Figure-4
Y*
Predetermined
Price Line
P0
Predetermined
Price Line
P0
AD Curve
AD Curve
Y
Y*(potential) GNP (Y)
(Potential)Y*
Y0
GNP (Y)
When output is either below potential or above potential, both of these positions will
exert pressure on firms to change prices. When output (Y) is below potential (Y*), there
will be pressure on firms to lower prices. When output (Y) is above potential (Y*), there
will be pressure on firms to raise prices.
Although the price level does not change immediately when firms find themselves
producing above or below their potential, there is pressure for a price adjustment. This
adjustment leads to a changed price level for the next year or period- not this year. For
example, if aggregate demand is above potential in the year 2001, then the price level
will be higher in 2002. When the aggregate demand curve is drawn to determine output
for the year 2002, the predetermined price will be drawn at a higher level. If the
intersection of the aggregate demand curve for the year 2002 and this new price line is
still not at an output level equal to potential, then there will be a further adjustment in
prices but this will not occur until the year 2003. The process continues this way until
aggregate demand equals potential output, at which point the firms adjust their prices will
no longer be present.
Now we will study the process through the price level changes
from one year to the next.
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PRICE ADJUSTMENT
We will assume that if demand in the previous period (Y-1) is greater than Y*, then
the price level P this period will be raised (The subscript “-1” indicates the previous
period). Conversely, if demand in the previous Y-1 is below Y* then the price level P will
be reduced.
So the difference (Y-1- Y*) measures the pressure on prices to change. Note that,
because P depends on Y-1, it is predetermined or set according to demand conditions
prevailing in the recent past.
Firms make their price decisions with the price of their inputs in mind. The most
important input is labor.
Hence, the behavior of the wage rate is a major determinant of price adjustment.
Wages tend to rise when conditions in the labor market are strong. Remember that, when
real GNP is high relative to potential, unemployment is low and employment is high.
These are conditions that are likely to lead to rising wages. So inflation will result any
time GNP is above its potential.
Inflation is the rate of increase in prices which is given by P-P-1 Inflation Rate
P-1
P This period’s price level
P-1 Previous period’s price level
And inflation rate is positively related the rate of deviation of Y from its
potential(Y*) which is given by (Y-1- Y*)
Y*
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So
P-P-1
= f (Y-1- Y*)
Y*
P-1
where f>0
This equation tells us that there is a positive relationship between the rate of
increase of prices (inflation rate) and the rate of deviation of GNP(Y) from potential.
Such a relationship is called a Philips Curve.
Y-1- Y*
Y*
If
is sometimes called Output GAP expressed in percentage terms.
Y-1- Y*
Y*
If
>0, we have a positive output gap.
Y-1- Y*
Y*
<0, we have a negative output gap.
So according to equation 1, when output gap got larger (in positive terms), rate of
inflation got higher too. On the other hand when output gap got smaller, rate of inflation
got smaller too.
Let’s call inflation rate, П;
П = P-P-1  Inflation Rate
P-1
So in its simplest form Philips Curve can be expressed as: П = f Y-1- Y*
Y*
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Let’s say that f= 0.2, this mean this year P would be (0.2 x 0.05= 0.01) 1% higher
than its level in the previous period.
We can express this sample Philips Curve graphically as follows:
Inflation(П)
Phillips
Curve
2%
1%
-5%
0
-1%
5%
10%
Output
gap(%)
Y-1- Y*
Y*
When П = f Y-1- Y*
Y*
where f =0.2
EXPECTATIONS AUGMENTED PHILPS CURVE
After the simple Philips Curve, economists have realized the importance of
expectations of firms about the inflation rate in determining their price. It has been
argued that firms will increase their prices according to the following equation:
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П = Пe + f Y-1- Y*  This is expectations augmented Philips Curve
where Пe = Expected inflation rate
Y*
This equation says that they will increase their prices by what they expect other
firms to increase their prices and plus some amount given by the conditions of demand
for their products in the previous period.
So if Y-1- Y*
> 0,
Y*
That would mean they have produced more than their potential, which would
make them believe that it is appropriate to increase their prices more than what other
firms are expected to increase(Пe).
So actual inflation rate(П) becomes equal to expected inflation rate(Пe) + f
Y-1- Y*
Y*
This expectations augmented Philips Curve suggested that as Пe increase, in other
words as firms and people start expecting higher inflation this year, actual inflation rate
will end up being higher by an amount equal to the increase in the expected infalation
rate.
П = Пe + f Y-1- Y*
Y*
So according to this equation, even when Y-1 = Y*, so that actual Y was equal to
its potential, if Пe >0, we would still have inflation. Because П = Пe even when
Y-1- Y*
=0
Y*
How we incorpporate Пe into our graphical model?
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EXPECTATIONS-AUGMENTED PHILPS CURVE
Inflation
(П) %
Phillips Curve
Expected
inflation is
4%(Пe)
4%
2%
0
-10
-5
0
5
10
П = Пe + f Y-1- Y*
Y*
In the above diagram, if Пe = 4%, П = 4% too when output gap is 0, when output
gap is >0, П increase above Пe, when output gap <0, П decrease below Пe.
What are the effects of changes in Пe?
This Expectations-Augmented Phillips Curve, gives us very important clues about
the difficulties of reducing inflation.
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Because as П increases, firms will increase their Пe for next year by looking at
this year’s higher Пe rate. But higher Пe means that they will raise their prices at a higher
rate next year. So even if we reduce aggregate demand below potential (Y*) it may take
several years for actual inflation rate to drop to acceptable levels.
Let’s give an example from the case of Turkey:
 If Пe increase, Philips-Curve will shift upward. For eample, if Пe becomes 6% rather
than 4%, we will have the following situation
New Phillips
Curve
Inflation
(П) %
Old
Phillips
Curve
6%
4%
0
-10
-5
0
5
10
Output gap
П = Пe + f Y-1- Y*
Y*
So if firms expect other firms to increase P by 6%, even if they are producing at
their potential (0 output gap). They will also increase prices by 6%. So that we will have
6% inflation (П) even if output gap is 0.
П = Пe + f Y-1- Y*
Y*
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Let’s say that in Turkey, firms form their expectations about this inflation rate
(Пe) by looking at the past year’s inflation rate(П -1).
In other words; Пe = П -1
This means that if in 1990 inflation rate was 60%, firms start expecting 60%
inflation rate for 1991 as well.
So П = 60% + f Y-1- Y*
Y*
For П to be less than 60%, (output gap) Y-1- Y* has to be negative which means
that
Y*
government should reduce aggregate demand below potential level of output(Y*). But
producing less than Y* means unemployment of labor force and the existing capital stock
so this unemployment must be maintained for several years until П falls down to
reasonable levels. Of course, the speed at which П will fall also depends on the value of f.
If f is large, this means that for every 1% increase in output gap (in negative terms)
inflation rate will fall by a larger amount. As inflation rate decrease П e will fall as well.
Why(Because Пe = П -1). So over years, as П decrease due to government policy of
keeping aggregate demand below potential level of output (Y*), Пe will as well. But it
will take many years before П falls to low levels because firms change their expectations
by looking at previous year’s inflation rate. So as П decrease, they will decrease П e
which means they will increase their price this year at a lower rate. But as long as П e is
still large, they will still continue to increase prices even if output gap is negative. So it
will take many years of unemployment before П decrease. That can be applied to today’s
conditionsof Turkey.
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Because of high inflation rate of the past year, firms expect high inflation rate this
year, so they will (probably) increase the price at a high rate even if the new government
reduces aggregate demand below potential and cause unemployment.
For example, we can calculate how many years it will take for Turkish
government to reduce inflation rate to 40% by giving a numerical example and what will
be the social cost to society in terms of unemployment within those years.
Assume that f = 0.5 for Turkish economy, then we have the following
Expectations-Augmented Philips Curve equation for Turkish Economy as follows:
П = Пe + 0.5 Y-1- Y*
Y*
Remember that Пe = П -1
Пe Expected inflation rate for this year
П -1 Last year’s inflation rate
Let’s say that П -1= 60%(1990) and let’s say that in 1991 Y-1- Y* so that П = Пe = П -1
(for year 1991). In 1992, let’s say that government reduces AD below its potential so that
Y-1- Y*
= - 20%
Y*
Let’s calculate how many years it would take for П to fall to 40% from 60%:
So far 1993 П93 = 60% + 0.5(- 20%)
So in 1993,
П = 60% - 10%= 50%
Since Пe = П -1
For 1994
Пe = 50% (inflation rate of 1993)
Then in 1994
П94 = 50% + 0.5 (-28%)
П = 50% - 10%= 40%
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So as you can see from the above example if f = 0.5 (actually very high value) it
would take 2 years for gaovernment to reduce inflation rate from 60% to 40%. But keep
in mind that this would be achieved at a vey high social loss. Why? Because for the next
two years we would have -20% output gap. So we would have a very high unemployment
of labor force and at the same time, existing capital stock (factories) would be used much
less than their potential.
So you can imagine that to reduce inflation from 60% to 10%, would take at least
4-5 years and it could be achieved at a cost of high unemployment during those years.
This tells us that if we want to reduce П, we have to accept higher unemployment for
many years.
REVIEW OF THE IMPORTANT POINTS
In the previous lectures we have shown that the process of price adjustment move
the economy toward potential GNP. The main mechanism through which this worked is
as follows:
1. Given the predetermined price level, the level of AD determines how much output (Y)
is produced in this year. If this level of output (Y) is less than Y* (potential output) price
level would be adjusted downward by firms at the beginning of next year. This process of
price adjustment is given by the simple Philips Curve:
П = f Y-1- Y*
Y*
So if AD was relatively low and esulted in Y-1 (last year’s output) being less than
Y*, price will be adjusted downward. In other words; price will fall this year (compared
to its last year’s level, P-1). As price decrease, AD would increase leading to an increase
in Y and this would continue until Y= Y*.
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2. If no inflation is expected, the prce adjustment equation relates the rate of inflation to
the deviation of GNP (Y) from potential
(Y*)  П = f Y-1- Y*
Y*
3. Under conditions of expected inflation, the price-adjustment relation is shifted upward
by the amount of the expected inflation given as Expectations-Augmented Philips Curve
which is given by
П = Пe + f Y-1- Y*
Y*
4. A simple model of expected inflation is that expected is given by last year’s inflation;
Пe = П -1
Equation 1 suggests that, the larger difference between real GNP (Y) and
potential GNP (Y*), the faster will be the reduction in inflation .
Suppose, for example, that the coefficient f in the price-adjustment equation(1) is
equal to 0.5. This value implies that a 10 percent fall of real GNP (Y) below potential,
which lasts for one year, will reduce the rate of inflation by 5% when Y is 20% below
potential or 1% of the rate of inflation will be reduced by 10%. Of course, the price
adjustmentequation works the other way around as well. If real GNP rise above potential
GNP, then there will be an increase in inflation.
 If П = 60% in 1991 and f = 0.5, and if Пe = П -1, what must be the percentage
deviation of Y from Y* in 1991 for П to fall to 50% in 1992?
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П = Пe + f Y-1- Y*
Y-1
П1992 = П1991 + f Y-1- Y*
Y-1
50% = 60% + 0.5
Y-1- Y*
Y-1
-10% = Y-1- Y*
0.5
Y-1

Y-1- Y* = -20%
Y-1
This shows us that inflation can only be reduced at a cost of considerable decrease
in GNP (below potential) which means significant increase in unemployment is necessary
to reduce inflation if it is to be done in a short-period of time.
For example, if government was willing to accept only a 5% decrease in a year
1992, it could achieve this by reducing GNP below Y* only by 10% in year 1991.
COMBINING AGGREGATE DEMAND AND PRICE ADJUSTMENT
The aggregate demand curve, in combination with price adjustment, governs the
dynamic response of the economy to a change in economic conditions. As an example,
we will look at what happens to the economy when the Money Supply is increased. We
assume that the economy starts out with 0 inflation and GNP equals potential GNP. The
increase in money initially pushes the aggregate demand to the right and increases output
gradually. Prices rise to bring economy back into equilibrium at potential GNP. We know
trace out the path of GNP as it returns to potential.
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Figure-1
P
П will be
higher in 1993
because Y> Y*
and expected
inflation
1994
1993
1992
1991
New AD
Curve
Initial AD
Curve(1991)
Y*
Y1992
GNP
Figure-2
P
Price Line
1994
1995
1996
Rate of decrease in
price in 1995 will be
larger than 1994
because of effect of
expectations of
–П(deflation)
New AD
Curve
Y*
GNP
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P
Figure-3
1997
PFinal
Final Price
Line
1996
New AD
Curve
So increase
in MS has
no effect
on Y
P Initial
Y*
GNP
In Figure-1, we show the aggregate demand curve intersecting he predetermined
price line in 1991. This intersection occurs where output is equal to potential GNP.
Suppose that it is the situation in the year 1991 but that starting in 1992 the Turkish
Central Bank increases the money supply. The AD curve shifts to right and GNP
expands. The economy goes into a boom (expansion) during 1992 and GNP (Y) is above
potential GNP since the stimulus to aggregate demand comes from Monetary Policy we
know from the IS-IM model that the interest rate falls, stimulating Investment Spending
then the multiplier expands. All this occurs during the year (1992) that the Money Supply
is increased.
With firms now operating above potential, they will adjust their prices upward.
The price line will shift up. We can easily calculate the exact size of the price adjustment
in 1993 using the Price-Adjustment equation given by
П = Пe + f Y-1- Y*
Y*
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Where
Пe = П -1
(To start with Пe = 0, since П in 1991 was 0).
We can calculate the inflation rate P-P-1 associated with the level of GNP for 1992 (Y-1).
P-1
[Note that this the time only if we know the value of Y-1, Y* and f ]
Then multiply the inflation rate by the previous price level (P-1) (given by price
line in 1992) to get the absolute change in the price level, (P- P-1) and hence the price
level P for 1993. We shift the price line in Figure-1 upward by the amount of this price
increase. Assuming that the Central Bank does not increase the Money Supply again, the
same aggregate demand curve continue to apply in 1993. Thus, the new point of
intersection of aggregate demand and the price line occurs at a lower level of output
compared with 1992. The economy moves up and to the left along the aggregate demand
curve.
What is happening in the economy? At a higher price level more money
demanded by people for transactions purposes. But since the Central Bank does not
increase the money supply again, this puts upward pressure on the interest rate. The
higher interest rate reduces Investment below, what it was in 1992 and this reduction has
multiplier effects throughout the economy, GNP falls.
According to Figure-1, GNP is still above potential in 1993. Thus there will be
another upward adjustment in the price level. This time the price adjustment will be the
sum of two effects.
The two effects correspond to the two terms on the right hand side of the priceadjustment equation:
П = Пe + f Y-1- Y*
Y*
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Where Пe = П -1
Because there was inflation the year before (1992), there will be expectations of
continuing inflation in 1993. This factor will add to inflation. On the other hand output is
no longer so far above potential. The contribution from that term in the Philips Curve will
be smaller. In the scenario in Figure-1, the price rises even more in 1994 than it did in
1993. Again the aggregate demand curve does not move so output falls again in 1994. As
before, the interest rate rise because of the increased demand for money and this reduces
the investment.
If output is still above potential, there will be another price adjustment. In Figure1, we have GNP below potential. Notice this GNP falls below Y* because expected
inflation keeps the price line moving up.
[It is possible that even in 1995 price line may keep moving up if the positive effect of
expected inflation is more than the negative effect of Y being less than Y* in 1994.]
But, in our example, we assumed that the negative effect of negative output gap
on П is more than the positive effect of expexted Inflation so that Prices are adjusted
downward by firms by the beginning of 1995. As price line reverse its previous
movement and begins to shift down, GNP will start to rise. The process continues period
after period until GNP eventually returns to potential.
In Figure-3, we have shown that the dynamic adjustment process will stop in 1997
when Y= Y* and there is no further adjustment in price. However, in the reality, process
may take longer years to finish completely.
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KEY POINTS ABOUT THE ABOVE ADJUSTMENT
The fact that the economy returns to potential GNP, as shown in Figure-3is a key
result of the Macroeconomic Theory. In the Long-Run, an increase in Money Supplydid
not increase GNP. The increase in money eventually leads to raises interest rates back to
where they were before the Monetary Expansion and eventually reduces Investment back
to its original level. Note that all other variables-except the price level- are also back to
where they were before the increase in Money Supply. In the Long-Run, the increase in
Money Supply had no effect on real variable. For this reason, we say that the Money is
Neutral in the Long-Run. It has a powerful effect on output in the Short-Run before
prices have had a chance to adjust. The same analysis holds in reverse for a decline in
Money Supply.
8) Exercises
Nominal
Suppose that the economy’s aggregate demand curve is given by the following equation:
Y= 2.287 + 2.855 µ/ρ and the price adjustment schedule is give by simple Phillips Curve
: π = 1.2 ( Y-1- 4000 ) where Yt = 4000.
The money supply is 600TL.
a. Plot the A.D Curve and the potential GNP line. Explain (using your
mathematical intuition) why the aggregate demand curve is not a straight line.
b. If P0 = 0.5 what will Y0 be? Will this place upward or downward pressure on
prices?
c. Compute the path of the economy – calculate GNP, the price level and
inflation for each until GNP is within 1% of potential. (Meaning that Y is
either less than 4400 or greater than 3600)
d. Diagram the economy’s paths on the demand curve plotted in part a. then
draw your own version of figures 1.2.and 3. (You may assume that inflation
was initially zero)
From these graphs, does the economy fall below, potential or does it converge directly to
equilibrium?
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ANALYTICAL
Using expectations augmented Phillips Curve, decide what happens when the
unemployment rate stays below the natural rate year after year.(meaning that Y stays > Y
year after year). Think about π.?
Suppose that there is a sudden permanent decline in potential GNP. Describe the behavior
of prices, output, interest rates, consumption, investment and net exports? ( use AD curve
and predetermine price line analysis to see the general effects to start with.
AD
AD
Y
MACROECONOMIC POLICY
Monetary and Fiscal Policy have powerful effects on the economy. Change in the money
supply or in government spending has an immediate impact on real GNP and a delayed
impact on the price level. An increase in the monetary supply, for example will stimulate
output and employment in the short–run, with inflation rising latter and real GNP
eventually returning to normal.
In this section of our lecture, we take a systematic look at the formulation and
evaluation of macroeconomic policy. This is monetary and fiscal policy. The fact that
monetary and fiscal policy has the potential to affect the economy suggests that the
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policies might be used to improve the macroeconomic performance. We will want to
investigate whether this is this is the case. We will also consider the issue of how to
choose between monetary and fiscal policy, both types of policies can shift aggregate
demand. But they have different effects on investments and net exports.
SHOCKS AND DISTURBANCES TO THE ECONOMY
Unforeseen or unpredictable events are commonplace in the economy. At the most basic
level many of the relationships we use to describe the economy depends on human
behavior which is frequently erratic. KEYNES used the term “animal spirits” to
characterize the moods of business people. Other economic relationships depend on
technology – the money demand relationships for example, depends on how sometimes
there are economic shocks or disturbances to the economy that might call for policy
intervention. We distinguish between two types of disturbances in this section.
1. AGGREGATE DEMAND DISTURBANCES
2. PRICE DISTURBANCES
An aggregate demand disturbance is some event other than change in policy that shifts
the aggregate demand curve. A price disturbance is some event that shifts the price
adjustment relationship. The immediate effect of a price disturbance is to change the
price level, unless policy acts to offset the disturbance. Another important policy problem
is DISINFLATION- getting the inflation rate down after it has been built into the
economy. In this sector we will consider the appropriate policy provided on how
technically advanced the financial system is. It seems that no matter how successful we
are in describing the systematic parts of economic behavior, there will always be some
room for uncertainty, and thus for shocks and disturbances to our economic relationships.
The model we developed up to now would certainly be affected by such shocks.
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SHOCKS TO AGGREGATE DEMNAD
Consider some examples of shocks to the behavioral relationship describing the
aggregate demand side of our model.
1. Foreign Demand Suddenly shifts away from TURKISH goods. NET EXPORT
demand falls.
2. Consumers suddenly increase their demand for consumer goods.
3. INVESTMENT spending suddenly decreases.
4. A new type of CREDIT CARD makes it easier to get by with less cash, the
money demand schedule shifts inward causing a decrease Md.
5. People suddenly ↑ their Md (holding more cash) because they start believing that
the new government in Turkey will bring down inflation rapidly.
X
(4)
(1)
X0
R
X1
Md 0
X0
X1
120
(R)
Md 1
Real (M)
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ANALYSING THE EFFECT OF AGGREGATE DEMAND SHOCKS
Disturbances both to spending and money demand, the two major components of our
model of aggregate demand, shift the aggregate demand curve: The downward shift in
Money Demand has the same effect as an increase in the money supply, which we know
shifts the aggregate demand curve to the right.
These shifts in A.D curve have immediate impacts on real GNP as shown in the
FIGURES below.
P
P
Final
price
B
A
C
Old AD
curve
New AD
New AD curve
Figure 1
Old AD
Figure 2
FIGURE 1
A.D has shifted to the left because of the decline in net exports. With real GNP below
potential GNP ( Y) After the drop in net exports, firms have found that the demand for
their products have fallen off and they will start to cut their prices. The drop in the price
level is shown in figure 1 as a movement down and to the right along the aggregate
demand (AD) schedule. The lower price level causes the interest rate to fall. With a lower
interest rate, invest spending and net exports will increase. This will tend to offset the
original decline in net exports. The process of gradual price adjustment will continue as
long as real GNP is below potential GNP. By the time that real GNP has again recovered
and returned to potential GNP, investment and net exports will have increased by just the
amount that net exports fall in the first place. The interest rate will be lower by enough to
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stimulate this much investment and net exports. In the long run, real GNP will be back to
normal, but during the period of general price adjustment. The economy will have gone
through a recession with an increase in unemployment.
FIGURE 2
When the demand for money drops, the aggregate demand curve will shift outward. The
interest rates drops, investment, net exports and consumption rise. But higher GNP will
cause price to rise, tending to raise the interest rate. Through this process of gradual price
adjustment, the economy will eventually return to normal. In the mean time however, the
economy has experienced a period of inflation and a boom in economic activity.
In both cases, there is a shock to AD which temporary moves the economy away from
potential GNP and send the economy into either a boom (expansion) or a recession.
Through gradual price adjustment of the price level, the economy eventually returns to
normal.
SHOCKS TO THE PRICE LEVEL
The shocks considered above had the effect of shifting the AD curve. Another type of
shock occurs when the price level shifts. There are several reasons why this might occur.
1. The price of an input to the economy might suddenly rise: the best
Example is an increase in price of petroleum in 1970.
2. A large group of workers, perhaps during a union negotiation may get a
wage increase that is abnormally high. When firms pass on the wage
increase in the form of higher prices, there will be an upward shift in the
price: a price shock.
3. Firms might simply make a mistake and increase their prices, perhaps
because they mistakenly expected an increase in inflation.
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FIGURE 3 – AN UPWARD SHOCK IN THE PRICE LEVEL.
P
PB
Price shifts up
PC
PD
PA
AD
Y
A price shock is shown in figure 3. If monetary and fiscal policies do not change, then the
real GNP will fall below potential GNP. After the initial price shock, the economy will be
operating blow its full employment level at YB. With no increase in money supply, this
will in turn cause prices to fall as try to cut prices to increase sales. The fall in the price
corresponds to a downward movement in the price- Adjustment curve, which will
continue until real GNP is equal to potential GNP. Eventually, therefore, the economy
returns to its potential. In the mean time, the price shock has caused a recession.
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RESPOND TO AD SHOCKS: STABILIZATION POLICY
Increase money demand
shifts AD curve to the
left
P
Price line
Increase money supply
pushes AD curve back
out.
Y
An increase in Md
Y
shifts AD to the left, raising interest rates and reducing real GNP.
Timely action by Central Bank to increase the money supply could prevent this recession.
This is called COUNTERCYCLICAL STABILIZATION POLICY because it attempts to
counter those disturbances to the economy otherwise would cause cyclical fluctuations in
real GNP and price level. Such a policy is also sometimes called ACTIVIST POLICY
because the policy makers are actively manipulating the instruments of monetary and
fiscal policy.
Another example: Suppose that there is an unexpected INVESTMENT boom caused by
business optimism that pushes AD curve to the right. Without any policy response we
know that this will result in a temporary increase in GNP followed by a periodical
increase in the rate of inflation. Policymakers could avoid this instability by taking some
action to reduce aggregate demand. The MS or G could be reduced or taxes could be
increased. Any of these actions will have the effect of bringing the AD curve back to the
left.
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SUMMARY
When an aggregate demand shock occurs, monetary or fiscal policy can affect the shock.
Whatever inward or outward shift of the aggregate demand curve has taken place can be
reversed through the policy move in the opposite direction.
THE RESPONSE TO PRICE SHOCKS
The response to a price shock raises difficult issues. Suppose that there is a price shock
in FIGURE 1. With no policy response, such a price shock tends to reduce real GNP and
raise the price level. In FIGURE 1, monetary policy does not respond to price shock. The
shock raises the price level from P0 to P1. Output falls from Yt to Y1. Then the priceadjustment process starts. In the next year, the price level drops to P2. Eventually, prices
fall back to normal and output returns to potential output.
P
1
P1
2
P final
3
4
5
P0
AD
Y1
Yt
Old AD
new AD
Y1 Y2 Yt
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Now, suppose that the monetary authorities increase the money supply in response to the
price shock. As shown in FIGUR 2, this shifts the AD curve outward and tends to reduce
the downward fluctuation in real GNP. In the example we have drawn, output falls only
to Y2 (instead of Y1). However, the increase in money supply will increase will increase
the fluctuation in the price level. WHY? Because if Y does not fall much below potential,
there will be little downward pressure on the price level. The price level will stay high for
a longer of time and never return to normal (its old level) if the monetary supply is not
reduced again. As shown in FIGUR 2, the price line will remain at a higher level if the
aggregate demand curve remains at its new higher position.
Therefore, with this policy that tries to offset the fluctuation in real GNP, there is less
downward pressure on the price level so that it never returns to its normal (old level).
Because of this, we say that with such a policy there is thus less price stability. In other
words, with a PRICE SHOCK, there is a tradeoff between the stability of real GNP and
the stability of the price level.
Policies that increase the money supply in response to positive price shocks are called
ACCOMMODATIVE POLICIES.
A policy that holds the money supply constant is called a NONACCOMMODATIVE
policy.
In the following figures, we show the behavior of GNP and the price level after a price
shock under accommodative and non-accommodative policies. These figures are the
graphs of the movements of Y and P from FIGURES 1 and 2.
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FIUGRE 3
FIGURE 4
NON ACCOMMODATIVE POLICY
P (Y)
ACCOMMODATIVE POLICY
GNP (Y)
Y
Y
In the short run
In the long run
Time
P
In the short run
In the long run
Time
P
Final
P
Po
Initial
P
TIME
TIME
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THE RESPONSE OF THE PRICE LEVEL AND GNP TO PRICE SHOCKS FOR
ACCOMMODATIVE AND NON-ACCOMMODATIVE POLICIES.
FIGURES 3 and 4 show that the accommodative policy is better in terms of output
stability but price stability is worsened.
The decrease in Yin the short run id much less with an accommodative policy but the
price level stays permanently at a higher level when the economy returns back to its
potential in the long run equilibrium.
DISINFLATION
The problem of maintaining price stability in the face of price shocks is closely related to
another type of price stabilization problem: that of bringing down the rate of inflation
when it has become too high and had become incorporated into people’s expectations and
price-setting behavior. This latter problem is called the problem of disinflation: that is,
reducing the rate of inflation. This problem requires us to pay close attention to the role
of EXPECTATIONS in the Phillips Curve.
The Phillips relationship as we have seen before can be written as:
∏ = ∏e + f (Y-1-Yt/Yt)
The most challenging problem of disinflation occurs when the expected rate of inflation
equal last period’s inflation rate; ∏e = ∏ - 1. With this expectation of inflation the only
way that inflation can be reduces is by letting actual output Y drop below Yt.
Equation 1 states that the change in the rate of inflation over its previous level ∏ - 1
depends on the percentage deviation of GNP from potential GNP.
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The Phillips curve tells us that if the inflation rate is viewed by the policy makers as
being too high and in need of reduction then some type of a recession is inevitable. The
essential policy questions related to disinflation are how long and how deep the recession
should be. In other words, how sharply should the policy makers reduce the policy
instruments (such as M and G) to bring about a path for real GNP that is consistent with
the desired reduction in inflation?
SETTING THE POLICT TO HIT A TARGET LEVEL OF GNP
To answer the above question, we first need to show how the policy instruments, such as
the monetary supply or government spending can be manipulated to get a desired path for
real GNP. Remember that with the price adjustment equation 1, the price level is
predetermined during the course of any particular year. Remember also that the monetary
and fiscal policies shift the aggregate demand curve to the right or left. The intersection
of the aggregate demand curve with the piece line gives the current value of real GNP.
Hence by changing monetary policy, government can achieve just about any value of real
GNP that it wants. So in the case of DISINFLATION, the aim of the policy maker is to
set the real GNP below potential GNP in order to put downward the pressure on prices
and reduce the rate of inflation.
In our previous exercises, we have used the AD equation to find Y for a given level of
money supply and then calculated the rate of change in the price level given certain initial
(P0) price level
Now we must use this method in REVERSE.
We want to find a level for MONEY SUPPLY for a given target level of GNP.
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The idea is shown in FIGURES 1 and 2 below:
LM1
P
R
LM0
Price line
AD
IS
Y1
Y2
Y
FIGURE 1
Y1
Y2
Y
FIGURE 2
In FIGURE 1, the economy is shown to be operating at potential output, Yt. Suppose that
the Central Bank wants to set the money supply to push the economy to a lower target
level, Y1, WHAT LEVEL OF THE MONEY SUPPLY SHOULD IT CHOOSE?
The answer as shown in FIGURE 2, is to reduce the money supply to the level that sets
the aggregate demand curve at a point of intersection with the predetermined price line at
the target level of output Y1. In the long run
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Numerical example:
Suppose that the AD curve is given by:
Y= 1432 +1.14 G + 2.855 M/P
Suppose that G = 750 TL and the predetermined price level, P equals 1, potential output
is 4,000TL and government would like to decrease it to 3,900TL.
Push the economy to a lower target level, Y1. WHAT LEVEL OF THE MONEY
SUPPLY SHOULD IT CHOOSE?
The answer, as shown in FIGURE-2, is to reduce the Money Supply to the level that sets
the aggregate demand curve at a point of intersection with the predetermined price line at
the target level of output Y1
Numerical Example:
Suppose that the AD curve is given by:
Y = 1432 + 1,14G + 2,855 M/P
Suppose that G = 750 TL and that the pre-determined price level P equals 1. Potential
GNP is 4000 TL. Government now wants to choose a Money Supply M to bring actual
GNP (Y) below potential to 3900 TL. For G = 750 and P = 1, the AD equation becomes:
Y = 2287 + 2,855M
The level of the Money Supply (M) is formed by setting output (Y) equal to 3900 and
finding M. The answer is M = 3900 – 2287 / 2,855 = 1613 / 2.855 = 566
M = 566 TL
M must be 566 TL for Y to fall to 3900 TL from 4000 TL.
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Problem of Disinflation
∏ = ∏e + f (Y-1 – Yt / Yt)
(1)
Previously we have argued that to bring down inflation is called the problem of
disinflation. And the most challenging problem of disinflation occurs when the expected
rate of inflation (∏e) equals last period’s inflation rate ∏e = ∏-1. When this is the case,
the only way that inflation can be reduced is by letting actual output Y drop below
potential output Y*. Equation (1) states that when ∏e = ∏-1 then
∏ = ∏-1 + f (Y-1 – Yt / Yt)
(2)
In this case, change in the rate of inflation over its previous level ∏-1 depends on the
percentage deviation of GNP from potential GNP.
This Phillips Curve tells us that if the implication rate is viewed by the policy makers, as
being too high and in need of reduction, then some type of recession is related to
disinflation are (1) HOW LONG and (2) HOW DEEP THE RECESSION SHOULD BE.
In other words, how sharply should the policy makers reduce the policy instruments to
bring about a path for real GNP that is consistent with the desired reduction in inflation?
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SETTING MONETARY OR FISCAL POLICY TO HIT A TARGET LEVEL OF
GNP
LM1
R
P
E1
LMo
Eo
AD1
Y1
Y*
Y
Y1
Figure-1
Y
Y*
Figure-2
The left-hand panel (figure-1) shows the situation in the economy. Output, at the initial
equilibrium point (E0) is equal to Yt. Government wants to set the Money Supply so that
the output is reduced to the level Y1. To do this, it must shift the aggregate demand curve
at a point of intersection with the predetermined price line at the target level of output Y1.
Numerical Example
Suppose that the aggregate demand curve is given by the following equation:
Y = 1432 + 1.14G + 2.855M/P
(3)
M and G are policy variables that shift the AD Curve.
As you can see Equation (3) is an AD Curve because there is a negative relationship
between Y and P. For given values of M and G, increase in P leads to a decrease in Y
(A.D).
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Interpretation of coefficients of G and (M/P):
1.14 => 1 Billion TL increase in G leads to 1.14 Billion TL increase in AD
2.855 => 1 Billion TL increase in (M/P) leads to 2.855 Billion TL increase in AD
Suppose that government has set government spending G at 750 TL (in billion) and that
the predetermined price level P equals 1. Potential GNP is 4000 TL. Central Bank now
wants to choose a Money Supply M to bring actual GNP below potential to 3900 TL. For
G = 750 and P = 1, the A.D Curve looks like
Y = 2.287 + 2.855M
(E.g. 4)
The level of the Money Supply is found by setting output Y in (Eq 4) equal to 3900 and
finding M. The answer is M = 3900 – 2287 / 2.855
M = 1613 / 2.855 = 566 TL
This shows us the technical aspect of conducting Monetary Policy. As (Eg 4) suggests if
we want Y to fall below Yt by a a large amount,
ALTERNATIVE DISINFLATION PATHS
Using ∏ = ∏e + f (Y-1 – Yt / Yt) where ∏e = ∏-1 and f = 0.2 we can clearly see (below)
that if a government would like to reduce inflation rate (∏) from 10% to 2% and if it
wants to do this in a relatively short period of time, a large increase in unemployment in
those years is inevitable. In other words, government should accept a severe recession for
these years.
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THREE PATHS FOR INFLATION AND THE GNP
GAP
Path 1
Path 2
Path 3
GNP
Year
GNP gap
Inflation
GNP gap
Inflation
gap
Inflation
0
0
10
0
10
0
10
1
0
10
-5
10
-10
10
2
0
10
-5
9
-10
8
3
0
10
-5
8
-10
6
4
0
10
-5
7
-10
4
5
0
10
-5
6
0
2
6
0
10
-5
5
0
2
7
0
10
-5
4
0
2
8
0
10
-5
3
0
2
9
0
10
0
2
0
2
10
0
10
0
2
0
2
Note: The GNP gap is the deviation of GNP from potential measured in percent; that
is, gap = (Y – Yt / Yt) * 100. Inflation is the percentage ∆ in the price level. Each path
shows the GNP gap and inflation over a 10-year period. The calculations are made
with the Phillips Curve with f = 0.2. In the 1st path, policy holds real GNP at its
potential level. Inflation stays at 10 percent. In the 2nd path, real GNP is depressed
below potential. Inflation drops steadily and gradually to 2 percent.
In the third path, policy is even more contractionary at first: GNP is 10 percent below
normal. Because of this MORE SEVERE RECESSION, inflation drops to 2 percent
SOONER THAN in the second path.
All of the 3 alternatives given in the above table are all feasible for the Central Bank
to undertake. If ∏ = 10% and government doesn’t want to cause recession to reduce
this inflation then government sets its policy in such a way that GNP gap is 0. In this
case (PATH 1) inflation stays at 10 % year after year.
However if government wants to reduce this inflation to 2 % the paths 2 and 3 show
only 2 of the alternatives open to the government. Earlier we said that all of these
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alternatives are feasible for Central Bank to undertake. Because, we have shown in
our earlier analysis of AD curve (and IS-LM) that government can pick (determine)
any value of Y it wants in the SHORT-RUN. Therefore, this means that it can also
pick up any value for the deviation of output from potential output, since Yt is
exogenous. By setting the Money Supply so that the aggregate demand curve is in the
appropriate place, the Central Bank can set output and hence the deviations of output
from potential output to the desired level.
These 3 alternatives were selected to indicate the kind of choice that Monetary
Authorities have to make when faced with excess inflation. Perhaps the most
important thing to note about the choices is that none of them is a good one. The latter
2 involve a recession, as the inflation rate is decreased. The 1st avoids a recession, but
gets
no reduction in inflation.
The last TWO PATHS are both successful in getting the inflation rate down from 10
to 2 percent. But there are important differences between the two paths. Path 2
involves a longer, but shallower (less deep) recession. GNP is just 5 percent below
potential for the entire period to get the inflation rate down to 2 percent. PATH 3
involves a shorter recession, but it is quite deep. GNP is 10% below potential. But in
this case the inflation rate is reduced more quickly, reaching 2 percent in 4 years.
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COMPARISON OF 3 PATHS
INFLATION (%)
Path 1
Time (Years)
Figure 1
Output Gap (%)
Path 1
Path 2
Path3
Time (Years)
FIGURE-2
As you can see in FIGURE-2 PATH 2 shows a long, shallow (not so deep) recession
and a slow decline in inflation (Figure-1). Path 3 shows a short, deep recession but a
quick decline in inflation. Path 3 has NO DETERMINATION OF MONEY SUPPLY
AND HOW MONETARY POLICY IS CUNDECTED UNDER DIFFERENT
PILICY RULES.
In our previous lectures we have analyzed and shown the effects of Random shocks to
the economy and argued that Monetary Policy can be used sometimes to deal with the
problems of inflation and unemployment associated with such shocks. Monetary
Policy, in the way we have studied it, involved changes in the Money Supply.
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Now, in this part of our lectures, we look at the Actual process through which Money
Supply is determined and the tools which government can use to change the Money
Supply. Later on, we will also discuss some alternative policy targets (in real life) for
the conduct of Monetary Policy. In each case, we will try to show that depending
upon the target of the policy Maker, conduct of Monetary Policy will be different.
MONEY SUPPLY
M = CC + D
The Money Supply consists of currency in circulation (CC) and checking deposits
(D).
The Main Tool (instrument) by which Central Bank controls the Money Supply (M) is
by selling bonds to, or by purchasing bonds from the banks and the public. These
purchases or sales of government bonds by the Central Bank are called Open-Market
Operations. To see how these Open-Market Operations affect the Money Supply, we
first define the MONETARY BASE (MB). The Monetary Base is defined as
CURRENCY IN CIRCULATION + RESERVES =>
MB = CC + RE (We will explain reserves later)
Central Bank does not try to exercise separate control of reserves and currency. The
Central Bank controls only the total of the two. The Central Bank lets the banks and
the private sector decide how much of the Monetary Base is Currency and how much
is Reserves.
RE →Bank Reserves at Central Bank
By regulation, banks are required to hold a certain ratio of their checking deposits on
reserve at the Central Bank. This ratio is called the “reserve ratio” (r). For example, r
might equal 1 (or 10 percent). Then Reserves RE are given by the formula RE = rD
(1)
Using Open-Market Operations, Central Bank can add to or subtract from the total
amount of bank reserves plus currency (in circulation) whenever it chooses.
An Open-Market Operation to expand the monetary base involves a purchase by
Central Bank of government bonds from the Central Bank. When a bank sells a bond
to the Central Bank, the bank receives a credit in its Reserve Account at Central Bank
which means its RESERVES at Central Bank increases. Therefore total amount of
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Reserves increases as Central Bank purchases government bonds from the banks.
Since MB (Monetary Base) MB = CC + RE, then any time Central Bank purchases
Bonds from the Banks, MB must rise. On the other hand, a sale of bonds by Central
Bank will reduce the Monetary Base.
There is a direct and positive relationship between the monetary base and the Money
Supply, and this is how Central Bank achieves its control of the Money Supply. The
relationship between the monetary base and the Money Supply is due to two factors:
1. Reserve Requirements (explained before, Eq. 2 RE = rD, r => reserve ratio set
by government.
2. Currency Demand: Most people want to hold some of their money in the form
of currency. We can express this demand in terms of a simple ratio. The
CURRENCY DEPOSIT RATIO (c) measures how much currency people
want to hold as a ratio of their deposits. For example, the currency deposit
ratio C might equal 0.2. Then CURRENCY DEMAND is given by
CC = cD
Eg.3
Now, using the above relationships and the definitions of M and MB, we can
derive the relationship between the Monetary Base and the Money Supply.
From the definition of the Money Supply, we have:
M = CC + D
(1)
But from Eq. 3 CC = cD
Substituting this into eq. (1) we get M = cD + D = (1 + c) D
From the definition of Monetary Base, we have MB = CC + RE
Since CC = cD from eq. 3 and RE = rD from eq. 2
MB = cD + rD = (c + r) D
So M = (1 + c) D
MB = (c + r) D
Dividing M by MB we get
M / MB = (1 + c) / (c + r) => M = (1 + c / c + r) MB
M → Money Supply
MB → Monetary Base
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(Eq 5)
(Eg 4)
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The coefficient that multiplies MB (1 + c / r + c) is called the MONETARY BASE
MULTIPLIER which we will call m => m = (1 + c / r + c).
m → Monetary Base Multiplier
Then M = m * MB
(eq. 6)
If r = 0.1 and c = 0.2, then m is 4. This means that Open–Market Operations that
increase the Monetary Base by 1 Billion TL would then increase M by 4 Billion
TL. Because of this multiplier, the Monetary Base is sometimes called highpowered money. Here, the reserve ratio and the currency ratio are assumed to be
fixed, so the Central Bank can control the Money Supply as accurately as it wants
by controlling the Monetary Base (However, in reality currency ratio can change,
so control of the Money Supply is not simple in real life).
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References:
1. Dornbusch, R. and Fisher, S. (1998) “Macroeconomics”, Mc GrawHill
2. Froyen T, R. (2002) “Macroeconomics” Pearson Education, New Jersey.
3. Hall, E. R and Taylor, J.B (1997), “Macroeconomics”, W.W Norton and
Company, New York.
4. Mankiw, G.N. (2003), “Macroeconomics”, Worth Publishers, New York.
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