Professional Documents
Culture Documents
Francesco Venuti
Source: www.ecb.int
1
Business Economics and Organization prof. Francesco Venuti The EUROPEAN CENTRAL BANK
Source: www.ecb.int
Source: www.ecb.int
2
Business Economics and Organization prof. Francesco Venuti The EUROPEAN CENTRAL BANK
Source: www.ecb.int
Source: www.ecb.int
3
Benefits of price stability
The objective of price stability refers to the general level of prices in the
economy. It implies avoiding both prolonged inflation and deflation.
Price stability contributes to achieving high levels of economic
activity and employment by:
Business Economics and Organization prof. Francesco Venuti
Source: www.ecb.int
4
INFLATION and MONEY
Some prices rise; some prices fall. One speaks of inflation if there is a
broad increase in the prices of goods and services, not just of individual
items. As a result, you can buy less for 1. Expressed the other way
around, a euro is worth less than it was before.
5
INFLATION and MONEY
* Consumer price inflation in the euro area is calculated every month by Eurostat. The Harmonised
Index of Consumer Prices (HICP) covers, on average, around 700 goods and services. It reflects
average household expenditure in the euro area for a basket of products.
6
INFLATION and MONEY
EXERCISE 1.
Business Economics and Organization prof. Francesco Venuti
EXERCISE 2.
Business Economics and Organization prof. Francesco Venuti
In 2009 the basket is the same, but lunch price increase to 35 euro and
a minute phone call costs 0,04 euro, one litre of gas costs 1,10 euro
and a night in the hotel costs 50 euro.
Find out the inflation considering only this basket.
Business Economics and Organization prof. Francesco Venuti 14
7
The IS-LM model
IS-LM MODEL
Since now
Business Economics and Organization prof. Francesco Venuti
8
The Goods Market and the IS Relation
Y = C(Y T ) + I + G
9
The Goods Market and the IS Relation
10
The Goods Market and the IS Relation
Investment, Sales, and the Interest Rate
I = a Y b i
or
I = I0 b i
Business Economics and Organization prof. Francesco Venuti 22
11
The Goods Market and the IS Relation
Determining Output
Y = C(Y T ) + I (Y , i ) + G
For a given value of the interest rate i, demand is an
increasing function of output, for two reasons:
An increase in output leads to an increase in
income and also to an increase in disposable
income.
An increase in output also leads to an increase in
investment.
12
The Goods Market and the IS Relation
Determining Output
Business Economics and Organization prof. Francesco Venuti
Figure 5
Equilibrium in the
Goods Market
The demand for goods is an
increasing function of output.
Equilibrium requires that the
demand for goods be equal to
output.
13
The Goods Market and the IS Relation
Deriving the IS Curve
In words:
The increase in the interest rate decreases
investment.
The decrease in investment leads to a
decrease in the aggregate demand and in
output, which further decreases consumption
and investment through the multiplier effect.
i I Z Y Yd C Z Y ..
14
The Goods Market and the IS Relation
Deriving the IS Curve
Figure
The Derivation of the IS
Business Economics and Organization prof. Francesco Venuti
Curve
(a) An increase in the interest
rate decreases the
demand for goods at any
level of output, leading to a
decrease in the equilibrium
level of output.
is drawn as downward-sloping with the interest rate (i) on the vertical axis and GDP (gross
domestic product: Y) on the horizontal axis
15
The Goods Market and the IS Relation
The IS Curve
Business Economics and Organization prof. Francesco Venuti
To summarize:
Equilibrium in the goods market implies that an increase in
the interest rate leads to a decrease in output. This relation
is represented by the downward-sloping IS curve.
Changes in factors that decrease the demand for goods,
given the interest rate, shift the IS curve to the left. Changes
in factors that increase the demand for goods, given the
interest rate, shift the IS curve to the right.
16
The Goods Market and the IS Relation
Shifts of the IS Curve
Business Economics and Organization prof. Francesco Venuti
Figure
Shifts of the IS Curve
An increase in taxes
shifts the IS curve to
the left.
M = $YL(i )
17
Financial Markets and the LM Relation
Real Money, Real Income, and the Interest Rate
in the demand for money leads to an increase increase in the interest rate.
in the equilibrium interest rate. The LM curve is therefore
upward sloping.
18
Financial Markets and the LM Relation
Deriving the LM Curve
19
Financial Markets and the LM Relation
Shifts of the LM Curve
Figure
Business Economics and Organization prof. Francesco Venuti
An increase in
money supply
causes the LM
curve to shift
down (right).
20
Putting the IS and the LM Relations
Together
IS relation: Y = C(Y T ) + I (Y , i ) + G
M
LM relation: = YL(i )
P
Business Economics and Organization prof. Francesco Venuti
Figure
The ISLM Model
Equilibrium in the goods market
implies that an increase in the
interest rate leads to a
decrease in output. This is
represented by the IS curve.
Equilibrium in financial markets
implies that an increase in
output leads to an increase in A
the interest rate. This is
represented by the LM curve.
Only at point A, which is on
both curves, are both goods
and financial markets in
equilibrium.
IS relation: Y = C(Y T ) + I (Y , i ) + G
M
LM relation: = YL(i )
P i
Business Economics and Organization prof. Francesco Venuti
LM
The short-run
equilibrium is the
combination of r and Y
that simultaneously
satisfies the
IS
equilibrium conditions
in the goods & money
Equilibrium Y
markets
interest
Equilibrium
rate
level of
income
21
Summary
Alvin Hansen.
The model examines the combined equilibrium of two
markets :
The goods market, which is at equilibrium when investments
equal savings, hence IS.
The money market, which is at equilibrium when the demand for
liquidity equals money supply, hence LM.
Examining the joint equilibrium in these two markets allows us to
determine two variables : output Y and the interest rate i.
Summary
IS curve
comes from Keynesian cross when planned investment depends
negatively on interest rate
shows all combinations of r and Y
Business Economics and Organization prof. Francesco Venuti
LM curve
comes from liquidity preference theory when
money demand depends positively on income
shows all combinations of r and Y that equate demand for real
money balances with supply
22
Summary
IS-LM model
Intersection of IS and LM curves shows the unique point (Y, r )
that satisfies equilibrium in both the goods and money markets.
Business Economics and Organization prof. Francesco Venuti
23
Putting the IS and the LM Relations
Together
24
Putting the IS and the LM Relations
Together
Expansionary and Contractionary Policy
Expansionary
Business Economics and Organization prof. Francesco Venuti
Contractionary
shifts the appropriate curve leftward
25
Putting the IS and the LM Relations
Together
The effect of an increase in GOVERNMENT SPENDING
LM
G T = S(Y ) I(i )
26
Putting the IS and the LM Relations
Together
The effect of an increase in GOVERNMENT SPENDING
27
Putting the IS and the LM Relations
Together
The effect of an increase in GOVERNMENT SPENDING
Business Economics and Organization prof. Francesco Venuti
in TAXES
Equilibrium in the goods market
implies that an increase in the
interest rate leads to a
decrease in output. This is
represented by the IS curve.
Equilibrium in financial markets
implies that an increase in
output leads to an increase in
the interest rate. This is
represented by the LM curve.
Only at point A, which is on
both curves, are both goods
and financial markets in
equilibrium.
28
Putting the IS and the LM Relations
Together
Monetary Policy, Activity, and the Interest Rate
Monetary policy does not affect the IS curve, only the LM curve.
For example, an increase in the money supply shifts the LM
curve down.
Interest rate i
right .
LM
2. Which
reduces the rate
of interest...
LM
3. And
increases output
by stimulating
investment.
i1
i2
IS
Y1 Y2 Income, Output Y
Business Economics and Organization prof. Francesco Venuti 58
29
Using a Policy Mix
30
Using a Policy Mix
Income Y
Hence the idea of a policy mix
31
The Central Banks response to G > 0
1. hold M constant
2. hold r constant
3. hold Y constant
If Congress raises G,
the IS curve shifts i
right LM1
If CB holds M
constant, then LM
curve doesnt shift. i2
i1
Results:
IS2
Y = Y 2 Y1 IS1
Y
Y1 Y2
Business Economics and Organization prof. Francesco Venuti 64
32
The Central Banks response to G > 0
If Congress raises G,
the IS curve shifts i LM1
right
LM2
To keep r constant,
CB increases M to i2
shift LM curve right. i1
Results: IS2
Y = Y 3 Y1 IS1
i = 0 Y1 Y2 Y3
Y
33
Using a Policy Mix
Income Y
Hence the idea of a policy mix
Budget surplus (% of GDP) 3.3 4.5 3.8 2.7 2.4 1.4 0.3 0.8
(minus sign = deficit)
GDP growth (%) 0.9 2.7 2.3 3.4 2.0 2.7 3.9 3.7
Interest rate (%) 7.3 5.5 3.7 3.3 5.0 5.6 5.2 4.8
34
The Clinton-Greenspan Policy Mix
Y2 Y1 Income, Output Y
Business Economics and Organization prof. Francesco Venuti 69
German reunification
35
German reunification
Y1 Y2 Income, Output Y
Liquidity trap
If increases in the money supply
fail to lower interest rates,
monetary policy is ineffective in increasing output.
36
CURRENT LIQUIDITY TRAP?
Y2 Y1 Income, Output Y
37
The U.S. Recession of 2001
Business Economics and Organization prof. Francesco Venuti
38
The U.S. Recession of 2001
Business Economics and Organization prof. Francesco Venuti
39
Business Economics and Organization prof. Francesco Venuti Other Theories
EXERCISE:
Analyze shocks with the IS-LM model
40
What is the Feds policy instrument?
41
The Great Depression
240 30
Unemployment
Business Economics and Organization prof. Francesco Venuti
(right scale)
220 25
billions of 1958 dollars
180 15
160 10
Real GNP
140 (left scale) 5
120 0
1929 1931 1933 1935 1937 1939
Business Economics and Organization prof. Francesco Venuti 83
42
The Spending Hypothesis:
Reasons for the IS shift
Drop in investment
correction after overbuilding in the 1920s
widespread bank failures made it harder to obtain financing for
investment
Contractionary fiscal policy
in the face of falling tax revenues and increasing deficits,
politicians raised tax rates and cut spending
43
The Money Hypothesis Again:
The Effects of Falling Prices
Pigou effect:
P (M/P )
consumers wealth
C
IS shifts right
Y
44
The Money Hypothesis Again:
The Effects of Falling Prices
Business Economics and Organization prof. Francesco Venuti
I because I = I (r )
planned expenditure & agg. demand
income & output
45
Some exercises and revision (1)
4.000.
Derive the LM equation and discuss the level of the interest rate
when income is 400.000.
What happens in the money market if income increase to 500.000?
Why? Explain detailed both with words and with algebra.
46
Some exercises and revision (3)
TR = 20.000 G = 80.000
I = 100.000 4.000i
47
The IS-LM model
in the OPEN ECONOMY
48
Openness in Goods and Financial Markets
49
Openness in Goods Markets
Exports and Imports
50
Openness in Goods Markets
Exports and Imports
Ratios of Exports to GDP for Selected OECD Countries, 2006
Country Export Ratio (%) Country Export Ratio (%)
Business Economics and Organization prof. Francesco Venuti
51
Openness in Goods Markets
The Choice between Domestic Goods and Foreign Goods
52
Openness in Goods Markets
Nominal Exchange Rates
53
Openness in Goods Markets
From Nominal to Real Exchange Rates
BUT
if we are interested in the choice
Business Economics and Organization prof. Francesco Venuti
54
Openness in Goods Markets
From Nominal to Real Exchange Rates
The Construction of the Real Exchange Rate
Business Economics and Organization prof. Francesco Venuti
EP
=
P*
55
Business Economics and Organization prof. Francesco Venuti
56
Openness in Financial Markets
The Balance of Payments
Table 18-3 The U.S. Balance of Payments, 2006 (in billions of U.S. dollars)
Current Account
Business Economics and Organization prof. Francesco Venuti
Exports 1,436
Imports 2,200
Trade balance (deficit = ) (1) -763
Investment income received 620
Investment income paid 629
Net investment income (2) -9
Net transfers received (3) -84
Current account balance (deficit = -) (1) + (2) + (3) -856
Capital Account
Increase in foreign holdings of U.S. assets (4) 1,764
Increase in U.S. holdings of foreign assets (5) 1,049
Capital account balance (deficit = -) (4) (5) 715
Statistical discrepancy 141
57
Openness in Financial Markets
The Balance of Payments
The Current Account
The sum of net payments in the current
Business Economics and Organization prof. Francesco Venuti
transactions.
58
Openness in Financial Markets
The Choice between Domestic and Foreign Assets
Figure 18 - 6
Expected Returns from
Holding One-Year U.S.
Bonds or One-Year U.K.
Bonds
1
(1 + i ) = ( E )(1 + i )
*
t t t e
E t +1
E
(1 + i ) = (1 + i )
*
t t e
E t +1
59
Openness in Financial Markets
The Choice between Domestic and Foreign Assets
It ignores risk.
60
Openness in Financial Markets
Interest Rates and Exchange Rates
(1 + i ) *
(1 + i ) = t
[1 + ( E E ) / E )]
t e
t +1 t t
E
e
i i E
*
t +1 t
t t
E t
E
e
i i E
*
Business Economics and Organization prof. Francesco Venuti
t +1 t
t t
E t
E =E i = i
e *
If t +1 t then t t
61
Openness in Financial Markets
Interest Rates and Exchange Rates
62
The IS Relation in an Open Economy
63
The IS Relation in an Open Economy
The Determinants of Imports
IM = IM (Y , )
Business Economics and Organization prof. Francesco Venuti
( + ,+ )
X = X (Y * , )
( + , )
64
Depreciation, the Trade Balance and Output
Depreciation and the Trade Balance:
The MarshallLerner Condition
NX = X (Y , ) IM (Y , ) /
Business Economics and Organization prof. Francesco Venuti
Exports, X, increase.
65
Depreciation, the Trade Balance, and Output
The Effects of a Depreciation
Business Economics and Organization prof. Francesco Venuti
66
Business Economics and Organization prof. Francesco Venuti Looking at Dynamics: The J-Curve
The J-Curve
A real depreciation leads
initially to a deterioration and
then to an improvement of the
trade balance.
Y = C + I + G IM / + X
Subtract C + T from both sides and use the fact that
private saving is given by S = Y C T to get
S = I + G T IM / + X
Use the definition of net exports, NX X IM / , and
reorganize, to get:
NX = S + (T G ) I
Business Economics and Organization prof. Francesco Venuti 134
67
Saving, Investment, and the Trade Balance
NX = S + (T G ) I
From the equation above, we conclude:
Business Economics and Organization prof. Francesco Venuti
68
The U.S. Trade Deficit: Origins and Implications
Business Economics and Organization prof. Francesco Venuti
Figure 1 U.S. Net Saving and Net Investment since 1996 (percent of GDP)
69
Output, the Interest Rate and the Exchange
Rate
Y = C (Y T ) + I (Y , r ) + G IM (Y , ) / + X (Y , )
*
( + ) ( + , ) ( + ,+ ) ( + , )
NX (Y , Y , ) X (Y , ) IM (Y , ) /
* *
Y = C (Y T ) + I (Y , r ) + G + NX (Y , Y , ) *
( + ) ( + , ) ( + )
70
Equilibrium in the Goods Market
71
PRICE and EXPECTATION
W = P e F ( u, z )
P = (1 + )W
72
PRICE and EXPECTATION
P = P e (1 + ) F (u, z )
Business Economics and Organization prof. Francesco Venuti
U L N N Y
u= = = 1 = 1
Business Economics and Organization prof. Francesco Venuti
L L L L
73
PRICE and EXPECTATION
Y
P = P e (1 + ) F 1 , z
L
74
PRICE and EXPECTATION
Aggregate Supply
Business Economics and Organization prof. Francesco Venuti
75
Aggregate Supply
Aggregate Supply
Lets summarize:
This means that for a given expected price level, the price
level is an increasing function of the level of output. It is
represented by an upward-sloping curve, called the
aggregate supply curve.
76