ECON 1002 NOTES

UNIT 1 CHAPTER 15
Expenditure:

Consumption spending on final goods and services; includes spending by not-for-profit

organisations; does not include purchases of newly built or existing houses

Government consumption spending (on currently produced goods and services)
government output is typically valued at cost rather than at market value (changes in
productivity lead to changes in G which do not actually occur); includes:
o Individual government final consumption government pays for the goods and
services consumed by private individuals e.g. health and education
o Collective government final consumption spending where the consumption
cannot be assigned to specific individuals e.g. on public goods
Does not include:
o transfer payments including interest payments to holders of government bonds;
transfer payments are spent by the recipients on buying goods and services and

are recorded as consumption spending

o government spending on investment goods
Investment spending (on production of goods for future use) government spending on
investment goods appears here as public-sector capital formation; includes:
o Changes in inventories
o Fixed capital formation includes housing construction
o Net acquisition of valuables
Net exports
o Imports Private consumption, government consumption and investment all have
an import content. To arrive at total spending of domestic output, we need to
subtract from total local residents spending actual spending on imports of goods
and services. This is the induced component.
o Exports This is the autonomous component.

Market prices prices paid by consumers

Basic prices prices of products as received by producers
Basic prices = market prices taxes + subsidies

Income:

Operating surplus net business incomes before direct taxes

Mixed incomes covers people who earn a living by selling their services or output but
are not employed by any organisation e.g. consultants, self-employed individuals such as

sole traders, partners in a partnership

Compensation of employees wages and salaries

Income produced vs income received

GDP measures output, and hence the income that is produced in this country.
GNI measures the income received by this country.
To convert GDP into GNI, the following must be added:

Employees compensation receipts from the rest of the world minus payments to the rest

of the world
Minus net taxes of production paid to the rest of the world plus subsidies received from

the rest of the world

Property and entrepreneurial income receipts from the rest of the world minus payments
to the rest of the world

Real and nominal measures

Implicit deflator OR Implicit price index = Nominal GDP/ Real GDP x 100
The implicit deflator is subject to revision when National Accounts are revised.
The chain weight volume index of real output is now used for calculating real GDP. This means
that the price weights (base prices) are adjusted each year on the basis of an average of prices in
the most recent few years.
GDP does not measure:

Unreported activities i.e. underground economy

Non-marketed activities
Economic bads

UNIT 2
CHAPTER 16
The long-term living standard of a nation is determined by the growth of its potential GDP.
Trough high unemployment; low demand; unused productive capacity
Recovery expansion; rising demand, employment, income and consumer spending
Peak top of a cycle; shortages of labour and essential raw materials; rising costs and prices
Recession contraction; fall in real GDP for two quarters in succession; falling demand,
production and employment
*Boom (non-technical term) period at or near the top of an abnormally strong recovery
*Slump (non-technical term) period at or near the bottom of an abnormally deep recession

Assumptions in macroeconomics:

There is a single productive (industrial/manufacturing) sector producing a homogeneous

output. The government is ignored as a producer and is treated as a purchaser of output.
The time scale in consideration is the short run.
o Short run the period during which the economy maintains a GDP gap
o Long run a period sufficient to allow time for the automatic adjustment
mechanisms to return economic activity to equilibrium (potential output) after it
has been disturbed by an exogenous shock

Other assumptions made in this chapter are: a fixed price level, no government, excess capacity,
and a closed economy.
What determines aggregate spending?

Desired (aggregate) spending what people want to spend out of the resources that are at their
command
The national accounts measure actual spending while the theory of GDP determination deals
with desired spending. People may be trying to implement spending plans that are inconsistent
with each other (desired), but this will generate economic forces that bring about consistency
after the event (actual).
Autonomous/exogenous spending does not depend on current domestic incomes (and hence,
GDP) while induced/endogenous spending does.
There are two main consumption theories: the Keynesian consumption function where current
consumption spending depends only on current income and the life-cycle theory and permanentincome theory which take a longer term view in determining consumption (that is, they take it as
being influenced by lifetime income). In actuality, consumption spending is determined by both
current disposable incomes and expectations of future disposable incomes.
Consumption function refers to the relationship between household consumption spending and
the variables that influence it.
APC the proportion of disposable income that households desire to spend on consumption (
C
Yd )
MPC the proportion of any increment to disposable income that households desire to spend on
C
consumption ( Y d )
The consumption function is derived by plotting (desired) consumption against disposable
income. Where C meets the 45o line, S cuts the real disposable income axis (desired saving is
zero).
An increase in wealth or a decrease in interest rates shifts the consumption function upward and
the savings function downward.

For desired investment spending, the effects of interest rates on inventory accumulation,
residential house building, and business fixed capital formation must be considered. Business
confidence also impacts investment.
Rising interest rates imply that interest-earning assets provide a greater return.
Where the consumption function (and MPC) is related to disposable income, the aggregate
spending function (and MPS) is related to real national income.
The fraction of any increment to national income (GDP) that will be spent on purchasing
domestic output is called the economys marginal propensity to spend (

AE
Y ). The marginal

propensity not to spend (marginal propensity to withdraw) is the fraction of any increment to
national income that does not add to desired aggregate spending.
Equilibrium GDP
At any level of GDP at which aggregate desired spending exceeds total output, there will be
pressure for GDP to rise. This may be because consumers and investors have unfulfilled orders
which signal to firms that they can increase their sales if they increase production, or because
consumers and investors spend on current output and on stocks of goods produced in the past.
The latter possibility would lead to an unplanned negative investment, which would lead to
actual spending being equal to GDP, stocks eventually running out and firms increasing their
output as they see their sales increase.
At any level of GDP for which aggregate desired spending is less than total output, there will be
pressure for GDP to fall. As stocks of unsold goods rise, firms will reduce the level of output to
the level of sales.
The equilibrium level of GDP occurs where aggregate desired spending equals total output.
This is shown using the AE curve and the 45o line (x axis real national income or GDP; y axis
desired aggregate spending).
The equilibrium level of GDP occurs where savings equals investment (under the
assumptions previously made about this economy).

When desired investment (constant) exceeds (is less than) desired saving, desired aggregate
spending exceeds (is less than) national output.

Changes in GDP
A change in desired aggregate spending resulting from a change in GDP causes a movement
along the aggregate spending function.
An increased desire to spend at each level of GDP causes a shift in the aggregate spending
function.
The aggregate spending function shifts when one of its components shifts, at a given price level.
Such changes could, for example, be induced by a change in the level of the interest rate set by
the monetary authorities. If the same change to spending occurs at all levels of income, the AE
line shifts parallel to itself.
If there is a change in the propensity to spend out of national income, the slope of the AE line
changes. An increase in AE causes the curve to shift upward, while a decrease causes it to shift
downward.
A downward shift in the consumption function causes an upward shift in the saving function, and
vice versa.
The multiplier provides a measure of the magnitude of changes in GDP induced by a given
change in autonomous expenditure. The multiplier is the ratio of the change in GDP to the
change in autonomous spending.

The simple multiplier measures the change in equilibrium GDP that occurs in response to a
change in autonomous spending at a constant price level. The larger the marginal propensity to
spend, the steeper is the aggregate spending function and the larger is the simple multiplier.
K=

Y
C

1
1c

where c is the marginal propensity to spend (same as MPC here) out of

national income

CHAPTER 17
Assumptions made in this chapter are: a fixed price level and excess capacity. In this model,
there is assumed to be an open economy with a government.
Changes to a component(s) of autonomous (exogenous) spending may be called an external
shock.
Tax payments reduce disposable income relative to national income; transfers raise disposable
income relative to national income.
Net taxes (T) = Total tax revenues total transfer payments
Budget balance = Total government revenue (net taxes T) government spending (G)
When revenues exceed spending, the government is running a budget surplus. When spending
exceeds revenues, the government is running a budget deficit. When these are zero, the
government has a balanced budget.
The budget surplus function is plotted with public saving (or T-G) on the y axis and national
income/GDP on the x axis. Its slope is the tax rate. The budget surplus increases as GDP rises
and falls as GDP falls.
National or public debt refers to the stock of outstanding government bonds. Public debt refers
to the debt of the entire public sector while national debt is the debt of the central government
only.
Tax rates are treated as exogenous, implying that tax revenues are endogenous.

The net export function refers to the negative relationship between net exports and GDP. The net
export function is plotted with next exports on the y axis and real national income or GDP on the
x axis. It is drawn on the assumption that everything that affects net exports, except domestic
GDP, remains constant. The major variables that must be held constant are foreign GDP, relative
international price levels, and the exchange rate.

Foreign GDP leads to a parallel shift of the net export function

Relative international prices
o Rise in domestic prices relative to prices in foreign countries leads to a
downward shift and change in slope (becomes steeper) of the net export function
o Fall in domestic prices relative to prices in foreign countries leads to an upward
shift and change in slope (becomes flatter) of the net export function
o Relative international prices change as a result of international differences in
inflation rates (with exchange rates fixed) and changes in exchange rates (with
price levels constant). The relationship between inflation rates or exchange rates
and domestic prices is positive.
o Exchange rate changes may be brought about by changes in interest rates
implemented by the monetary authorities (as a result of demand for assets
denominated in the home currency). When the domestic interest rate is raised, the
currency will appreciate.

Equilibrium GDP

Aggregate spending approach

o Personal income taxes (and transfers) cause personal disposable income to differ
from national income. Induced consumption needs to be adjusted by calculating
the marginal response of consumption to a change in national income as the
product of the MPC and the fraction of national income that becomes disposable
o

income.
The marginal propensity to spend on national output (c) is the slope of the
aggregate spending function. It may also be called the marginal response of

desired aggregate spending to a change in national income. It is calculated by

subtracting the marginal propensity to import from the marginal response of
consumption to a change in national income.
o At equilibrium GDP, desired spending is just equal to national output (GDP) and

is, therefore, just sufficient to purchase the total domestic product.

Augmented saving-investment approach Injections (investment, government spending,
and exports) must be equal to leakages (savings, taxation and imports). This may be
rewritten as:
S + (T G) = I + (X IM)
Total domestic saving / national saving = national asset formation
*S private saving
*(T G) government budget surplus; public sector (government) saving
*(X IM) net acquisition of foreign assets or overseas investment
*I domestic investment

Changes in aggregate spending

Changes in any of the components of planned aggregate spending will cause changes in
equilibrium GDP, at a given price level.
Deriving the multiplier in an open economy with taxes:
Y = C + I + G + (X IM)
Y = a + b (1 t)Y + I + G + (X mY)
where a= autonomous consumption, b = mpc, t=income tax rate, m = mpi

Y b(1 t)Y + mY = a + I + G + X
a+ I +G+ X
1b ( 1t ) +m

Y=

Multiplier =

1
1b ( 1t ) +m

and c = b(1 t) m

The bigger the marginal propensity to consume, the larger the multiplier.
The larger the income tax rate and the propensity to income, the smaller the multiplier.
Any policy that attempts to stabilize GDP at or near desired level (usually potential GDP) is
called stabilization policy.
The Keynesian Revolution refers to the proposition that governments can alleviate recessions by
deliberately stimulating aggregate demand.
Fiscal Policy:

A change in government spending (or any autonomous component of desired

spending) changes the equilibrium level of GDP by the size of the spending change
times the simple multiplier.

A change in tax rates causes a change in the difference between disposable income and
national income. As a result, the relationship between desired consumption spending and
national income also changes. A change in tax rates will also cause a change in c, the
marginal propensity to spend out of national income.

A decrease in the tax rate results in a non-parallel upward shift of the AE line, that is, an increase
in slope of the line.
Changes in the income tax rate change the value of the multiplier, making equilibrium
GDP more or less responsive to changes in autonomous spending. The lower is the income
tax rate, the larger is the simple multiplier.

Changes that would alter the slope of the AE line are a shift in the marginal propensity to
consume, a shift in the rate of income tax, and a shift in the propensity to import.

Balanced budget changes This is done by altering spending and taxes equally. For
example, the government increases tax rates to raise an extra $100 that it then uses to
purchase goods and services. When this $100 is taken away from households, these
households reduce their spending on domestically produced goods by mpc x $100.
Therefore, the spending of this entire $100 by the government has an expansionary effect
because it shifts the aggregate spending function upwards and thus increases GDP.
A balanced budget increase in government spending will have a mild expansionary effect
on GDP, and a balanced budget decrease will have a mild contractionary effect.
The balanced budget multiplier measures these effects as the change in GDP divided by
the balanced budget change in government spending that brought it about.
When government spending is increased with no corresponding increase in tax rates, we
say it is deficit-financed. Because there is no increase in tax rates, there is no consequent
decrease in consumption to offset the increase in government spending. With a balanced
budget increase in spending, however, an offsetting increase in the tax rate and decrease
in consumption does occur. Thus, the balanced budget multiplier is much lower than the
multiplier that relates the change in GDP to a deficit-financed increase in government
spending (with the tax rate constant).

Monetary policy There is a negative relationship between interest rates and GDP from the
spending side of the economy.
Lessons and limitations of the income-spending approach:

The level of GDP that we have been determining is based on demand conditions alone.
When prices change, real GDP will change by amounts different from those predicted by

the simple multiplier.

Changes in desired aggregate spending generally change both prices and GDP.

The simple multiplier continues to be a valuable starting place in calculating actual

changes in GDP.
No matter what the price level, the components of aggregate spending add up to GDP in

equilibrium.
No matter what the price level, equilibrium requires that desired aggregate spending must
equal output (GDP) in equilibrium, or equivalently that injections equal leakages.

UNIT 3
CHAPTER 18
The price level is no longer assumed to be constant. No longer will we maintain the assumption
that national output is purely demand-determined, because there is excess productive capacity.
All shocks to the economy, both on the demand and the supply sides, affect both real GDP and
the price level. This means that such shocks have both real and nominal effects.
Aggregate demand
Aggregate demand is the level of desired real domestic spending that would equal actual
production at each possible price level.
A rise in the price level shifts the aggregate spending curve downward, while a fall in the price
level shifts it upward. The change in the price level causes:

Changes in private consumption This link is provided by wealth.

o A rise in the domestic price level lowers the real value of all assets that are
denominated in money units (e.g. cash, bank deposits, financial instruments).

A change in the price level affects the wealth of holders of assets denominated in
money terms in exactly the opposite way to how it affects the wealth of those who
issued the asset
Prices rise real value of the asset falls the real wealth of the bond holder
decreases while that of the issuer increases as he has to repay less purchasing
power)
With inside assets (issuer and holder are both in the private sector), the
wealth changes resulting from a change in the price level are offsetting

and so have no net effect on private sector wealth.

With outside assets (only holder being of the private sector), there is a
negative relationship between the price level and net private wealth (held

in outside assets denominated in nominal money units).

o When individuals suffer a decrease in their wealth, they increase their saving so as
to restore their wealth to the level that they desire. An increase in desired saving
implies a reduction in desired consumption. Conversely, an increase in wealth
results in a rise in consumption.
A rise in the domestic price level lowers the real value of total private-sector wealth;
this leads to a fall in desire private consumption; this in turn implies a downward
shift in the aggregate spending line.
A fall in the domestic price level leads to a rise in wealth and desired private

consumption, and thus to an upward shift in the aggregate spending line.

Changes in net exports Changes in the domestic price level causes changes in the
relative prices of domestic and foreign goods.
A rise in the domestic price level shifts the net export function downward, which
shifts the aggregate spending curve downward.
A fall in the domestic price level shifts the net export function and the aggregate
spending curve upward.

A rise in the price level shifts both the net export function and the consumption function
downwards. This causes a downward shift in the aggregate desired spending curve, causing the
level of GDP to fall all other exogenous variables being held constant.
A fall in the domestic price level increases real GDP because it shifts the aggregate spending line
upward all other exogenous variables being held constant.

Any change in the price level leads to a new AE line and hence to a new level of GDP
consistent with injections and leakages being in balance. Each combination of GDP and its
associated price level defines a particular point on the AD curve.
The aggregate demand curve shows, for each price level, the associated level of GDP for
which aggregate desired spending equals total output, and is consistent with the level of
income generated at that output.
The points on the AD curve are said to be consistent with spending decisions. If that level of
output is produced, aggregate desired spending at the given price level will exactly equal total
output.

Any change in exogenous spending that we have been holding constant causes the aggregate
spending curve to shift (whether parallel or non-parallel), and will also cause the AD curve to
shift. Such a shift is called an aggregate demand shock. (Only a change in price causes a shift in
the AE curve but a movement along the AD curve.)
Since the simple multiplier measures the magnitude in the change in GDP in response to a
change in autonomous spending when the price level is constant, it also gives the magnitude of
the horizontal shift in the AD curve in response to a change in autonomous spending.

Aggregate supply and macroeconomic equilibrium

Aggregate supply is the total output of goods and services that firms wish to produce, assuming
that they can sell all that they wish to sell at the going price level.
Short-run aggregate supply curve shows the quantity of output that firms would like to
produce and to sell at each price level, assuming constant prices of inputs
Long-run aggregate supply curve shows the desired quantity of output that firms would like to
produce after the price level and input prices have fully adjusted to any demand shock
The slope of the SRAS curve depends on the relationship between:

Costs and output As outputs increase, unit costs increase due to the need to use less
efficient standby machinery, to hire less efficient workers or to pay overtime rates to

additional workers.
Prices and output
o Price-taking (quantity-adjusting) firms only produce more if price rises and will
produce less if price falls. This is because their units costs tend to rise with output.
o Over some (small) range of output, price-setting firms will keep their prices
constant and satisfy changes in demand by running down or building up
inventories. They will increase their prices when they expand production into the
range where unit costs are rising.

Another way of explaining why the SRAS curve is positively sloped involves real wages. Pricetaking firms produce output at the level where marginal cost equals marginal (and average)
revenue. An increase in demand will lead to an upward shift in the MR curve (and price); firms
will expand output and increase employment.
Money wages, by assumption, are fixed in the short term. As the price of final output goes up,
workers money wages will buy fewer goods. The real wage has fallen, making inputs cheaper
relative to output.
Workers then resist a permanent fall in their real wage. Money wages will eventually start to rise
and the relative input and output prices faced by firms will return to their original level.
Shifts in the SRAS curve, aggregate supply shocks, are caused by:

Changes in the price of inputs An increase in input prices causes an upward shift of the

SRAS curve while a decrease causes a downward shift.

Changes in levels of productivity If labour productivity rises, the unit costs of
production will fall as each worker is producing more per hour.

Macroeconomic equilibrium occurs at the intersection of the AD and SRAS curves.

At a lower price level than that of equilibrium, the excess desired aggregate spending will cause
prices to bid up, and output will increase along the SRAS curve. Desired spending here is
consistent with a level of GDP that is greater than the desired output of firms.
At a higher price level than that of equilibrium, desired spending will not be large enough to
purchase everything that firms wish to produce at that price level.

Macroeconomic equilibrium requires that two conditions be satisfied:

1. At the prevailing price level, desired aggregate spending must be equal to national
output (this is true along the AD curve)
2. At the prevailing price level, firms must wish to produce the prevailing level of
national output, no more and no less (this is true along the SRAS curve)
Changes in GDP and the price level

Keynesian SRAS curve: When real GDP is below potential GDP, individual firms are operating
at less than normal-capacity output. They hold their prices constant at the level that would
maximize profits if production were at normal capacity. They then respond to demand variations
below that capacity by altering output. If demand rises enough so that firms are trying to squeeze
more than output out of their plants, their costs will rise, and so will their prices.
Aggregate demand shocks cause the price level and real GDP to change in the same direction.
Recall: The simple multiplier gives the extent of the horizontal shift in the AD curve in response
to a change in autonomous spending.
If the price level remains constant and if firms are willing to supply all that is demanded at the
existing price level (i.e. the aggregate supply curve is horizontal), the simple multiplier gives the
increase in equilibrium GDP.
When the SRAS curve is positively sloped, the multiplier (which gives the extent of the change
in equilibrium GDP) is smaller than the simple multiplier.

The SRAS curve has an increasing slope and may be considered in three ranges:

Flat range Any change in aggregate demand leads to no change in prices and a response

of output equal to that predicted by the simple multiplier.

Intermediate range A shift in the AD curve gives rise to appreciable changes in both real

GDP and the price level.

Steep range The economy is near its capacity constraint. Any change in aggregate
demand leads to a sharp change in the price level and little to no change in real GDP. The
multiplier is nearly zero.

The effect of any given shift in aggregate demand will be divided between a change in real
output and a change in price level, depending on the conditions of aggregate supply. The steeper
the SRAS curve, the greater is the price effect, and the smaller is the output effect.
Shape of the SRAS curve:

Positive slope
o As output rises, unit costs rise and a higher price level is necessary to compensate
firms.
o If product prices rise with no increase in input prices, production becomes more
profitable. Since firms are interested in making profits, they will usually produce

more.
Increasing slope (first asymmetry)
o Changing prices frequently is too costly, so firms set the best possible prices when
output is at normal capacity and then do not change prices in the face of shortterm fluctuations below normal capacity.
o When firms are faced with unused capacity, only a small increase in the price of
their output (if any) may be needed to induce them to expand production at least
up to normal capacity. However, the further output is expanded beyond normal
capacity, the more rapidly unit costs rise and hence the larger is the price that is
needed to induce firms to increase output even further.

Following a decrease in aggregate supply, the price level rises and real GDP falls, resulting in
stagflation.
CHAPTER 19

Induced changes in input prices

Potential output is the total output that can be produced when all productive resources are being
used at their normal rates of utilization.
Output gap = Actual output Potential output
When actual output exceeds potential output, the demand for inputs (including labour services)
will be relatively high. When actual output is below potential output, this demand will be
relatively low.
When GDP is at its potential level, wages will tend to be rising at about the same rate as
productivity is rising.
When there is neither excess demand nor excess supply in the labour market, wages will tend to
be rising at more or less the same rate as labour productivity; as a result unit labour costs will
remain constant. With unit labour costs remaining constant, there is no pressure coming from the
labour market for the SRAS curve to shift or the price level to change.
Upward (downward) pressure of wages means that there is pressure for wages to rise faster
(more slowly) than productivity is rising, implying that unit labour costs will be rising (falling)
and the SRAS curve shifting to the left (right).
The boom that is associated with an inflationary gap generates high profits for firms and
unusually large demand for labour that exerts upward pressure on wages.
The slump that is associated with a recessionary gap generates low profits for firms, unusually
low demand for labour, and a desire on the part of firms to resist wage demands and even to push
for wage concessions that exerts downward pressure on wages and unit labour costs.
Adjustment asymmetry Excess demand can cause unit labour costs to rise very rapidly; excess
supply normally causes unit labour costs to fall only slowly. Wages are said to be sticky.

Inflationary gap rise in demand for labour rising unit costs (wages rise faster than
productivity) upward shift of the SRAS curve rise in price level inflation
Recessionary gap fall in demand for labour slowly falling unit costs (wages rise slower
than productivity) slow downward shift of the SRAS curve fall in price level
unemployment
Long-run consequences of aggregate demand shocks
Expansionary shocks: A once-and-for-all demand shock sets off an adjustment process that
eventually returns GDP to its potential level but (normally) at a different price level.

Contractionary shocks:

Flexible wages Flexible wages that fell during periods of unemployment would provide
an automatic adjustment mechanism that would push the economy back towards full

employment whenever output fell below potential.

Sticky wages In a recession, money wages often rise more slowly than productivity and
some money wages actually fall. However, there is typically only a small difference
between the rate at which money wages are changing and the rate at which productivity is
changing, causing unit costs to fall slowly. The downward shifts in the SRAS curve occur
slowly, and the adjustment mechanism that depends on these shifts will act sluggishly.

The weakness of the adjustment mechanism requires that speedy recovery back to full
employment be generated mainly from the demand side. This implies that the force leading to
recovery must usually be a rightward shift of the AD curve rather than a downward drift of the
SRAS curve.
1. Unemployment can persist for quite long periods without causing decreases in unit costs
and prices of sufficient magnitude to remove the unemployment.
2. Booms, along with labour shortages and production beyond normal capacity, do not
persist for long periods without causing increases in unit costs and the price level.
The long-run aggregate supply curve (or classical aggregate supply curve) shows the relationship
between the price level and real GDP after wage rates and all other input costs have been fully
adjusted to eliminate any unemployment or overall labour shortages.
Once all the adjustments that are required have occurred, the economy will have eliminated any
excess demand or supply of labour resulting in full employment and potential output. The
vertical shape of the LRAS curve is due to the workings of an adjustment mechanism that brings
the economy back to its potential output, even though actual output may differ from its potential
level for considerable periods of time. Along the LRAS curve, all the prices of all outputs and all
inputs have been fully adjusted to eliminate any excess demands or supplies. Proportionate
changes in money wages and the price level (unchanged real wages) will also leave equilibrium
employment and total output unchanged.
With a vertical LRAS curve, in the long run total output is determined solely by conditions of
supply, and the role of aggregate demand is simply to determine the price level.

When an economy moves to a higher price level on the LRAS curve, total output and total
desired spending do not change, but their compositions do. The higher the price level, the lower
the personal wealth (for a given nominal stock of assets) and hence the lower is private
consumption. Also, net exports are lower due to lower exports and higher imports. Suppose an
inflationary gap is created by an increase in government spending. Money wages and the price
level rise to remove this gap. At the new long-run equilibrium, the higher level of government
spending is exactly offset by lower private consumption and investment as well as net exports.
Real GDP in the short and long run
GDP may be increased by: an increase in aggregate demand (temporary), a temporary increase in
aggregate supply or a permanent increase in aggregate supply.
Economic growth is a gradual but continual rise in potential GDP.
Cyclical fluctuations in GDP are caused by shifts in the AD and SRAS curves that cause actual
GDP to deviate temporarily from potential GDP.
Government policy and the business cycle
The use of taxes and spending by the government in an attempt to control the economy is known
as fiscal stabilization policy.
Fiscal stabilization:

Recessionary gap
o The gap may drive wages and other input prices to rise sufficiently more slowly
than productivity growth in order to shift the SRAS curve to the right.
o The AD curve could shift to the right because of lower taxes or increased
government spending. This may substantially shorten what would otherwise be a
long recession. However, it may stimulate the economy just before private-sector
spending recovers on its own, causing an inflationary gap to open up.

Inflationary gap
o Wages and other input prices may be pushed up by excess demand, causing the
SRAS curve to shift to the left.

o The AD curve could shift to the left because of increased taxes or reduced
government spending. This approach avoids the inflationary increase in prices that
accompanies the first method. However, if private-sector spending falls, GDP may
be pushed below potential, thus opening up a recessionary gap.
As GDP increases, the government budget surplus increases (as net taxes increase and
government spending remains constant). Therefore, there are increases in leakages as the
economy expands and decreases in leakages as it contracts.
Generally, the wedge that income taxes place between national income and disposable income
reduces the marginal propensity to spend out of national income. This reduces the size of the
multiplier and, hence, the size of the change in equilibrium GDP for a given change in
autonomous spending. The effect is to stabilize the economy, reducing the fluctuations in GDP
that are caused by changes in autonomous spending. The fact that net tax revenues rise with
GDP means that there are fiscal effects that cause the budget to act as an automatic
stabilizer for the economy. Because no policies need to be changed in order to achieve this
result, the properties of the budget that cause the multiplier to be reduced are called
automatic fiscal stabilizers.
If the government follows a balanced budget policy, its fiscal policy is pro-cyclical as it ties its
spending in each period to the tax revenue it raises. This means that the government moves with
the economy, raising and lowering its spending in step with everyone else, exactly counter to the
theory of fiscal stabilization.
Limitations of discretionary fiscal policy:

Lags It is possible that by the time a given policy decision has any impact on the
economy, circumstances will have changed such that the policy is no longer appropriate.
o Information lag time to collect and process statistics
o Decision lag delay between the initial recognition of a recession or inflation and

the enactment of legislation to change fiscal policy

o Execution lag time between the enactment and implementation of the change
Debt and deficits
Open economy Fiscal policy may not be effective in influencing aggregate demand
under a floating exchange regime because exchange-rate movement can cause offsetting
changes in net exports.

The role of discretionary fiscal policy

o Fine-tuning the use of fiscal and monetary policy to offset virtually all
fluctuations in private-sector spending
o Gross-tuning the occasional use of fiscal policy to remove large and persistent
GDP gaps

A change in monetary policy today takes about one year to have its maximum impact on output
and a further year to have its maximum impact on the inflation rate.
UNIT 4
CHAPTER 20
Money is defined as any generally accepted medium of exchange. It serves the following roles:

Medium of exchange This makes the double coincidence of wants unnecessary, and
facilitates specialization and division of labour. To serve as a medium of exchange, it
must be readily acceptable and therefore of a known value, have a high value relative to

its weight, be divisible and be difficult, if not impossible, to counterfeit.

Store of value (for individuals, but not society as a whole) Money must have a

relatively stable value to perform this function.

Unit of account Money may be used purely for accounting purposes, without having a
physical existence of its own. It is a nominal unit of measure used to value any economic
item. A related function of money is that is can be used as a standard of deferred payment
since payments that are to be made in the future are also specified in money.

Origins of money:

Metallic money e.g. gold and silver due to their limited supply and constant demand
o Greshams Law Bad money drives out good.
o Seigniorage revenue generated from the power to create currency
Paper money This originally started as a written promise by a goldsmith to pay a certain
amount of gold on demand. Such paper money, which became bank notes, was backed by
precious metal and was convertible on demand into this metal.
o Fractionally backed paper money Banks had, and have, only a fraction of the
claims outstanding against them in reserves available as precious metal to pay
those claims.

o Fiat money As time went on, note issue by private banks become less common,
and central banks, which are (usually) state-owned institutions, took control of the
currency. Originally central banks issued paper currency, in the form of gold
certificates, that was fully convertible into gold. However, central banks could
issue more currency than they had in gold. Thus, even though the need to
maintain convertibility under a gold standard put an upper limit on note issue,
central banks had substantial discretionary control over the quantity of currency
outstanding. Eventually, the gold standard was abandoned and currencies were no
longer convertible into gold and derived value from acceptability in exchange.
Fiat money is widely acceptable because government order, or fiat, declares it
to be legal tender (must be accepted by law for purchase of goods or services
or discharge of debts).
How does money get into the economy?
What the central bank has direct control over is referred to as high-powered money, the cash
base, or the monetary base. This consists of currency (banknotes and coins) held by the public
and the banks, and of deposits held by banks with the central bank, but excludes compulsory
cash ratio deposits.
The central bank gets high-powered money into the economy simply by buying securities
(usually government debt instruments). It pays for these purchases with newly issued highpowered money.

Bankers deposits:

Central Bank buys securities from an agent in the private sector the Central Bank
writes a cheque to be paid into the recipients bank account at Bank A Bank As
deposits rise by the same amount as the balance in Bank As account at the Central Bank
monetary base rises

Seller: Dr Bank
Cr Securities
Central Bank: Dr Securities
Cr Reserves (owing to Bank A)
Bank A: Dr Reserves (held at Central Bank) Cr Deposit liabilities (owing to Seller)

Central Bank sells securities to an agent in the private sector Central Bank receives a
cheque from the buyers bank account at Bank A Bank As deposits fall by the same
amount as the balance in Bank As account at the Central Bank monetary base falls
Seller: Dr Securities
Central Bank: Dr Reserves (owing to Bank A)
Bank A: Dr Deposit liabilities (owing to Seller)

Cr Bank
Cr Securities
Cr Reserves (held at Central Bank)

The division of high-powered money between bankers deposits and currency is determined by
the demand for currency by the general public.
Demand for currency increases private individuals (or firms) withdraw bank deposits in cash
bank withdraws bankers deposits from Banking Department of Central Bank (if it did not
have enough cash) Banking Department sells securities to Issue Department to replenish its
stock of cash Issue Department prints currency
The money supply/stock refers to the total amount of money in the economy.
Bank deposits are a form of money called deposit money. This is defined as money held by the
public in the form of deposits in commercial banks that can be withdrawn on demand.

Banks can create money by issuing more promises to pay (deposits) than they have cash reserves
available to pay out.
If the amount of money is increased too quickly (that is, faster than real GDP is growing),
inflation will result.
M0 monetary base: notes, coins, commercial bank reserves at the Central Bank (bankers
deposits)
M1 M0 + current account and checkable deposits
M2 M1 + savings accounts and non-interest bank deposits
M3 M2 + private sector deposits and foreign exchange deposits with banks
M4 M3 + private sector bank deposits and money market investments
M5 M4 + building society deposits

Two models of the creation of deposit money:

Ratios approach Deposit money is created on the basis of a given amount of reserves.
In general, banks deposits are their liabilities, and whatever loans they make or securities
they purchase constitute their assets. Banks can create deposits (and loans) that are some
multiple of their cash reserves in a system of fractional reserve banking, analogous to the
fractional backing of note issue. Cash held by the banks can be currency in their tills or
deposits at the central bank.
One bank in a multi-bank system cannot produce a large multiple expansion of
deposits based on an original accretion of cash when other banks do not also expand
their deposits. Loans created by a bank increase its deposits. The majority of the cheques
written on these deposits will be deposited in other banks, therefore causing the bank to
suffer a cash drain.
A multi-bank system creates a multiple increase in deposit money when all banks
with excess reserves expand their deposits in step with each other.
However, when the banking system as a whole creates significant amount of new deposit
money, the system will suffer a cash drain as the public withdraws enough cash from the
banks to maintain its desired ratio of cash to deposits.

A cash drain to the public greatly reduces the amount of new deposits that can be
created on the basis of a given amount of cash.
R cash held in bank reserves; C cash held by non-bank public; H high-powered
money; D size of bank deposits; x desired reserve ratio of banks; b publics cash to
deposits ratio
C + R = H; C = bD; R = xD bD + xD = H D =

H
b+ x

Money multiplier:
M money supply
H
M = C + D M = bD + D M = (b + 1)D M = (b + 1) b+ x

(b +1)
(b+ x ) H =

M
H

( b+1 )
The money multiplier is given by ( b+ x )

and it tells us how much bigger the money

supply is than the cash base of the system.

The smaller is the banks desired reserve ratio, x, the greater is the money multiplier.
The smaller is the publics desired cash ratio, b, the greater is the money multiplier.

A competitive banking system Banks work in a competitive environment to attract the

reserves they need in order to create deposit money.
Banks wait until they have found a profitable lending opportunity, and they then take
steps to make sure that funds are available to make the loan. They do this by offering
higher interest on deposits, or by borrowing from other banks.
In a competitive market, there will be a market-clearing interest rate for both deposit
money and loans.

The supply curve of loans is determined by the supply curve of deposits and the spread.
The spread is the difference between what the banks have to pay to borrow money
(interest paid on deposits) and what they get by lending it (interest received on loans).

The Central Bank aims to control deposits via the demand for bank loans, by adjusting interest
rates. Having chosen what they think is the correct interest rate to generate the desired demand
for loans, the Central Bank supplies whatever high-powered money is demanded at that going
interest rate.
In the absence of high legal reserve requirements, banks chosen reserve ratios tend to be very
small, subject to the need to supply cash on demand when customers wish to withdraw deposits.
The banking system as a whole is in competition with other financial channels in the economy
for the available amount of borrowing and lending business at any point in time.
Causes of financial crises include:

Optimism in the upturn

Greed turns to fear

CHAPTER 21
In 2009, when interest rates in the UK were lowered as far as they could go and the monetary
authorities still wanted to further stimulate demand, quantitative easing (printing money) was
implemented.
Money values and relative values
The classical dichotomy can be stated in different forms. Stated in order of general acceptance:

The level of money prices has no effect on the real economy. When every money price
is changed in equal proportion there is no change in the relations of any one price or
wage to another and no cause to alter real behaviour. This version is relevant when, after
undergoing a major inflation, a country decides on a currency reform that takes zeros off

its currency.
Neutrality of money The long-run equilibrium values of all real variables are
independent of what happens in the monetary side of the economy. A change in the total
amount of money leads to changes in money prices but not in allocation of resources
or level of real GDP. However, critics have pointed out that purely monetary shocks can
have real effects in the short run for example, inflation can alter real interest rates and

investment spending.
An increase in the total amount of money leads to a proportionate increase in all
money prices, and has no effects on any real variables (even in the short term) as
long as the rise in prices is fully anticipated. Objections include:
o Not all prices can be changed quickly, even if inflation is anticipated.
o Events in the monetary sector of major economies in 2007 and 2008 led to the
recession of 2008-2010.

Monetary illusion refers to behaviour that responds to purely nominal changes in money prices
and values in either direction. While people may not realize at first that an inflation leaves them
unaffected, they will realize eventually. Over the long term, real spending decisions are affected
relatively little by purely nominal changes in all money prices (and wages).
The real part of the economy is considered to deal with variables such as relative prices,
quantities and the allocation of resources while, in the monetary part, the absolute level of prices
is determined by monetary forces.
The monetary sector of the economy does not just consist of the money stock; it includes other
financial assets that have a rate of return and whose market value can change.
The markets for financial assets and liabilities interact with good markets through the interest
rate (price of borrowing money), the exchange rate (price of obtaining foreign currency) and the
wealth effects that arise when the real value of assets changes.
The valuation of financial assets

Wealth is made up of money and bonds (all other forms of financial wealth including interestearning financial assets plus claims on real capital). In our analysis, however, bonds will be
assumed to be assets just like the debt of the central government.
The present value of a bond, or of any asset, refers to the value now of the future payment(s) to
which the asset represents a claim. It also represents the amount that a person would be willing to
pay now (at the current rate of interest) to secure the right to the future stream of payments
conferred by the ownership of the asset.
A bond (in this case, a perpetuity) that will produce a stream of income of $100 per year is worth
$1000 at 10% interest or $2000 at 5% interest. As such the present value of any asset that yields
a given stream of money over time is negatively related to the interest rate.
The present value of an asset determines its market price:

If the market price is more than the present value, a potential buyer could, instead of
paying this amount for the bond, lend this amount at the going interest rate. By the end of
the year, she would have accumulated 5% of this higher value as interest, in addition to
the principal. This amount would be greater than the return that would otherwise be

generated by the bond.

If the market price is less than the present value, a potential buyer could borrow this
amount at the current rate of interest to buy the bond. At the end of the year, the bond
yields the present value plus interest, which exceeds the value of the market price plus
interest (which the buyer needs to pay). Clearly, it would be worthwhile for buyers to pay
such a market price. However, no holder would want to sell the bond. If the holder of the
bond needed an amount less than the bonds present value, he could borrow this amount
for the year, pay it back plus interest, and still have more than if he had sold the bonds at
the beginning of the year.

If the market price of any asset is greater than the present value of the income stream that it
produces, no one will want to buy it, and the market price will fall. If the market value is below
its present value, there will be a rush to buy it, and the market price will rise. In a free market,
the equilibrium price of any asset is the present value of the income stream it produces.

1. If the rate of interest falls, the value of an asset producing a given income stream
will rise.
2. A rise in the market price of an asset producing a given income stream is equivalent
to a decrease in the rate of interest earned by the asset.
3. The nearer the maturity date of a bond, the less the bonds value will change with a
change in the rate of interest.
The supply of money and the demand for money
Assumptions: exchange rate is fixed; some segmentation of domestic and international financial
markets
In most major countries, the authorities implement monetary policy by setting interest rates and
letting the money stock be determined by how much is demanded at that interest rate.
The demand for money is the amount of wealth that everyone in the economy wishes to
hold in the form of money balances. With a given level of wealth, a rise in the demand for
money necessarily implies a fall in the demand for bonds, and vice versa.
The opportunity cost of holding any money balance is the extra interest that could have
been earned if the money had been used instead to purchase bonds.

The motives for holding money are:

The transactions motive This refers to holding money to pay firms for goods and
services and employees for labour services. This motive arises because payments and
receipts are not synchronized. The larger the value of GDP, the larger is the value of all

transactions and hence the larger is demand for transactions balances.

The precautionary motive Precautionary balances provide a cushion against uncertainty
about the timing of cash flows. The precautionary motive arises because individuals and
firms are uncertain about the degree to which payments and receipts will be
synchronized. To provide the same degree of protection as the value of transactions rises,

more money is necessary. The precautionary movie causes the demand for money to vary

positively with the money value of GDP.

The speculative motive Speculative balances are those money balances held as a hedge
against the uncertainty inherent in fluctuating prices of other financial assets. Any holder
of money balances forgoes the extra interest income that could be earned if bonds were
held instead. Wealth-holders hold part of their wealth as money and part as bonds
suggesting that, as wealth rises, desired money holdings also rise.
Changes in wealth are fairly small in the short term, and they are ignored. However, over
the long term, variations in aggregate wealth can have a major effect on the demand for
money. The speculative motive leads individuals and firms to add to their money
holdings until the reduction in risk obtained by the last pound added is just balanced by
the cost of interest forgone on that pound. The speculative motive implies that the
demand for money will be negatively related to the rate of interest.
The real demand for money (or the demand for real money balances) is the nominal
quantity demanded divided by the price level. Other things being equal, the nominal
demand for money balances varies in proportion to the price level; when the price level
doubles, desired nominal money balances also double.
M = kPY MV = PY (quantity theory of money)
M money supply (exogenously determined); k constant (percentage of total
transactions that people wish to hold as money); P price level Y equilibrium GDP;
V=

1
k

velocity of circulation

Since k and Y are constant, increases or decreases in the money supply lead to
proportional increases or decreases in prices.
The velocity of money shows the average amount of work done by a unit of money. It
shows how many times one unit of money must be used.
The price level is determined by the quantity of money.
Quantity of money (supply) changes price level changes nominal demand for
money changes

Money forces and aggregate demand

Monetary equilibrium occurs when the interest rate is such that the demand for money equals the
supply of money the demand to hold money equals the supply available to be held and the
demand to hold bonds equals the supply available to be held.
The supply of money is shown as a vertical line. When people find that they have less money
than they wish to hold, they can sell some bonds and add the proceeds to their money holdings.
This does not change the total supply of money or bonds and simply redistributes these supplies.
The interest rate adjusts to clear the money market for a given level of money stock and a given
money demand curve.

Excess demand for money balances Firms and households try to sell bonds to add to
their money balances. However, the economys total supply of money and bonds is fixed.
If everyone tries to sell bonds, there will be no one to buy them, and the price of bonds
will fall, leading to a rise in the rate of interest. As the interest rate rises, people
economize on money balances, because the opportunity cost of holding such balances is
rising. Eventually, the interest rate will rise enough that people will no longer be trying to
add to their money balances by selling bonds and there is no longer an excess supply of

bonds.
Holding of larger money balances than preferred The total quantity of bonds is fixed.
When all agents enter the bond market and try to purchase bonds with unwanted money
balances, they bid up the price of existing bonds, and the interest rate falls. Individuals
and firms then become willing to hold larger quantities of money. The fall in interest rate

and corresponding fall in the price of bonds continue until firms and households stop
trying to convert bonds into money.
The determination of interest rate depicted here is often called the
liquidity preference theory of interest or the portfolio balance
theory. Aggregate spending, especially investment but also
consumption and net exports, is sensitive to changes in the interest
rate. Here, then, is a link between monetary factors and real spending
flows.

If the authorities wished to relax monetary policy (expansionary policy), they could increase the
money supply causing holders to demand more bonds, raising the price of bonds and lowering
the interest rate.
However, the authorities would set the level of interest rate, rather than the money supply. To
relax monetary policy, the Bank lowers the interest rate. At this lower interest rate, the public
wishes to hold more money by selling bonds. If the Bank did nothing, the sales of bonds would
raise the interest rate. However, the Bank wishes to maintain that interest rate and, so,
accommodates the publics desire to switch from bonds to money by buying bonds and supplying
money. The money supply thus

increases to whatever is

demanded at the new interest rate.

The transmission mechanism is the mechanism by which changes in monetary policy affect
aggregate demand. It connects monetary forces and real spending flows. It operates in two
stages:

Interest rate and investment spending The negative relationship between investment and
the rate of interest is called the investment demand function.

Aggregate spending and aggregate demand A change in the interest rate, by causing a
change in desired investment spending and hence a shift in the AE curve, causes the AD
curve to shift.

The accelerator theory of investment assumes that the level of investment is related to changes in
GDP. The demand for machinery and factories is derived from the demand for the goods that the
capital equipment is designed to produce. If there is a demand that is expected to persist, and that
cannot be met by increasing production with existing industrial capacity, then new plant and
equipment will be needed and investment spending will occur.
With a fixed capital-output ratio, net investment
occurs only when it is necessary to increase the
stock of capital in order to change output.

Macroeconomic cycles and aggregate shocks

Aggregate demand shocks may come from a change in world demand for domestic exports, or
from an autonomous shift in investment or consumption coming, perhaps, from a wave of
optimism or pessimism.
Multiplier-accelerator theory (links systematic fluctuations in GDP to systematic fluctuations in
investment spending)
1. A theory of cumulative upswings and downswings explains why, once started, movements
tend to carry on in the same direction. The multiplier process tends to cause cumulative
movements.
According to the accelerator theory, investment is likely to fall to a very low level when
consumer demand is low and there is excess capacity. Once demand and output start to rise
and entrepreneurs come to expect further rises, investment spending may rise very rapidly.
Current decisions to produce consumer goods and investment goods are very strongly
influenced by business expectations. Such expectations can sometimes be volatile, and
sometimes self-fulfilling. If enough managers think the future looks rosy and begin to invest
in increasing capacity, this will create new employment and income in the capital goods
industries, and the resulting increase in demand will help to create the rosy conditions whose
vision started the whole process.
2. A theory of floors and ceilings explains why upward and downward movements are
eventually brought to a halt. A rapid expansion cannot go on forever because the economy
eventually runs into bottle-necks (or ceilings) in terms of some resources. Inflation will pick
up, and either the monetary authorities will put interest rates up or firms will cut investment
in anticipation of a downturn. A contraction is also eventually brought to an end as firms
cannot postpone investment and run down stocks, and consumers cannot put off buying
goods indefinitely. The small upturn in spending then leads to further spending and the start
of the upswing of the cycle.
3. A theory of instability explains how, once a process of upward or downward movement is
brought to a halt, it tends to reverse itself (explained above).
The accelerator causes the desired level of new investment to depend upon the rate of change
of GDP. A levelling-off in GDP at the top of the cycle may lead to a decline in the amount of
investment and a subsequent decline in the level of GDP.
Positive demand shock An autonomous increase in investment causes the AD curve to shift to
the right. The increase in GDP brought about by this increase in investment increases the

transactions demand for money and this puts upward pressure on interest rates. If the monetary
authorities are to hold the initial level of the interest rate, they must buy bonds and so permit
money stock to rise. This increase in the money stock imparts a further rightward shift to AD.
The price levels rise and real wages fall. Unemployment will be falling and excess demand for
certain types of labour will develop. Soon workers will demand, and employers will concede,
increases in money wage rates. This then causes a leftward shift of the SRAS curve as wage rises
are partly passed on in the form of higher prices and output starts to fall.
Negative demand shock An autonomous fall in investment causes a leftward shift in the AD
curve as the economy moves into recession. As GDP falls, the transactions demand for money
will also fall, and with a fixed money stock this would lead to a fall in interest rates. However, if
the monetary authorities are pegging interest rates, they will reduce the money supply in order to
stop interest rates falling. This decrease in the money stock imparts a further leftward shift to
AD. However, because the SRAS curve is flatter to the left of Y* than to the right, more of the
initial adjustment falls on GDP and less on the
price level.
Only as higher unemployment leads to falling
money wages and these falls get passed on into
lower prices will the SRAS curve shift
downwards and the economy return to its
potential level of output.

Policy responses
If the authorities had known that investment was about to rise and could have implemented a
policy change that had immediate effect, they could have acted to shift the AD curve straight
back down again so that it never shifted. The monetary authorities could do this by raising
interest rates and the fiscal authorities by increasing taxes or cutting government spending.
Taylor Rule The authorities raise interest rates when inflation is above target and when actual
GDP is above potential and vice versa. If GDP is at potential and inflation is on target, the policy
interest rate will equal the long-run real rate plus the current inflation rate.

If the monetary authorities respond in a timely way to the positive demand shock, they may be
able to improve the outcome. The danger of mistimed policy interventions is a serious one, and
this is the main case against attempts to use active monetary or fiscal fine-tuning of the economy.
The case for an active policy response may be much stronger in the event of a negative demand
shock as the automatic adjustment processes are much slower working in a downward than an
upward direction.

Positive supply shock A positive supply shock, such as a fall in world raw material
prices, shifts the SRAS curve down to the right. The economy would experience a rise in
GDP and falling prices.
Fall in price level rise in real money supply lower interest rates increase in
investments increase in real GDP
However, if the monetary authorities were pegging interest rates they would tend to
reduce the money stock rather than let interest rates fall and this would make the
economy follow a path closer to staying on the LRAS but at a lower price level.
Secondly, to the extent that the economy did move to the right of Y*, this would set up
inflationary pressure that would tend to make prices rise again until SRAS had shifted

back up to its initial position.

Negative supply shock A negative supply shock causes an upward shift of the SRAS
curve. This results in an increase in price level and falling output known as stagflation.
Rise in price level fall in real money supply higher interest rates lower
investment lower GDP
However, if the monetary authorities peg the interest rate, they will resist the rise in
interest rates by increasing the money supply, shifting the AD curve to the right.

A monetary policy that holds the interest rate constant (until it is deliberately changed by
policymakers) stabilizes the effects of supply shocks on real GDP but it amplifies the effects
of demand shocks.
Policy responses
With a fixed interest rate, there will automatically be a stabilizing change in the money supply,
although if policymakers were fixing the money stock there may be a role for temporary countercyclical monetary or fiscal changes to aid the return to equilibrium.
Implementation of monetary policy

The main objective of monetary policy is to maintain price stability, that is, to control inflation,
and this is done by setting a specific short-term interest rate that then influences other localcurrency interest rates.
Interest rates are set in order to hit an inflation target.
The Bank Rate is the rate of interest that the Bank pays on commercial banks operational
balances at the Central Bank. Suppose the Central Bank changes the Bank Rate. Banks then
change their base rates because they know that the Central Bank has changed the interest rate at
which it will lend high-powered money to the banks as this rate is set just above the Bank Rate.
Banks will not wish to lend to their customers at a rate lower than they themselves might have to
borrow.
Suppose that the Bank wishes to raise its official interest rate (the Bank/discount Rate rate at
which it will lend to the private banks). Very quickly the banks raise the rates at which they will
lend to their customers.
When the Bank Rate is high, banks will be reluctant to increase their lending (and so increase
money supply) because they do not want to risk having to borrow reserves from the Central
Bank, and there will be a lower demand for loans from the banks when loan rates are higher.
When the Bank Rate is low, banks will be more inclined to increase lending (and hence the
money supply) because the penalty for having to borrow reserves from the bank is low, and
because demand for borrowing from the banks is high.
Monetary policy instruments:

Interest rates
Repo rate - The repo rate is the rate at which the Central Bank buys back securities (from
commercial banks) it has previously sold in the money markets. If the repo rate is
increased, it makes borrowing expensive for commercial banks and vice versa. This
increasing of the repo rate restricts the availability of money and is used to control

inflation. The opposite will be done to encourage growth.

Open-market operations This involves lending and borrowing operations relating to the
money markets. It involves the buying and selling of government securities in order to
manipulate the money supply.

Minimum reserves The higher the reserve requirement, the lower the money supply and

vice versa.
Standing facilities This allows participating banks to make deposits with and take loans
from the Central Bank for overnight duration. The deposit and loan rates so specified in
effect put upper and lower bands around the short-term interest rate that can rule in the

market for overnight money.

Bank/Discount rate
Qualitative instruments consumer credit regulation, credit rationing, moral suasion,
control through directives

During the recession, when interest rates could not be lowered any further, a policy of
quantitative easing was employed. This involves the Central Bank buying large amounts of
assets with money created for this purpose by the Central Bank itself.

There is a rise in the price of bonds and a fall in their long-term rates, making it cheaper

for companies to borrow to finance investment.

The money supply increases, resulting in an increase in spending and liquidity, and

freedom of commercial banks to lend.

Purchases of assets such as company shares boost the stock market, encouraging

consumer spending.
Consumer confidence increases, thereby encouraging spending.

CHAPTER 24
Inflation in the macro model
Any event that tends to drive the price level upwards is called an inflationary shock.
Supply shocks: A negative supply shock shifts the SRAS curve upwards, causing GDP to fall
while inflation picks up. The authorities have two alternatives:

No monetary accommodation Adopt an interest rate policy that keeps the money

supply constant and the AD curve in its initial position.

Monetary accommodation Lower the interest rate sufficiently to shift the AD curve
rightwards, so that it intersects the new SRAS curve at potential GDP. To achieve this,
they must increase the money supply by buying bonds. AD shifts rightwards and the
supply shock is said to be accommodated by an increase in the money supply.

Isolated supply shocks:

No monetary accommodation The leftward shift in the SRAS curve opens up a

recessionary gap. Market pressures tend to cause wages and other input prices to fall
relative to productivity. The SRAS curve then slowly shifts downward, back to the

original equilibrium position.

Monetary accommodation Monetary authorities react by increasing money supply,
shifting the AD curve to the right. Monetary accommodation can return the economy to
potential GDP relatively quickly, but at the cost of a once-and-for-all increase in the price
level.

Repeated supply shocks: As an example, assume that powerful unions are able to raise money
wages faster than productivity is increasing, even in the face of a significant excess supply of
labour. Firms then pass these on in the form of higher prices, causing a wage-cost push inflation
an increase in the price level due to increases in money wages that are not associated with an
excess demand for labour.

No monetary accommodation The initial effect of the leftward shift in the SRAS
curve is to open up a recessionary gap. If unions continue to negotiate increases in wages,
prices continue to rise while output and employment continue to fall. Eventually, unions
will stop forcing up wages in order to maintain jobs for those who are still employed. The
economy eventually comes to rest with a stable price level and a large recessionary gap.
The persistent unemployment may eventually erode the power of the unions, so that real
wages and unit costs begin to fall. In this case, the supply shock is reversed, and the

SRAS curve will shift downward until full employment is eventually restored.
Monetary accommodation Monetary authorities accommodate the shock by lowering
interest rates relative to where they would otherwise be, and increasing the money supply.
This shifts the AD curve to the right, at the potential level with higher prices and money
wages. Workers are no better off than they were originally. If multiple supply shocks
occur and are accommodated, equilibrium GDP always returns to full employment but at
the cost of further rounds of inflation. The wage-cost push tends to cause stagflation,
with rising prices and falling output. Monetary accommodation tends to reinforce
the rise in prices and to offset the fall in output.

Once started, a wage-price spiral can be halted only if the monetary authorities stop
accommodating the supply shocks that are causing the inflation. The longer they wait to do so,
the more entrenched will become the expectations of continuing inflation. Accommodating a
negative supply shock risks setting off a wage-price spiral, but accommodating the first-round
effects of shocks may limit the output and employment losses that are otherwise inevitable.

Demand shocks: A rightward shift in the aggregate demand curve causes the price level and
output to rise. The authorities have two alternatives:

No validation The initial AD shock opens up an inflationary gap. The pressure of

excess demand soon causes wages to rise faster than productivity, shifting the SRAS
curve upwards. As output and prices are higher, money demand increases. In order to
hold the money supply constant, the money authorities will have to sell bonds and
increase interest rates, thus choking off the excess demand for money. As long as the
money supply is held constant, the rise in the price level moves the economy upwards

along its fixed AD curve.

Validation of the shock This involves reacting to the increase in the demand for money
that accompanies an increase in autonomous spending by permitting the money supply to
rise.
If the initial demand shock creates an inflationary gap and the monetary authorities relax
monetary policy, then nominal money supply rises when output starts to fall.
Spurred by the inflationary gap, the wage increases cause the SRAS curve to shift to the
left. Fuelled by the expansionary monetary policy, the AD curve shifts to the right. Both
of these shifts cause the price level to rise. But if the shift in the AD curve offsets the shift
in the SRAS curve, the inflationary gap does not diminish. The validation of an isolated
demand shock thus creates a series of repeated demand shocks that permit the inflation to
continue.

Any force that shifts AD to the right or SRAS to the left causes the price level to rise.
Such inflation can continue for some time without any increases in the money supply.
The rise in prices must eventually come to a halt, unless monetary expansion occurs. If a
rise in prices is to continue, it must be accompanied by continuing increases in the money supply
(or decreases in money demand).
In the short run, inflation is not purely a monetary phenomenon as it has real consequences for
output and employment. In the long run, however, it is a purely monetary phenomenon.

The Phillips Curve

When current GDP is at potential level, there may be a substantial amount of frictional and
structural unemployment known as the natural rate of unemployment (NAIRU).
When the unemployment rate is below the NAIRU, demand forces put pressure on wages to rise
faster than productivity. When the unemployment rate is above NAIRU, demand forces put
pressure on wages to rise more slowly than productivity or even to fall. When unemployment is
at NAIRU, demand forces exert neither upward nor downward pressure on wages relative to
productivity.
The Phillips Curve relates the percentage rate of change of money wage rates to the level of
unemployment.

The transformed Phillips curve shows the speed with which the SRAS curve is shifting upwards.

The micro behaviour that lies behind the flat part

of the Phillips curve to the left of Y* is explained
in two parts. The first concerns the theory of shortrun oligopoly pricing whereby firms tend to
absorb cyclical demand fluctuations by varying
their outputs rather than prices. The second
concerns the theory that money wage rates do not
fall rapidly in the face on an excess supply of
labour, although they can rise rapidly in the face
of excess demand for labour.
The general expectation of an x% inflation
creates pressure for wages to rise by x% more than
productivity, and hence for the SRAS curve to
shift upwards by x%.
Random shocks, originating from sources
independent of one another, may have a large
positive or negative effect in any one year. Over the period of a sustained inflation, however,
positive shocks in some years will tend to be offset by negative shocks in other years, so that
overall they contribute little to the long-term trend of the price level.
Percentage increase in unit wage costs = demand effect + expectation effect + shock effect
The short run Phillips curve shifts upwards when inflation expectations rise and down when they
fall.
CHAPTER 25
Unemployment that is associated with actual GDP being below potential is called cyclical
unemployment. The two measures of unemployment are:

The claimant count The number of people claiming unemployment-related benefits

ILO (International Labour Office) unemployment Those who are out of work, want
a job, have actively sought work in the last four weeks, and are available to start work in

the next two weeks, and those who are out of work, have found a job, and are waiting to
start in the next two weeks; measured by means of a monthly survey
There are three main types of unemployment:

Cyclical or demand-deficient unemployment aggregate spending in the economy is

insufficient to purchase the output that would be supplied when the economy is at

potential GDP
Frictional unemployment arises as part of the normal turnover of labour
Structural unemployment occurs when there is a mismatch between the characteristics
and skills of the people looking for work and those desired by potential employers

Frictional and structural unemployment make up equilibrium unemployment, which is defined as

the unemployment that exists when GDP is at its potential level (and when unemployment is at
NAIRU), and hence when there is neither a recessionary nor an inflationary gap.
Unemployment is the result of the balance of two continuous flows: the flow of potential
workers into unemployment and the flow of workers out of unemployment.
Low-skilled workers and young workers are more likely to be unemployed.
Someone is involuntarily unemployment is they would accept an offer of work in a job for which
they are trained, at the going wage rate, if such an offer could be found.
Consequences of unemployment:

Lost output
Personal costs

Cyclical unemployment
This can be measured as the number of people who would be employed if the economy were at
potential GDP minus the number of persons currently employed. The participation rate refers to
the proportion of the population of working age that is economically active and so working or
actively seeking work.
Hypothetically, fluctuations in GDP are not sufficient to create fluctuations in involuntary
unemployment.

Realistically:

New Classical Approach: Agents continually optimize and markets continuously clear; hence
there can be no involuntary employment. It explains unemployment as the outcome of voluntary
decisions made by rational people who are choosing to do what they do.
One explanation of cyclical fluctuations in unemployment assumes that they are caused by
fluctuations in the willingness of people to supply their labour. This approach incorrectly
assumes that wages fall in booms and rise in slumps and that there is no systematic cyclical
involuntary unemployment.
The second explanation lies in errors on the part of workers and employers in predicting the
course of the price level over the business cycle.

New Keynesian Agenda: There is a labour market equilibrium in which there is an excess supply
of labour at the going wage rate. Attempts to explain involuntary unemployment look for reasons
why wages do not respond quickly to shifts in supply and demand in the labour market. If so,
quantity demanded and quantity supplied may not be equated for extended periods of time even
though people are behaving rationally. These theories start with the everyday observation that
wage rates do not change every time demand or supply shifts.

Nominal wage and price rigidities that slow the adjustment towards full equilibrium:

Long-term relationships Money wages do not adjust to clear labour markets as resulting
from the advantages to both workers and employers of relatively long-term, stable
employment relationships. Optimizing firms in such an environment will adjust

employment rather than wages during the cycle.

Menu costs and wage contracts Changing prices and wages in response to every minor
fluctuation in demand is a costly and time-consuming activity. Hence, it may be optimal
for firms to react to small changes in demand by holding prices constant and responding
with changes in output and employment.

Real wage rigidities that are not eliminated over time, but continue in full equilibrium:

Efficiency wages In labour markets with informational asymmetries, where unobserved

characteristics of job applicants are correlated with the reservation wage (the wage at
which they are prepared to work), it may not be optimal for firms to pay the marketclearing wage. Efficiency wage theory implies that firm may find it advantageous to pay
high enough wages so that working is clearly a superior alternative to being laid off. This
will improve the quality of workers output (also through direct effects on nutrition and

general health) without firms having to spend heavily to monitor workers performance.
Union bargaining Those already in employment have more say in wage bargaining than
those out of work.

Equilibrium unemployment
People who are unemployed while searching for jobs are said to be frictionally unemployed or,
alternatively, in search unemployment. The normal turnover of labour would cause some
frictional unemployment to persist, even if the economy were at potential GDP and the structure
of jobs in terms of skills, industries, occupations, and location were unchanging.
Structural unemployment refers to unemployment caused by a mismatch between the structure of
the labour force in terms of skills, occupations, industries, or geographical locations and the
structure of the demand for labour. It increases if there is either an increase in the speed at which
the structure of the demand for labour is changing or a decrease at which labour is adapting to
these changes.

Technological revolution and the decline in manufacturing employment and rise in service
employment are results of economic growth that shift the demand structure for the demand for
labour.
Changes in NAIRU result from:

Demographic changes age, gender

Hysteresis The size of NAIRU can be influenced by the size of the actual current rate of
unemployment. This means that the NAIRU will be higher after periods of high
unemployment than after periods of low unemployment. Important factors are experience
and on-the-job training and insider-outsider segregation in a heavily unionized labour

force.
Increasing structural change
Unemployment benefits

Explaining unemployment:

Demand shocks negative demand shocks

Supply shocks negative supply shocks
Persistence

Reducing unemployment:
Once inflation is low and the unemployment level is close to NAIRU, aggregate demand policy
should be neutral; that is, it should aim to maintain GDP at its potential level. The most that
demand management can do about equilibrium employment is to try to make sure that it does not
rise as a result of hysteresis effects associated with major deflations.

Reducing persistence requires a reform of the benefits system and active policies to
ensure that those in danger of long-term unemployment get work experience and training;
management of the benefits system; reduce mismatch by making it easier for workers to

change occupations by assistance for retraining and relocation

Labour market reform management of the structure of wage bargaining