Welcome to the second lecture of our couse in Macroeconomics.

Today we will cover three topics that help us to settle

the basis for a better understanding of the evolution of

GDP both in the long and in the short run.

The first topic is focused on the relationship between savings and investment decisions.

In this topic, we will see how the financial system

connect lenders and borrowers or, in other words,

those who save (in this lecture, mainly the public and the private sector)

and those who invest (mainly firms and households).

We will also see how this interaction can be understood

assuming a market for loanable funds which determines the equilibrium

level of savings, investment and interest rate.

The second topic is an introductory analysis of labour markets and unemployment.

Within the complexity that characterizes unemployment,

we will distinguish a long run component and a short run component

and we will see how the latter -also called cyclical unemployment

- is closely related with the fluctuations in GDP.

The third topic introduces the

<span id="w0" class="word-text">Consumer Price Index (CPI)  </span>that, together with the GDP
deflator,

is one of the main tools to measure inflation.

We will understand the main steps to compute a simplified version

<span id="w0" class="word-text">of the CPI and</span> how to use the CPI (or eventually another price
index)

to compare nominal and real variables across time.

It is now time we start with the first of the topics: savings

and investments.

The first part of this lecture covers the relationship between

two variables that are crucial to understand growth in the

long run: savings and investment. In the previous lecture, we

have seen that capital stock is an important determinant of

productivity and income per capita

and that the flow of physical investment accumulates in the

stock of physical capital. Hence, the determinants of investment

are crucial to understand the variability of incomes

and standards of living across countries.

One way to start the analysis of savings and investment is

to use our framework of the National Accounts with the four

sectors mentioned in Unit One: households, firms,

public sector, and foreign sector. We will assume for now that we are

in a closed economy. A country with a closed economy is a country

that has no economic transaction with any other country;

in this context exports and imports are zero

and we can simplify the model to have only households,

firms and the public sector. We will relax this assumption in Unit

four, where we will introduce explicitly in our model the capital

flows between the interior sector and the foreign sector.

If we put together firms and households we get what we call

the private sector. And the other sector of interior economy is the public sector.

Given that we have only the private sector and the public sector,

total national savings must be originated in either of these sectors.

To understand how total savings are defined we introduce

here three new variables: first, taxes, denominated by capital t (T)

which is equal to the total amount of resources that the sector,

that the public sector gets from the private sector.

Second, disposable income denominated by capital y sub d (Yd).

And third, private savings, denominated by capital s sub

pr (Spr). The disposable income of the private sector is equal to

the total income of the economy (Y) minus taxes (T).

This disposable income is used either to consume or to save.

So, private savings are equal to total income minus taxes minus

consumption. Given that we are working in the context of national

accounts, the variables income and consumption are the same

that we have defined in Unit One. Hence, some variables used

to define "private savings" are the same variables that we use in

our analysis of national accounts. The private sector saves

that part of the total income that is neither used to pay taxes

nor consumed. Let's now consider the public sector.

We define a new variable called Public Savings denominated by capital

s sub pu (Spu). The revenue of the government is equal

to the taxes it collects from the private sector

(T) and these resources are used either to purchase goods

and services (G) or to save. So, public savings are equal

to taxes minus the government purchases of goods and services.

From the previous slides, we have said that national savings

come from either the public or the private sector (remember that we are assuming

a closed economy). Hence, we can define national

savings as the sum of private and public savings.

On the one hand, private savings are equal to national income

minus taxes minus private consumption. On the other hand,

public savings are equal to taxes minus the public purchases

of goods and services. Combining the three expressions and simplifying

T we get that national savings are equal to national income

minus private consumption minus the public purchases of goods

and services. We can also remember from Lecture one that national

income is equal to private consumption plus investment plus

government purchases of goods and services

plus net exports. In a closed economy net exports are zero

and, therefore, investment is equal to national income

minus private consumption minus government purchases.

Combining the results we have that in a closed economy national

savings are equal to investment. The identity between savings and

investment in a closed economy says something quite important:

the expansion of the productive capacity of a economy

depends on the decisions of not consuming today

and producing goods that can be used to produce other goods

in the future (investment goods). In Unit four we will see that

in an open economy, investment can also be expanded with

the inflow of foreign investment. A last explanation in this video

is to answer a question: what if the amount that firms and households

want to invest is smaller than the amount that households and the

government want to save? The key to answer this question is in the

concepts of non-desired investment and the increase in inventories.

if households and the public sector want to increase savings, they

will consume less, firms will sell less and they will accumulate

large inventories that are considered non-desired investment.

Do you remember that in Unit one we have said that

all the production that is not sold is regarded investment?

So, the link between changes in consumption and changes in non-desired

investment is what makes the identity "S equals I"

to be always true. Next we are going to disentangle how markets

connect the savings of one particular agent with the investment

of another. This is done in what we call the market of loanable funds,

the topic of our next video.

In the previous video we have seen that in an economy as a whole

(assuming a closed economy) savings are equal to investment.

This is true in the aggregate but it does not need to be true for

each individual or firm. Some households can save and not make any

investment and some others can invest, for instance in a new house,

without having saved all the money in advance.

When firms and households invest, for instance buying machinery or new houses,

they usually rely in some way or another

on financial markets. The financial system is the set of firms,

markets and institutions that link investors (who want to borrow money)

to savers who want to lend money. The analysis of the financial system

can be very complicated because there are many available channels

and instruments through which savers and borrowers interact.

The most intuitive way to approach the financial system

is to think that lenders deposit their money into a bank

and the bank, as financial intermediary, lend the money to borrowers.

In reality, there are many other options

like the bonds market, the stock market and the mutual funds

but we will try to keep things simple at this stage.

A market for loanable funds is a way to summarize and simplify

all this complexity by assuming that there is only one market

in which lenders represent the supply and borrowers represent

the demand. The price in this case would be the interest rate.

This is the return that lenders receive from borrowers for

allowing them to use a monetary unit, say dollars, euros,

pesos, for a year. The interest rate is expressed as a percentage

of the amount borrowed, charge by a lender to a borrower for

using their savings for a period, typically, one year.

For instance, if you deposit one hundred euros into a bank

for a year at a ten percent interest rate,

you are paid ten euros (the ten percent of one hundred)

for lending the one hundred euros to the bank for one year.

In general we can think in two kinds of interest rates.

The first one is the real interest rate which is adjusted for

changes in prices over the length of the loan.

The second one is the nominal interest rate.

This is the interest rate used to compute the payments and

it is not adjusted for price changes. For instance,

if a bank offers to pay you back one hundred and ten

if you deposit one hundred euros for a year,

the nominal interest rate is ten percent.

But if the inflation is three percent, then the real interest rate

is approximately ten percent minus

the three percent increase in prices. This is to say

a seven percent. When thinking in the market for loanable funds,

we will kepp things simple by assuming that prices do not

change and therefore, real and nominal interest rates are going to be

the same. In the market for loanable funds the demand

comes from households and firms who wish to borrow to make an

investment. For instance, a household that is planning to buy a new house

borrows money using a mortgage. Another example is a firm expanding

its factory and borrowing money to buy new machinery.

Obviously, the amount of borrowers want to borrow depends on

how expensive is the loan. This is given by the interest rate:

the higher the interest rate, the larger the amount the borrower

must repay for the loan and the more expensive the loan is.

Hence, an increase in the interest rate discourages some borrowers

and the quantity demanded for loanable funds

decreases. For instance, if we graph the representation of this

market with the interest rate in the vertical axis and the

funds in the horizontal axis we can start with a situation

in which the interest rate is seven percent

and the amount that borrowers want to borrow

is thirty billion. And if the interest rate goes down to four

percent, more firms and households will be willing to borrow and

the amount that borrowers want to borrow may increase, for instance,

to eighty billion. This example captures the idea that the demand

for loanable funds is downward sloping. The supply of loanable

funds comes from people who have some extra income

and they want to save and lend out. For lenders, the interest rate

represents the difference between consuming today and consuming

in the future. If a lender deposits her money into a bank today,

reduces her consumption today with the goal of consuming more tomorrow.

The increase in consumption (tomorrow) will depend on the

interest rate: the higher the interest rate, the larger

the potential increasing consumption and, therefore, the larger

the incentive to save. For the public sector

a high interest rate would produce extra incentive to run a public

surplus rather than public deficit. Hence, an increase in the interest rate

expands the amount of resources that savers

are willing to deposit into the banks and the quantity supplied of loanable

funds increases. For instance, if interest rate is four percent, the amount

of loan that lenders are willing

to deposit maybe fifty billion. But, if the interest rate increases

up to a eight percent, the amount of loans that lenders are willing

to deposit may grow up to one hundred billions.

This is an example of why the supply of loanable funds is upwards sloping.

In this market for loanable funds the interest rate adjusts

for equilibrating supply and demand. In this sense, the interest rate

works in the same way that any other prize do you have

studied in microeconomics. As in microeconomics, we are particularly

interested in the equilibrium values of prices

(interest rate in this case) and quantities (of loanable funds).

Let's imagine that the interest rate is too high.

In this case, the supply of loanable funds is larger than the demand

and there is an excess of supply. As in other cases in microeconomics, if there is

an excess of supply, then the prize (the interest rate) decreases until the quantity

demanded is equal to the quantity supplied.

We can see that in equilibrium, savings are equal to investment

which is consistent with our analysis of these two variables

in the context of National Accounts system in a closed economy.

Our next objective is to show you how to do policy analysis

using the analysis of the market of loanable funds.

The analysis of savings and investment through the market for

loanable funds opens the possibility to discuss

how some exogenous changes affect the relevant variables in equilibrium.

For instance, what will happen if the government implements

a tax reform in which consumption is more heavily taxed

and savings are exempted? Or, what would be the impact of an

increase in public expenditure in goods and services (keeping

taxes unchanged)? If a change in the tax policy

increases households' incentives to save, private savings will increase

and national savings will increase. In the market for loanable funds,

the increase in national savings is represented as a shift

of the supply to the right. A comparative static analysis, like the one

conducted in microeconomic analysis,

shows that the increase in national savings entails a lower

equilibrium interest rate and a higher equilibrium level of savings and investment.

If we remember that the investments accumulate as capital stock,

which is one of the determinats of productivity, it seems that

this policy is highly recommendable. However, the implications

of the policy are not so simple: first, if savings are more

abundant among richer households (which does not seem implausible),

this policy will be regressive in the sense that the rich

will end up pain less taxes. Second,

more savings and less consumption is not always good

because consumption is a part of the demand of goods and

services produced by firms and if this demand is reduced,

there will be less incentives to produce... which is not good.

As almost always in macroeconomics, economic interventions can

have both positive and negative effects and a lot of caution is

needed before to recommend a policy. An increase in the government

expenditure in goods and services produces in general many and

diverse effects, but we can use the market for loanable funds

to assess what would be the impact on investment

an interest rate. We already know that an increase in the purchases

of goods and services by the public sector expands the public deficit.

We can alternatively say that it reduces public savings.

And therefore, ceteris paribus, it reduces national savings.

This reduction can be formalized as a reduction of the supply

of loanable funds. This means a shift of the supply curve

to the left. In the new equilibrium, interest rate will be higher

with a smaller level of savings and investment.

Abstracting from the other effects that the increasing government

spending can have, the expansion of the public deficit leads to

a reduction of investment. This means smaller capital stock

and lower productivity in the long run. Summarizing the

analysis of the relationship between savings, investment and

capital accumulation, we can emphasize that in a closed economy,

national savings equal investment.

The market of loanable funds schematically describes

the interaction between borrowers (the demand side of the market)

and lenders (the supply side) through the financial system.

The result of this interaction is an equilibrium level of interest rate

and investment. Finally, the market for loanable funds helps

to understand how different policy alternatives

affect investment and capital accumulation in the long run.

In the first lecture of this course we have seen that the level

of economic activity in a country is closely associated to its

average standards of living. One of the main channels through which

this connection is established is in the labour market.

High productivity countries have more productive workers

that naturally receive higher wages. High wages are very powerful

determinants of higher average household incomes.

Given that a detailed and complete analysis of the labour market

is complicated, in this video we will present an introduction.

We will focus on the meaning of the main statistics of the labour

market and on the relationship between the evolution of unemployment

rate and the fluctuations of other macroeconomic

variables like the GDP. The main statistics of the labour market

are usually elaborated by the statistics offices

in each country. The Bureau of Labour Statistics in the

US, and, in the case of Spain the Instituto Nacional de Estadística.

In most of the countries, the main information

source is a representative household survey and therefore the

indicators are based on the voluntary answers of the members

of the household. According to these answers

adult individuals are classified either as employed,

unemployed or out of the labour force.

An individual is classified as employed if she or he was, at the

time of the interview, working as paid employee,

self-employed or unpaid worker in a family member's business.

Individuals are classified as unemployed if they were not employed,

were available to work and have been looking for a job during

a period of four weeks before the interview.

The third category, "out of the labour force",

includes all the individuals older are sixteen that are neither

employed nor unemployed. Basically, it incorporates those

who are neither working nor

looking for a job. Natural samples are students and retirees.

The labour force includes all those who are willing to work

either employed or unemployed. The graph shows the size of these

three groups in Spain in the first quarter of 2017.

Employed people were more than eighteen million

while unemployed were more than four point two million.

The category "not in the labour force" included almost

twenty four million individuals. The Instituto Nacional de Estadística

restricts the analysis of the labour situation

to all the population older than sixteen

given that this is the legal limit to participate in the labour force.

Another way of looking at the problem of unemployment

is focusing on gender differences in the labour market outcomes.

This graph shows the same three categories (employed,

unemployed and not in the labour force)

as percentages of the total population older than sixteen.

We can see that the share of women not been part of the labour force

(the white blue in the bottom of each column)

is larger than the share of men in the same situation;

this is probably related with the traditional role of women

in the labour market and their engagement in home production.

With the information in the three categories mentioned before

we can calculate the most important variable of the labour force:

the unemployment rate. The unemployment rate is equal to the

number of unemployed divided by the sum of the employed

and the unemployed. This ratio represents the share of the

labour force that is unemployed. It is also possible to

calculate the labour force participation rate.

This is the ratio between the labour force

(employed plus unemployed) and the adult population.

This ratio represents the share of the population that is actively

participating in the labour market. Unemployment rates vary a lot

all across countries. In 2016 Spain was one of

the countries with the highest level of unemployment

(close to twenty percent) while some other developed countries

like the US and Germany have unemployment rates below five

percent. On the other hand developing countries like Argentina

have quite low unemployment rates while other developing countries

like South Africa exceed twentyfive percent of unemployment.

Unemployment is such an important issue in modern economies that deserve

a detailed analysis. This is our next topic.

It is probably not unfair to say that the labour market statistics

are cold numbers. Many different personal stories

and situations are hidden behind those indicators.

Some individuals are unemployed because they voluntarily quitted

from a job with the idea of getting a better position

while others have been fired; some of them have been unemployed for

a long spell while others have been unemployed for only a few weeks.

To understand how large is the room for policy interventions

in the labor market, it is important to distinguish two categories

within this large variability.

The first one is the long run unemployment associated to what

economists call the "natural" rate of unemployment.

Even in a very good economic situation reducing unemployment to

zero is practically impossible; there will always be some portion of

the population looking for a job. For instance, recent graduates,

people who were just fired or people that just moved to a new city.

Quite often, this people have not had time to start looking for

a job yet. All of them will be classified as unemployed.

The idea of the natural rate of unemployment captured these fact;

it is defined as the normal rate of unemployment around which

the actual unemployment rate fluctuates.

Changes in these rate are small and rare and its level (close to five

percent in most of the countries) is pretty stable.

The other component of unemployment, called cyclical unemployment,

is characterized by short run fluctuations around the natural rate.

This component is closely associated to the overall economic situation

and perspectives; its fluctuations are mainly

generated by the changes in the demand for workers by firms:

when the economic situation is particularly good,

many firms want to expand their production

and therefore they hire more workers; in these periods this component

of unemployment is particularly low. The existence of a cyclical

component of unemployment is relatively easy to see by looking

at the evolution of the labour market in the US and Spain after

the recession of 2008.

These countries had different pre-crisis levels of unemployment

in the years 2004 to 2007

but both experience a clear increase in this variable

between 2008 and 2010.

The economic crisis in Spain was more acute and longer but in both

countries unemployment started to decrease as long as the economic

situation improved. The cyclical component is important in our

analysis because it is the part of unemployment that can be affected

by policies related to the level of economic activity in the

short run. Let's imagine that the government or central banks

can influence the level of GDP in the short run

(a topic that we will discuss in the last lecture of this course).

If this is the case, inducing a higher level of GDP will

have the side-effect (a very important side-effect indeed)

of reducing unemployment.

What is inflation and what are its causes and consequences are among

the most important topics in macroeconomics.

In the next lecture, we will introduce the monetary system

and the causes of inflation explicitly in our analysis;

in this unit, we will start by understanding how inflation is measured

with the Consumer Price Index.

To understand the definition and the measurement of inflation it is useful

to start by recalling what is the growth rate of a variable.

The growth rate of any variable is the percentage change of that

variable in a given period. To calculate a growth rate we

use the change of the variable between a period t and period t plus one
in the numerator and the initial value in period t in the

denominator. For instance, the growth rate of GDP between

2015 and 2016 is given by the GDP

in 2016 minus the GDP in 2015

divided all by the GDP in 2015.

In the previous lecture we have implicitly seen

this concept by stating that the evolution of the growth rate

of the GDP deflator is a measure of the changes in prices of

domestically produced goods. The definition of growth rates

and its formula are important because the inflation rate is the

increase in the overall level of prices in the economy

and it is measured as the growth rate of a price index.

This price index can be the GDP deflator we have defined the

previous unit or the Consumer Price Index, that is our next topic.

The Consumer Price Index measures the overall cost of a

basket of goods bought by a typical family.

Its main purpose is to evaluate how the change in prices affect

the cost of leaving of that family. The first step to calculate

the Consumer Price Index, the CPI, is the definition of a "representative" basket.

This is based on surveys of families that provide information

on their consumption of goods and services.

With this information, the quantity of each good consumed by

a typical family are defined. These surveys are collected every

several years and therefore the basket remains the same for

quite long periods. In Spain, the relative importance of the different

kind of goods in the basket of the CPI

(Índice de precios al consumo in Spanish) have been recently updated

with a survey from 2016. This survey revealed

that the group of goods of food and beverages account for twenty
percent of the total expenditure of a typical family.

Other important groups are transportation, with thirteen percent,

and spending and hotels, cafés and restaurants, which is

the twelve percent of the total expenditure.

The second step is collecting information, in a representative

sample of shops, on prices of each of the goods in the basket.

The information on prices is collected

usually every month. Once we have prices and quantities,

the cost of the basket can be calculated by multiplying the quantity

of each good by its price. The fourth step is computing the index.

For doing so, we need to define a base year and then dividing

the cost of the basket in any year for the cost of the basket

in the base year. The fifth and last step is to calculate the

inflation rate by computing the growth rate of the CPI in the

way described at the beginning of this lecture.

Let's see an example to make this process more concrete.

The first step would be to define the basket of goods.

Let's assume that after the consumers' surveys we confirm that families

consume a very simple basket. Only five sandwiches and ten lemonades.

The second step would be to collect the prices of these two goods

in a representative sample of shops. Assuming yearly data,

let's say that in 2014, the average price of sandwiches

is twenty dollars and the average price of lemonade is

five dollars. In 2015, the respective prices

are twenty five and five point five and in 2016

there are thirty and six. The third step is to compute

the cost of the basket for each year: one hundred and fifty

in 2014, one eighty in 2015

and two hundred and ten in 2016.

The fourth step is to compute the Consumer Price Index.

Remember that the Consumer Price Index is the value of the basket in

each year divided by the value of the basket in the base year.

If the base year is 2014, the CPI

in 2014 will be equal to

a hundred and in 2015, one hundred and twenty,

and finally, in 2016, one hundred and forty.

The last step, the calculation of the inflation rates, is based

on our definition of inflation and our definition of growth rates.

We will measure inflation as the growth rate of the CPI,

that is, twenty percent between 2014

and 2015 and sixteen point seven percent between

2015 and 2016.

Obviously, in reality the computations are more

complex because we have many more goods,

but otherwise the procedure is the same. It is just computing

how the cost of the basket of goods changes along time.

In economics, we usually differentiate between nominal and real variables.

This is important to answer questions like...

Are the standards of living improving with time?

Did our grandfathers earn in their first job more or less than we do?

A nominal variable is a variable that has not been adjusted

for changes in prices over time, while real variables are adjusted for such changes.

If we observe that the nominal variable (like wages)

is higher today than what it was ten or fifteen years ago,

we are not sure if the purchasing power of wages increased

because it may be the case that prices increase even more than

the nominal wages. For instance, if the wage of a worker in Spain

increased at twenty five percent between 2001

and 2016 but prices also increase in that period,

we do not know if the quantity of goods and services that the

worker is able to buy has increased or not.

For comparing the purchasing power of wages across time

we need to transform the nominal wage into the real wage by

using a price index like the CPI. For instance, if we want to put

wages of 2001 in euros of 2016

we can use the following formula: the real wage of 2001

expressed in euros of 2016 is obtained

multiplying the nominal wage of 2001

by the price index in 2016 and dividing

by the price index of 2001.

Let's imagine that the Spanish price index in 2001

was one hundred and in 2016 was

one hundred and thirty six. Suppose also that the nominal wage

in 2001 was two thousand euros.

Applying the formula, we can get the real wage of 2001

in 2016 euros. So, the purchasing power of wages

in 2001 was equivalent to two thousand seven hundred

and twenty euros in 2016.

If the nominal wage in 2016 was

two thousand five hundred (an increase of twenty five percent)

the purchasing power in 2016 is lower than in 2001.

Two last points about the transformation of nominal variables

into real variables.

First, when we want to compare variables across time,

we want to exclude the kind of illusion that inflation produces:

an increase in nominal variables is not very informative if prices are also

increasing. So, most of the time, economic analysis

is based on real variables. Second, given that there are several price

indexes (the CPI and the GDP deflator are the most prominent examples)

the transformation of nominal

into real variables should be obtained with the "right" index.

Right, in this case, means that the basket that it is used

in the elaboration of the index should be similar to the goods

that are implicitly related to the nominal variable:

for instance, for nominal wages the CPI is the

adequate index. For variables from the national accounts, like

the GDP, a good choice is the GDP deflator. But, if you want to analyze

a variable like imports, then a specific price index elaborated

with a basket of imported goods will be preferable.

The distinction between nominal and real magnitudes is a powerful

tool that you will require for the analysis of the evolution

of any economic variable across time.

In this lecture, we have discussed three topics that are

important building blocks of our explanation of economic growth in the long run

and economic fluctuations in the short run. In the first part of the lecture,

we have seen that, in closed economy, investment equals private

plus public savings. Additionaly, we have presented the relationship

between savings and investment through the model of a market for loanable funds.

This model helps us to understand how some policy changes

in relation to taxes or public spending can affect savings,

investment, capital accumulation and growth in the long run.

In the second part, we have presented the main vartiables of the labour market

and analized the different dimensions of one of the crucial variables

in macroeconomics: unemployment. We have tried to simplify

a very complex phenomenon and discriminate between the long run component

of unemployment (the natural rate) and the short run component (the cyclical part).
We have also confirmed that the short run component is tightly

connected with the GDP fluctuations. The higher the growth rate of GDP, the larger

the reduction in unemployment. In the third part,

we have complemented our knowledge of the GDP deflator with the introduction

of another price index: the Consumer Price Index,

the CPI. The CPI is an alternative variable to measure inflation

and to transform nominal variables into real variables.

In the next lecture, we wll see how money and the financial system work,

what are the central banks, how money is created and what is the relationship

between the quantity of money and the price level.

In this part of the lecture we will introduce some basic definitions

associated to the concept of money and a characterization of

different kinds of money used in the past.

We will also discuss some features of money in contemporary

economies. We will start our basic definitions with the concept of

an asset. An asset is any form of wealth: from real estate to financial

assets, from valuable paintings to jewellery, from cars to cash.

The second important concept is money. We will define money as the

assets that can be easily used to buy goods and services.

In principle, in contemporary economies we rapidly identify

money with banknotes and coins. Even though the main intuition

of this identification is correct, we will see that money is

more complicated that it would seem. The third important crucial

concept is the one of liquidity. Liquidity is the facility with

which an asset is converted into cash, this is banknotes and coins.

An asset is liquid if it can be converted into cash without a large

to loss of value. For instance, a banknote is extremely liquid because

it is already cash. The balance in a savings accounts are almost as liquid as

a banknote because it is possible to pay with a debit

card in most of the shops or, eventually,

to use it in an cashpoint. But the house or a very rare

and valuable piece of jewellery is not very liquid because it

takes a lot of time and effort to transform it into cash.

We have already defined money as those assets that can be easily

used to buy goods and services. As we will see, many kinds of objects

have been generally accepted for exchange in human history.

Despite this variety, there are three main roles that money

has in a modern exchange economy. First, and related with its

definition, money is a medium of exchange. A medium of exchanged is

kind of asset that people accept with the purpose of using it

in future transactions. So, a medium of exchange must be

generally accepted for trading. Eventually, you can exchange a house

for three cars, or car ride for some quantity of gasoline.

But, neither a house nor car nor gasoline are generally accepted for buying

goods and services. So, they are not mediums of exchange.

Money is also a store of value. Given that transactions

are not simultaneous, durability is a necessary characteristic

of a medium of exchange. When the value of an asset

in the future is not certain, people are reluctant to accept that

asset when selling goods and services. This is why perishable

goods, like an ice-cream, can never be used as medium of exchange.

And this is why, historically, hard materials,

like precious metals, have been used to produce money.

Finally, money is also a unit of account.

It means that all the prices are defined in terms of the monetary

unit. In many countries in Europe all the prices are defined in

euros while in the US they are denominated in dollars.

An interesting example of the role of money as unit of account

is related with the transition in 1999 from

the 'peseta' to the euro in Spain. Immediately after the transition,

some money users, mostly old people, defined all the prices in 'pesetas'

even though the euro was already the official currency.

For them, the 'peseta' was stil the unit of account

but they used the euros as a medium of exchange.

Eventually, with time, everybody got used to the euro and the

'peseta' ceased to be the unit of account. When we think about ancient money,

the reference to gold and silver coins is obvious.

For centuries people thought of money very naturally in terms

of precious metals; this kind of money is called commodity money:

coins had intrinsic value because of their content of gold and

silver but they also have a value because they were a medium

of exchange. In some historical situations

people preferred to melt the coins and use the precious metals

for other uses but, most of the time, they used the coins as money.

The silver coin in the pictures comes from the North of Africa around the

9th century BC. The gold coin is a Persian coin from around

the 5th century BC. More recently, basically in the 19th century

and the first half of the 20th centuries,

most of the money was what we call the commodity-backed money;

commodity backed moneys were composed mainly of banknotes but

that these those were explicitly backed by precious metals stored

in the vault of a bank. The picture shows a one hundred dollars

banknote of 1928 in which the gold certificate explicitly

guarantees that there was a deposit of gold to back the banknote.

However, today, if you look carefully to the banknotes in Europe

or USA you will not find any reference to precious metals.

In fact, they are not backed by precious metals whatsoever.

There is no institution that guarantees that you will receive

some intrinsically valuable thing in exchange for your banknotes.

Then, the question is… Why these pieces of paper are valuable

but these ones are not? The answer is simple: they are valuable

because everybody thinks so. Every person is willing to accept

a dollar or a euro in exchange of good only because she knows

that she can buy another good in exchange of the banknote.

Trust is nowadays the most important basis for the value of

money. This is why our money is called fiduciary money,

from Latin 'fiducia' which means trust,

confidence, reliance. This fiduciary money is also called fiat

money and it has some legal support in the sense that it is considered

'legal tender'. It means that it is valid for meeting

any financial obligation. If you must honour a debt, you can always

use official currency to do so. This characteristic of legal

tender, which is true for most of the currencies worldwide, is

made explicit in current dollars. However, nothing

and nobody guarantees the value of a currency for present and future

transactions. For instance, the periods of rapid increases in prices

in Germany in the 1920s reduced systematically

the value of the German Mark; in those years more and more marks

were needed to buy the same amount of goods and services.

Banknotes of 50 millions of marks were printed.

The value of the mark in terms of gold declined dramatically.

Or what is the same, the price of gold in marks increased enormously.

And not only gold, but any good in the economy.

This process, called hyperinflation, can eventually happen in

any country if the monetary authorities do not act responsibly.

In such cases, those individuals keeping a large quantity

of cash can experience a large loss of value.

Banknotes can lose their functions as store of value and medium

of exchange… German children in the hyperinflation period played

using packs of banknotes as bricks. Hyperinflation is destructive

for an economy as people lose confidence in money, and then

money loses its role. Luckily it a rare phenomenon in modern economies.

To understand how the monetary system works it is convenient

to introduce a refinement in our basic macroeconomic model.

First, we introduce a central bank, which is a crucial actor in

the monetary and financial system. The central bank has several

different and important roles in the economy; however, for now,

we will emphasize that it is the responsible to create the bank notes

and coins that circulate in a monetary area.

Then, we introduce commercial banks. They are like the firms in our

basic macroeconomic models but they are a very specific firms,

type of firms. We will assume that they are the only financial intermediaries

in the economy. In this sense, their role will be to receive deposits

from savers and lend some money to those who want to invest

or consume. As we will see, commercial banks play a crucial

role in the monetary system. All the other firms, together with the

households and the government, are "the public"

who, basically, use the currency created by the central bank

and demand financial services, like the use of bank accounts,

from the commercial banks. So, remember, when we analyse the monetary and

financial system, we have: the central bank,

the commercial banks and the public. Commercial banks play a

crucial role in the contemporary monetary system.

An important part of the profits of the banks comes from the

fact that they borrow money at a low interest rate and lend
money at a higher interest rate. In practice, if you deposit some

money into a bank account (like a current account or a savings account)

you receive a lower interest rate than what you must pay

if you borrow some money from the same bank.

And where does the money that the bank lends come from?

Basically, the bank lends the money that some of their clients

lends to the bank through deposits. In other words,

the money that is deposited into a bank is not fully preserved

in the vaults of the bank and a share of it is lent to another client.

This is the base of the process of money multiplication.

Let's introduce a simple example to understand it.

We can think that in the first step, a depositor adds

1000 euros to her account. This is deposit 1.

From that money the bank keeps some reserves, let's say

100 euros in its vault. These reserves have to be available

in case some depositors want to make withdrawals.

The other 900 euros are lent to another client.

And something very important happens here:

the total amount of mediums of exchange climbs to

1900. This is because the first client

can use up to 1000 euros with her debit card from her

bank deposit while the second client can use up to 900

euros in cash that she now ownes.

Let's assume that the second client also deposits her money

into the bank. This is deposit 2. The bank again reserves 10 %

(90 euros) into the vault and lends the other 90 %

(810 euros) to a third client.

The total amount of medium of exchange continues increasing:

now the total amount of mediums of exchange would be: 1000,

plus 900, plus 810. In total,

2.710 euros. This process can keep going and going with many

deposits and many loans. At the end, after many, many transactions,

when the process is infinitely long, the total amount of medium

of exchanges would be 10.000 euros.

This number arises from the mathematical property of some sums

of infinite series and it is equal to the total currency

at the beginning (1000 euros) multiplied by one

over the share of each deposit that the commercial banks

keeps as reserves (10 % in our example).

These numbers in our example represent very important

variables in real-life macroeconomics. The initial 1000 euros

in our example is equivalent to the total currency issued

by the central bank; it is the sum of the value of all the banknotes

and coins in an economy. In macroeconomics, this is called

the monetary base; in our example, all the monetary based ends up

being kept by banks as reserves. The reciprocal of the reserve

ratio is called the money multiplier.

In our example, the reserve ratio is one-tenth and the money

multiplier is, then, ten.

This number is crucial in monetary economics:

the money multiplier shows how many euros are created by

commercial banks per each euro issued by the central bank.

The total amount of mediums of exchange is called the money

supply. This is the total amount of money created by the financial

system. A part of it is created by the central bank, another

part is created by commercial banks through money multiplication.

Okay, this sounds like a very complex process. So, let's take a

break and after the break let's summarize the main concepts
that we have introduced implicitly.

As we have already explained, central banks are probably the

most important institution in a monetary system.

They are responsible for overseeing the banking system and regulating

the quantity of money available in a monetary area.

The central bank of the United States, the Federal Reserve, is

a mix of a public and private institution.

The central bank of the Euro Area, the European Central Bank,

is a public institution. In general, there is a central bank related

to a particular currency in each country. However, in Europe we have

a very special, and interesting, case

where there is one central bank for many countries.

This is because these countries share the same currency, the euro,

and therefore there is only one monetary policy for all of them.

One of the main roles of a central bank is to regulate the banking

system. All the central banks have authority over commercial banks:

they are entitled to impose some restrictions

on the functioning of commercial banks to guarantee some degree

of fairness, transparency and stability. Related to this role,

central banks have a responsibility of being the lender of

last resort. In a previous video we have started to understand

why a lender of last resort is so important. The fractional-reserve

banking system introduces a potential fragility in commercial

banks. If many clients start to convert their deposits into cash,

the bank can face liquidity problems and, eventually, if the

situation is very acute, go bankrupt. If one bank

loses its credibility, other banks can eventually face similar problems

and generate a domino effect. This fragility of commercial banks

can be greatly reduced if there is an institution

providing enough short and medium term credit to commercial

banks when they face liquidity problems.

This institutional role is called the lender of last resort

and it is the responsibility of central banks.

If a commercial bank has liquidity problems, it can borrow money

from the central bank. The central bank lends money to commercial

banks but it does not lend money directly to the public.

The price of a loan from the central bank to commercial banks

is a very specific interest rate called the discount rate.

We will see that the discount rate is a very important variable managed

by central banks to implement monetary policies.

We shall stop at this point and continue in the next video with

the study of the role of monetary control

of a central bank.

We are going to continue with the study of the role of central banks,

now it is the turn of monetary control.

To this aim, we shall describe the central bank's tools to control

the monetary supply. We have already discussed some characteristics

of commercial banks, the nature of fractional-reserve

banking system and some of the rules of central banks.

We have also said that one of the responsibilities of a central

bank is to regulate the money supply. We will see later in this lecture

that when prices are too high, a recommended policy is

to reduce the money supply.

Or, when there is a danger of a recession, the recommended policy is

to expand the money supply. But the process of money creation

is controlled not only by the central bank but also by commercial

banks; hence, we need to understand what are the tools that the former does

have to change money supply. Usually three main tools of monetary

control are described: the first one is based on exchanging

government bonds and is called an open market operation;

the second one is based on the central bank lending money to

commercial banks and the third one is related with the legal

reserve requirements that the central bank imposes

to commercial banks. The first one consists in the implementation

of open market operations. Open market operations are based

on buying or selling government bonds, also called sovereign

bonds. So, to understand and open market operation, it is important

to describe what is a government bond and how the government borrows

money. When we analysed public savings in lecture 2, we have said

that, when taxes are not enough to pay the public purchase of goods

and services, the government borrows money.

In other words, if T is smaller than G, the government runs a deficit

ans it must borrow the money it needs. So, the public deficit of

a year, is equal to the amount of money that the government borrows

from other sectors of the economy.

What are the mechanisms that the public sector uses to borrow

money? The most usual is to sell government bonds.

A government bond is a debt certificates issued by the government.

These bonds are usually associated to medium or long-term debt.

For instance, this bond for the United States government was issued

in 1976 and has to be repaid in 1986.

So, it is a ten-years government bond.

There are government bonds with different maturities but, of course,

there are always less liquid than cash.

So, when the public sector wants to borrow some money it sells

bonds to households, firms and commercial banks.

In exchange, the government receives money that is

used to cover the deficit. Then, the public and commercial banks

have always some stock of government bonds.

And there is a secondary market for these bonds which are traded

very frequently. Hence, in any time, the central bank can trade government

bonds with the public or the commercial banks.

Now we may come back to the tools of monetary control and

the open market operations. Open market operations consist

in the central bank buying or selling sovereign bonds

from or to commercial banks or to the public.

Every time that the central bank buys government bonds to the

public or commercial banks, it is exchanging money for bonds.

It is giving a liquid asset to the public or commercial banks

(cash) and taking out a less liquid asset

(bond). After receiving the cash, the public increases the deposits

and the process of multiplication takes place;

the money supply increases. On the other direction, if the central

bank wants to reduce the money supply, it sells government bonds

to the public or commercial banks. To pay the bonds, they use

their cash or deposits and, therefore, the total reserves of

the commercial banks and the deposits are reduced

and the money supply shrinks. The second mechanism through which

the central bank changes the money supply is by lending money

to commercial banks. If the central bank lends some more money

to commercial banks, they expand their reserves,

have more room for lending money to the public and the process

of money multiplication is set in motion.

When commercial banks borrow money from the central bank, they

have to pay an interest rate called the discount rate.

This is a very specific interest rate charged by the central

bank to commercial banks. So, when the central bank

wants to lend more money to commercial banks, it reduces the

discount rate a and makes more profitable for commercial banks to

borrow money. With this extra money, commercial banks can increase

their reserves and therefore, expand the money supply.

When the central bank wants to reduce the money supply, it increases

the discount rate, induces the commercial banks to borrow less money

and reduces their reserves. The third one,

probably the less important today, is the adjustment of the legal

reserve requirements. One of the regulations that central banks

introduce in the banking system is a minimum share of reserves

for each deposited quantity of money. To reduce the money supply,

the central bank can increase the reserve requirements and induce

those commercial banks which are close to the legal minimum

to increase their reserve ratio. The increase in the reserve

ratio implies a reduction in the multiplier.

For a given level of reserves, a smaller multiplier implies a reduction

in the money supply. This mechanism is only rarely implemented

because, among others things, it is not very useful for increasing the

money supply. The legal reserve requirement is a legal minimum, so,

reducing this legal minimum does not necessary

imply that banks change your effective ratio.

They can still keep their old ratio and comply with the new minimum.

In lecture 2, we have defined inflation as an increase in a

price index. Now, we will present a theory of the main cause

of inflation. Why, in some periods, prices increases steadily?

Why, as we have already mentioned, in some countries there were

processes of extremely high inflation? We will see that the classical

theory of inflation emphasizes that one of the main reasons

of these processes, specifically in the long run,

is the growth in the money supply. The first thing we need to

do is to establish a relationship between the value of money

and the price level. If prices increase, it means that more

that more money is needed to buy the same quantity

of goods or, in other words, goods are more expensive in terms

of money. So, if P is a price index (like the CPI),

P is value of goods in terms of money.

More specifically, we can say that P is the average value (with

the corresponding weights) of the goods included in the basket

of the index in terms of money. Alternatively, 1 over P can

be thought as the value of money in terms of goods.

Every time that the prices index P increases,

1 over P decreases. Every time that goods become more expensive,

the value of money decreases.The determination of the value

of money can be analysed with a framework similar to the ones

we have used to analyse the value of all the other goods in

the economy: a market in which we have a demand

and a supply. We can graph both the money supply and the money demand

in a standard scheme of a market with the value of money

in the vertical axis and the quantity of money in the horizontal

axis. Remember that the value of money is 1 over P.

The money demand is given by the amount of wealth that the public

(households, non-financial firms and the public sector)

wants to hold in liquid form. This money demand depends mainly

on 3 variables: the price level (capital P), the interest rate (r)

and the total income of the economy (capital Y).

In topic 5 of this course we will discuss how the interest

rate and the total income of the economy affect the money demand.
So far, we will focus on the relationship between

the money demand and the price level. The price level affects the

quantity demanded of money because money is mainly a medium

of exchange. The public decides to hold their wealth in money instead

of other assets because money can be used

to buy goods and services. Hence, if prices increase,

the public will want to increase their money holdings to be able

to purchase the same quantity of goods and services.

Here, of course, we are assuming ceteris paribus, like in microeconomics.

So, in this reasoning , both the interest rate and the total

income are kept constant. Then, higher prices, ceteris paribus, imply

higher money demand. So, when P increases, the value of money decreases

and the quantity demanded of money increases.

So, the money demand in our graph has a negative slope.

Regarding the money supply, we already know that, in principle, it

is controlled by the central bank. We have already learned

that the process of expanding or contracting the money supply

is not so simple because the commercial banks also play a role.

However, just for simplicitly, we will assume by now

that the center bank fully controls the money supply and that it does not

depend on the price level. Hence, in our graph the

money supply will be a vertical line. So, we have a money supply

defined by the central bank and a money demand defined by the

public. The equilibrium defines the value of money in the economy

(1 over P) and therefore, also defines the price level P.

In the example, the central bank defines a money supply of

1000 and, given the money demand,

the value of money will be 2. Hence, given that the price level

is the inverse of the value of money, the price level will be

one half. What happens if the central bank decides to increase

the money supply? An increase in the money supply is represented

as a shift of the money supply curve to the right.

In this case, there is more money in circulation and the value of

money decreases. In our example, if the money supply increases

to 1400, the value of money in the new

equilibrium will decrease to one. In this case the price level

will be also one. Hence, the quantity of money in the economy

controlled by the central bank is the primary cause of changes

in the value of money, and therefore, of the price level in the

long run. This is the main lesson we learn from the classical

theory of inflation. Any increase in the money supply leads

to an increase in the price level in the long

run. This was the idea of the Noble Prize winner

Milton Friedman when he said that "inflation is always and everywhere

a monetary phenomenon". We will furthrer analyse the relationship

between the money supply and the price level and other macroeconomic

variables, in the next video.

We have seen in the previous videos that the central bank has

the responsibility of conducting the monetary policy which can

be summarized in expanding or contracting the money supply.

We have also learnt that a monetary expansion produces a

decrease in the value of money and an increase in the price

level. Now, we introduce the following question...

What is the effect of a monetary expansion in other important

macroeconomic variables like production and unemployment?

To understand the impact of the expansion of the money supply on

these variables it is necessary to come back to the distinction

between nominal variables and real variables.

In lecture 1 we have seen that there are two versions of

GDP: real and nominal. Real GDP is valued at constant prices while

nominal GDP is valued at current prices.

It means that changes in real GDP are representing changes

in quantities. The distinction between nominal variables and

real variables applies not only to the GDP. Indeed,

all the economic variables can be classified in nominal or real.

A nominal variable is a variable measured in monetary units

while a real variable is measured in physical units.

Although, in principle, agricultural production

could be measured in real viariable when this agricultural

production is measured in current prices it becomes a nominal variable.

Nominal variables can be transformed into real variables when they are

explicitly adjusted for inflation or when constant prices are

used like in the case of the real GDP: even though real GDP

is measured in monetary values, it is adjusted for inflation

because the prices of a base year are used.

Real wages are real variables because even though they are

measured in monetary units, they are adjusted for inflation.

The classical dichotomy says that the behaviour of real variables

is intrinsically different from the behaviour of nominal variables.

Coming back to our question, the classical dichotomy states that

nominal variables are affected by changes in the monetary side

of the economy while real variables are not.

According to the classical dichotomy, prices are affected by

changes in the money supply but real variables are not.

If this is correct, changes in the money supply will affect

the price level but will not have any effect on the quantity produced,

the real GDP or unemployment. This is also called monetary neutrality.

Changes in the quantity of money, according to the classical

dichotomy, will be neutral for real variables.

Classical dichotomy and monetary neutrality provide a very interesting

implication of the relationship between money supply

and price levels in the long run. This relationship is studied

through the quantity equation. In this equation we have four

variables. We already know three of them: the real value of output

or real GDP (capital Y), the price level (capital P), and

the money supply (capital M). The money supply is multiplying a new

variable: the velocity of circulation of money (capital V).

Velocity of money is related with the idea of how many times

a banknote is exchanged for newly produced goods and services

in a given amount of time. I mean one-euro coin can be used

for buying a soda. The person that sold the soda can buy a coffee;

and the person selling the coffee can buy and ice cream and the

person selling the ice cream can buy a sandwich. The same coin of one-euro

has been used in four euros worth of spending. It means that

the velocity of circulation is four. In this way, the quantity

equation says that if total money supply in an economy is one

thousand euros and each euro is used four times,

this money supply is enough for buying a total production of four

thousand euros. This is what the quantity equation says:

the money supply, multiplied by the velocity has to be equal to the nominal

value of the total production. The quantity equation can be

used to understand the determinants of inflation in the

long run. The first step is to incorporate the fact that in

general, velocity of circulation is pretty stable in the long run,

at least compared with other variables in the equation.

The second step is to recall the monetary neutrality principle:

in the long run, changes in money supply can only affect nominal

variables. So, real GDP has to be unaffected by changes in money

supply. Hence, in the long run, any increase in money supply generates

a proportional increase in the price level.

If we plot the average growth rate of money supply on the horizontal

axis and the average growth rate of prices in the vertical

axis, the quantity theory will suggest that most of the countries

should be on the 45 degree line:

the points in this line are those in which percentage money growth

is equal to percentage growth in prices.

The dots in this graph represent a sample of counties between

1980 and 1990: in most of them,

average inflation is similar to average money growth suggesting

that the quantity theory predicts decently

well what happens in real world. Although, this is an indication

of the neutrality of money in the long run, as we shall see in

future videos, monetary variables can still influence real

variables in the short run.

Hi. Welcome to our four lecture of the course. In this lecture,

we will focus on the international side of macroeconomics.

At the beginning of this course we explained that

some interactions between the interior and the foreign sector are summarized

in exports and imports. But apart from that, when explaining the

topics of savings and investment and money and financial assets,

we have in general made the simplifying assumption that each

economy is isolated. Now, it is time to relax that assumption.

In this lecture, we will come back to the definition of exports

and imports of goods and services and we will also incorporate

the flow of capital across countries into our analysis.

Additionally, we will see what is the relationship between these

capital flows, the domestic levels of savings and investment

of each country. We will also explore the relative value of each

currency, called exchange rates and we will understand the difference

between real and nominal exchange rates.

In the last two videos we will present the purchasing-power

parity theory and we will use this theory to explain how the

nominal exchange rates are influenced by the relative inflation

of the countries. We hope you enjoy this lecture.

Hello! In this part of the lecture we will present some basic definitions

that are important to expand the analytical framework that we have been

using so far. The first important distinction here is between

an open and a closed economy. We talk about a closed economy when

it does not interact with the rest of the world.

In lecture one, we have said that the sectors of an

economy are the households, the firms, the public sector and the foreign sector.

Using this terms, if an economy is closed, it has no links

between the interior sector and the foreign sector.

An open economy is an economy that interact freely with the rest

of the world. Most of the economies have some degrees of openness.

In our profession, we usually use the expression "a closed economy"

to caracterize a country with few economic interactions with

other countries although, in reality, a totally closed economy

does not exist. One of the main links between two economies

is the trade of goods and services. Some of the goods and services

produced in the interior sector are bought by agents in the foreign sector.

The value of these goods and services is called exports.

The interior sector bought some goods from the foreign sector

that are included in private consumption, government expenditures

or investment and they should be discounted from the GDP.

The value of these goods is called imports.

Then, in an open economy, the expenditures side of the GDP includes

the trade balance that incorporates both exports and imports.

The trade balance is defined as the value of exports minus

the value of imports. Exports and imports can be used to approximate

the degree of openness of an economy. In a closed economy both exports

and imports are very small because all the links with the rest

of the world are small. In these cases, trade balance is also small.

However, it can be the case that both exports and imports

are large and the trade balance is small...

if exports and imports are similar in absolute value.

To measure the degree of openness of an economy we usually add

exports plus imports and express that amount as a percentage

of the GDP. In this table, some basic statistics of

trade balance of selected countries are presented.

The first three columns show the GDP, the value of exports and

the value of imports. The fourth column shows the balance of trade;

some of them are positive and some are negative.

Fifth column shows the balance of trade as a percentage of GDP.

The last one, the degree of openness.

Germany, for instance, has very large exports and imports.

Exports are thirty eight percent of the GDP. Its trade balance is positive

and more than eight percent of the GDP; its degree of

openness is very large: close to seventy percent.

To compare Germany with Mexico is interesting. Mexico is more opened than

Germany with exports plus imports being more than seventy two

percent of the GDP but this is generated in a context of a smaller GDP,

smaller exports and imports and a very small (negative) balance of trade:
less than two percent of the GDP in absolute values.

So far, it is a nice discussion about trade but an open economy,

the residents of one country cannot only buy goods and services

from another country. They can also participate in the international

financial market buying or selling assets.

What kind of assets are we talking about?

Well, it can be money or stocks, bonds, physical assets like

land or real estate, whole firms, etc. For instance, if a Spanish bank

buys a large quantity of stocks of a Mexican bank, a Spanish

firm is buying Mexican assets. If an Italian investor buys land

to produce wool in Argentina, an Italian resident -a firm

or a household- is buying Argentinian assets. In the framework of the

National Accounts, all these transactions of each country

are recorded in an account called net capital outflow.

In each country, the net capital outflow is defined as domestic

residents' purchases of foreign assets minus foreigners' purchases

of domestic assets. This net capital outflow can be positive or negative.

For instance, let's assume that the only exchange of assets between the interior

sector of Spain and the rest of the world, the foreign sector,

is as follows: a Spanish resident acquires stocks of a Mexican bank

valued in two hundred million of euros. This is a positive capital

outflow for Spain. A Colombian resident acquires recently issued Spanish

government bonds valued in one hundred fifty million euros.

It is a negative capital outflow for Spain.

The net capital outflow in this case would be fifty million euros.

Making this example more general, if we think about

a standard financial transaction in the international capital

market, we tend to think that it is, for instance, a transaction

of stocks, bonds, real estate for money. But money is also a financial asset.
So, for instance, if a Spanish resident buys stocks of a Mexican firm

and pays with dollars or euros, it is the exchange of assets for

other assets. If it is an exchange of assets for assets with

the same value, this value will be represented with a plus

and a minus in the net capital outflow of both countries.

Hence, the net capital outflow of this transaction will be zero for both countries.

When is there a net capital outflow different from zero?

Only when some of the assets are exchanged for something

that it is not an asset: in our case, it will be goods and services

which are recorded in the trade balance.

This makes a connection between two concepts introduced in this video:

the trade balance (related with goods and services) and the net

capital outflow (related with assets). In the next video we will formally

see the connection between the exchange of goods and services and

the exchange of assets. We will also introduce the relationship between

these two variables and the savings and the investment possibilities

of each country. See you in video three.

Hello! In this video we will see, in the framework of the national accounts,

the relationship between net exports and net capital outflow.

And then, we will move to the connection between net capital

outflow and two concepts incorporated in topic two,

savings and investment. If we think in the simplest version of exchange,

barter is the exchange of goods by goods.

An individual has a car and she wants a motorbike;

another individual has a motorbike and wants a car;

then she gives the car in exchange for the motorbike. This is a

possible exchange. However, most of the contemporaneous forms

of exchange imply the exchange of a good or service for an asset...

Money. The owner of the car exchanges the car for money
and uses this money to buy the motorbike.

This intuition that any trade involves the exchange of goods

and services for an asset, usually money,

is important to understand the correspondence between movements

of goods and services and capital movements in an international setting.

In the macroeconomic analysis of international transactions

we care about the aggregates of the movements of goods and services

(trade balances) and the aggregate international exchange of

assets or capital flows. In terms of the national accounts,

the net difference of value between exports and imports

is the trade balance. The net difference of the exchange of

assets is the net capital outflow. If exports exceed imports,

the foreign sector must pay that difference with an asset.

If foreign sector pays with an asset somebody in the interior

sector is becoming owner of an asset that previously was the

property of somebody in the foreign sector.

So, it is equivalent to say that the country is investing

in foreign assets. Or, in other words, domestic investors are investing

abroad. Then, the positive trade balance translates into an equal

net capital outflow. So, there is an identity between net exports

and net capital outflows. For instance, let's imagine that the

trade balance between Mexico and Colombia is summarized in

three hundred million euros of Mexican beer exported to

Colombia and two hundred million euros of Colombian coffee

exported to Mexico. At the end of the year, there is a difference

of one hundred million euros in favour of Mexico.

This implies that net exports are one hundred million for Mexico

and minus one hundred million for Colombia.

The Colombians residents must cancel the difference with some asset.
There are many possibilities of assets: some piece of land

near Cali. Or a factory in Medellín. Or some Colombian financial asset

(for instance, a private bond sign by a Colombian banker

or a Colombian sovereign bond). Or some US American dollars

previously owned by a Colombian. As a result, a person or a firm from Mexico

became the owner of assets worth one hundred million

that were previously owned by a Colombian resident.

In other words, Mexico has a positive net capital outflow of

one hundred million and Colombia a negative net capital outflow

of one hundred million. In real world, many of the

cancelations of international trade imbalances

are made with a very specific asset: money.

And, in general, it is not any money but internationally accepted

currencies like dollars or euros. This implies

that a portion of the foreign assets that all the countries have

is in dollars or in euros (of course, for USA

dollars are domestic assets and for the European countries of

the euro area the euro is a domestic asset).

Many times, these countries use these dollars or euros to

cancel a negative trade balance. So, an unbalanced international

trade relationship means usually dollars or euros flowing from

the country with trade deficit to the country with trade surplus.

The country with trade deficit has a negative capital

outflow and the country with trade surplus has a positive

capital outflow. The international map of unbalances in the flow of goods

and services is, in some way, mirrored by the international map

of net capital outflows. In this part of the lecture

we will incorporate the concepts of trade balance and net capital

outflow to expand the relationship between savings and investment

that we depeloped in unit two. In that part

we have used the accounting identity of the GDP as total spending

in goods produced in the interior sector.

That identity means that the GDP is equal to consumption, investment,

government expenditure and net exports. In unit two

we have focused in a closed economy and therefore we have assumed

that net exports are zero. If we allow net exports to be different

from zero and rearrange terms, we get an expression which total

savings (Y minus C minus G) is equal to investment plus net exports.

When we assumed a closed economy, net exports were zero

and savings were equal to investment. Now, in an open economy

total savings are equal to investment plus net exports.

Given that net exports are equal to the net capital outflow,

our final expression is that savings are equal to investment

plus net capital outflow. It means that total savings of a country

can go either to investment in the interior sector of that country

or to buy foreign assets. Within the national accounts framework,

this purchase of new assets is recorded in net capital outflows.

This expression has a quite simple and very powerful interpretation:

when savings are larger than investment, the excess of loanable funds

flows abroad in the form of positive net capital outflow.

When savings are smaller than investments, foreigners are financing

some of the country's investment and net capital outflow is

negative. In this graph we can see the evolution of savings,

investment and net capital outflow in the United States in

the last forty five years. Since the beginning of the eighties

there is a persisting gap between investment (the blue line)

and savings (the red line). It implies that net capital outflow,

the green line below, is negative. Domestic savings are not enough
for local investment and some foreign investors are becoming

owner of domestic assets of the United States.

Additionally, the trend of both savings and investment seems

to be downwards since the end of the seventies.

This suggest a slower capital accumulation which will probably

not help for future growth. So far, we have presented a

simple framework to understand some features of international

trade and the international flow of capitals

together with the determination of domestic savings

and investment in each country. In the next video

we will move to the evolution of nominal exchange rates and

real exchange rates. These two concepts are associated to the

relative values of currencies and the relative prices across

countries. See you in the next video.

Hello! In this part of the course, we will think about the basic

mechanisms that underlie the determination of prices in an

international context. In the previous lecture, when we talk

about money supply and prices, we have set a simple theory that explains

the long run changes in price levels in each country.

We have said that in the long run, the largest part of price changes

is explained by what happens with money supply.

The quantity theory says that if money supply increases more

than the production of goods and services in the long run, prices increase.

A general increase in prices is equivalent to a reduction

in the value of money. But so far, this analysis has been restricted

to what happens in the interior of each economy.

In this part of the lecture, we move to price determination

in an international setting. Hence, we will try to explain the behavior

of relative values among currencies, for instance, the value

of the euro relative to the British pound or the dollar.

This will be analyzed considering the relative values among

goods and services in different countries.

For instance, how expensive is a coffee in Mexico in relation to

a coffee in Argentina? The first concept, the value of a currency

relative to another currency is the nominal exchange rate.

The second concept, the value of some goods and services in

a country relative to the same set of goods and services

in another country is the real exchange rate.

The nominal exchange rate (in this course identified with the

letter e) is the rate at which one country's currency trades

for another. In other words, it is the value of one currency in terms

of another currency. For instance, on September the first

2017, the nominal exchange rate of the euro in

relation with the dollar is one point nineteen.

It means that for each euro you can get one point nineteen dollars.

The nominal exchange rate of the euro in relation to

the British pound is zero point ninety one

which means that with a euro you get less than a pound.

Each of these nominal exchange rates can be seen from the other

point of view. If the nominal exchange rate of the euro

in relation with the dollar is one point nineteen,

the nominal exchange rate of the dollar in relation to the

euro will be one over one point nineteen which is equal

to zero point eighty four. And the nominal exchange rate of the

British pound in relation to the euro will be one over zero point

ninety one, which is one point zero nine. These relative values,

or nominal exchange rates, are not stable and experience considerable fluctuations.

When a currency increases its value in relation to another

currency (or a set of them) we say that this currency appreciates.

When a currency decreases its value in relation to another currency

(or a set of them) we say that this currency depreciates.

For instance, the value of the euro in relation to the dollar

has not been stable in the last seventeen years.

After the creation of the euro and until approximately 2000

the euro deppreciated against the

dollar. From an initial value of around one point two,

the value of the euro decreased up to zero point eighty six.

Then increased on until almost one point six in 2008

and then started a decline with a strong cycles.

After a short period of appreciation during 2017,

the value today is around one point nineteen, which is very

close to its initial value in 1999.

The real exchange rate is the rate at which the goods and services

of one country are traded for the goods and services of another country.

In this course, it will be called with an e and a superscript R.

An intuitive way of thinking about real exchange rates

is to try to answer where (or in which country)

is more expensive to buy a good. Imagine that you are planning

to buy a standard mobile phone and you are about to flight from Madrid

to New York. Is more convenient to buy the phone in Madrid

or in New York? For comparing the prices, you must take into account

that prices in Madrid are expressed in euros and prices

in New York are expressed in dollars. Let's imagine that in Madrid

the price is four hundred fifty euros and in New York is

five hundred dollars. Then, you can calculate how many euros

you need to buy the mobile phone in the United States.

If the price in Spain is four hundred fifty euros and the exchange
rate of the euro in relation to the dollar

is one point nineteen, with your four hundred fifty

euros you can get four hundred fifty times one point nineteen dollars.

It is five hundred thirty five point five dollars.

So, if instead of buying the phone you exchange your

four hundred fifty euros for five hundred thirty five point five

dollars, and use these dollars to buy the phone in New York

you save thirty five point five dollars.

In this case you are comparing two things:

the first one is the price in Madrid in euros, transformed to dollars;

to transform the price in Madrid to dollars, we use the price in

euros (let's call it P) and multiply the price for the exchange

rate (e). The second element of your comparison is the price

in New york in dollars, called P*.

The ratio between these two quantities is the real exchange

rate of that particular mobile phone between Madrid and New York.

For making a more general analysis of the evolution of prices

between two countries it is convenient to implement the real

exchange rates not only with a mobile phone

but with a broader set of goods and services.

In this case, what would be the right price to consider?

A very natural and usual answer is to use the prices of the goods

included in the consumer price index in each country.

So, in the formula in the previous slide, P will be the consumer

price index in the own country and P* will be the consumer

price index in the foreign country. What is the interpretation

of the value of the real exchange rate? It is basically saying

if an economy is more or less expensive than another one.

In our example, if the real exchange rate between Madrid and New York
is larger than one, it means that the price in Madrid

in dollars is larger than the price in New York in dollars: Madrid

would have been more expensive. If the real exchange rate

would have been smaller than one, it would mean that Madrid would

have been cheaper than New York. Then, if the real exchange rate

of country in relation to another one is larger than one,

it would mean that the first country is more expensive than

the second one. And vice versa. In many occasions to compare the

evolution of a currency, it is important to compare its value

not against another currency, but against several other

currencies. For instance, for European countries it is important

to convert the value of the euro against not only the dollar

but also to the British pound, the yen (from Japan),

and the yuan (from China). When the comparison of values

is made against a weighted average of several currencies,

it is called the effective exchange rate. The effective exchange rate

can be nominal (if the comparison is only about the

value of currencies) or real (if we also consider the price levels

of the countries). Maybe it is time to summarize our results

so far with an example and some data. In this graph we have

the real effective exchange rate of Germany, Spain and the

United States in the period 2000 to 2016.

For the three countries, the value in 2010

is one hundred. United States are in green, Germany in red

and Spain in blue. Remember that the effective exchange rate

compares each currency with the weighted sum of other currencies.

If it is real, like in this case, it compares currencies but

adjusting by prices in each country. Since the establishment

of the euro and until 2008,

the real exchange rate of the United States has declined

while the ones of Germany and Spain increased.

If you remember our previous graph in this lecture, this is

mainly driven by the nominal appreciation of the euro.

A nominal appreciation of the euro will produce, ceteris paribus,

an increase of the real exchange rate in the euro countries

and a decline in the real exchange rate of the commercial partners

of the European countries (like the United States).

This is what we observe in this part of the graph.

But, at the same time we observe that the effective real exchange rate

of Germany increase less than the one in Spain.

Since 1999, Germany and Spain have the same currency

(the euro); so, the nominal exchange rate between them is always one

(one euro is worth one euro everywhere).

So, the faster increase of the effective real exchange rate

in Spain compared with Germany can only be explained by a

change in relative prices. The higher inflation in Spain compared

with Germany between 2000 and 2008 explains

the higher relative increase of the real exchange rate in that

country. The next two topics, the last topics of the lecture,

will focus in the main causes of the changes of nominal

exchange rates in the long run.

Hi! Let's assume for a while that the limitations of the assumption

of the purchasing-power parity theory are not serious.

Let's imagine for a while that most of the products are tradeable

commodities; let's assume that there are no relevant barriers to trade

and that the law of one price applies to most of the products in

international markets. If this is the case, the cost of buying

a product in any country should be the same.

A consumer can use the same quality of Mexican pesos to

buy a Big Mac in Mexico or in Madrid. The quantity of pesos

needed to buy a Big Mac in Madrid will be the price of the Big Mac

in euros multiplied by the nominal exchange rate of the euro

in relation to peso. In our notation this will be P

multiplied by e, the nominal exchange rate of the euro.

The cost of a Big Mac in Mexican pesos will be directly the

price in Mexico. In our rotation, it is P*.

Saying that cost of buying a product is always the same in any

country is equivalent to say that the real exchange rate is

always one. If P multiplied by e is equal to P*,

then the real exchange rate is always one.

Rearranging, we have that the nominal exchange rate will be the ratio

between the price level in the foreign country

and the own price level. For instance, the nominal exchange rate

of the euro in relation to the Mexican peso

will be the ratio between the price level in Mexico and the

price level in the euro area.

This formula has a very important implication:

if price level in the euro area doubles and the price

level in Mexico does not change, the exchange rate of the

euro in relation to the Mexican peso

will decline to one half. In more general, terms the evolution of the

exchange rate between two currencies will depend on the relative

inflation of those currencies. If one currency experiences high

inflation in relation to the other currencies,

its exchange rate in relation to the other currencies will decline.

This graph shows two variables for a set of seventeen countries

in the period 2005-2015.

The variable in the vertical axis is the depreciation of the currency

of each country against the dollar of the United States.

In the horizontal axis we have the difference between the

inflation of each country and the inflation in the United States.

A country like South Africa, with a much larger inflation than

the United States is the one with the highest depreciation

against the dollar. In the other side, Switzerland,

with less inflation than the United States, experience an appreciation

(or a negative depreciation) against the dollar.

the clear positive relationship between the two variables is

an empirical confirmation that the parity-purchasing power theory

is a reasonably good theory to explain what happens

with the nominal exchange rates in the long run.

It is interesting to connect this result with the one we discussed

in the previous lecture. The quantity theory formalizes the idea

that if money supply increases more than the production of

goods and services, price levels increase.

The increase in the price level is equivalent to a decrease

of the value of money in terms of goods and services.

When we talk about depreciation, it is equivalent to a reduction

of the value of money in terms of the other currencies.

Then, inflation and depreciation are two connected phenomena;

the increase in the money supply starts both processes.

The implications of the parity-purchasing power theory are

very important: they suggests that the choice of the monetary

policy implemented in a country has not only strong influence

on the price level of that country but also on

the value of the currency relative to other currencies.

Persistent increases in the money supply

would lead to a persistent inflation and persistent depreciation

in the long run.

In 2008, the global economy faced the worst crisis in 80 years:

in many countries there were negative growth rates of GDP per capita,

unemployment peaked, public deficits expanded and

public debts reached unprecedent levels. Although the severity

of the crisis was unusual, economic recessions are quite frequent

in most economies and they share some common characteristics.

In this lecture, we will focus on the model of aggregate demand

and aggregate supply. This model is the most important theoretical tool

to understand the main causes of economic fluctuations.

In the first part of the lecture we will describe some elements

of the evolution of the economy of the United States in the

last decades to present the salient features of the economic fluctuations.

In the second part, we will make a very rapid presentation

of the model of aggregate demand and aggregate supply.

In the third part, we will discuss the most important characteristics

of the aggregate demand: the justification of its negative slope and

the causes of its shifts. In the fourth part we will describe and

analyse the two curves of aggregate supply (the long run and the

short run curves). In the last part we will use the model to propose

an explanation of the kind of fluctuations we observe in real world.

We hope you will enjoy this lecture.

Since the beginning of this course we presented several macroeconomic

aggregates: the GPD and the GDP per capita,

the aggregate investment, the unemployment rate, the price level,

the money supply… Today, we start to combine many of these

variables to understand one of the most important topics in macroeconomics:

what are the main characteristics and the causes of macroeconomic fluctuations?
This graph shows the evolution of the real GDP

in the USA in the last 50 years.

In this period there is an average growth of around three per cent.

At the same time, it is quite obvious that there are some fluctuations

around this trend. For instance, in the years around

1974, 1982, 2001

and, more importantly, 2008 there are clear reductions

in GDP. These contractions of the GDP are called recessions and

are identified in our graph with the grey areas.

Before and after each recession there are periods of more rapid growth.

In this graph we focus our attention on the period

1998-2011. The periods 1998-2000,

2002-2007 and from 2010

are periods of expansion of the GDP,

while the years 2001 and 2008/2009

were clearly periods of deceleration of growth

or contraction of the GDP.

What does produce these fluctuations? In topic 1 we have understood

what is the GDP and how it is measured and we have learnt

that the determinants of the GDP in the long run

are the capital stock, the quantity of labour, the human capital, the natural

resources and the technological level. ln topics 2 and 4 we understood

how investment is determined in the long run

and in topic 3 we have understood how the price level is determined

in the long run. To analyse these topics, we have assumed that

the classical dichotomy is true: it means that changes in nominal variables

do not affect real variables. One crucial assumption

we make at this point is that the classical dichotomy holds in the

long run but it does not in the short run. It means that the fundamental
forces that produce the evolution of real GDP in the long run

are essentially different from the forces that produce

the fluctuations in the short run. This is also true

for other real macroeconomic variables like unemployment.

More specifically, we will move away from the classical dichotomy

and we will assume that in the short run,

real and nominal variables are highly intertwined.

For instance, changes in price level (a nominal variable)

can produce changes in the real GDP. The economic cycle

is not only related with the GDP. For instance, in this graph,

in which we have the unemployment rate in the United States

in the last decades, we see that unemployment also experiences

large fluctuations. If you remember lecture 2 of this course, unemployment

has a cyclical component and this component is closely related

with the GDP fluctuations. In the recession periods around

1974, 1982, 2001 and 2008,

unemployment rates increased substantially

and they slowly returned in general to the pre-recession levels

in the periods following the recessions. We say that unemployment

is a counter-cyclical variable because it goes in the opposite direction

than the GDP along the economic fluctuations.

In expansions the GDP increases and the unemployment rate decreases

and the reverse happens during recessions.

To explain these fluctuations, we will analyse the macro variables

in the short run moving away from the classical dichotomy;

we will try to explain the economic cycle with a new model:

the model of aggregate demand and aggregate supply

Hi! In this video, we will present the basic structure of the model

of aggregate demand and aggregate supply.

We will see that its graphical representation is quite similar

to a standard model of a competitive market in microeconomics:

it has a measure of prices in the vertical axis,

a measure of production in the horizontal axis.

And it has a demand with negative slope, a supply with a positive slope.

However, the model relies in a completely different structure.

The two most important variables of the model of aggregate demand

and aggregate supply are the real GDP and the price level

(measured for instance with the consumer price index).

In the graph, the real GDP will be identified with a Y

and it is represented in the horizontal axis of the graph.

The price level is our measure of prices and it is represented

in the vertical axis of the graph. The aggregate demand, like

the demand in microeconomics will have a negative slope.

We will see that in this model we have a long run aggregate

supply and a short run aggregate supply. For now,

we will focus on the short run aggregate supply

which, like the standard supplies in microeconomics has a positive slope.

Like in microeconomics, an equilibrium in this case will be the

point at which the quantity demanded is equal to the quantity supplied.

Like in microeconomics, we will have shifts of the curves

(for instance in the aggregate demand) when for a given price level

there is a smaller or large quantity demanded.

We will have movements along each curve, when price level and GDP

move together along, for instance, the short run aggregate supply.

After this short introduction, we will see in more detail

the logic behind each of these curves to understand how can this

model help to explain the macroeconomic fluctuations.

Hi! With the main features of the aggregate demand already in our
toolbox, we can initiate the analysis of the aggregate supply.

Here, as we will see, things are slightly more complicated because

the aggregate supply behaves in one way in the short run

and in another way in the long run. The aggregate supply curve,

shows the relationship between the economy's price level and

the total quantity of final goods and services that firms produce

and sell. We will see that in the short run the aggregate supply

is upward-sloping as we have seen in the first part of

this lesson. But we will also see that in the long run, the aggregate

supply is completely inelastic: its graph is completely vertical.

The long run aggregate supply is the potential output

what we call (Y) sub (N). The potential output or aggregate supply

in the long run depends on the aggregate capital stock (K), aggregate

labour (L), aggregate human capital (H), natural resources (N)

and the technological level (T). The long run aggregate supply

is not affected but the price level: remember

that in the long run we assume that the classical dichotomy applies

and real variables (like real GDP) are independent of nominal variables

(like the price level); for this reason, the long run aggregate

supply is completely vertical. If any of the elements that

determine the long run aggregate supply change,

the aggregate supply will change for any given price level.

For instance, if a country improves slowly but steadily its

level of education, or receive a lot of migrants that start

to participate in the labour market, the long run aggregate supply

will shift to the right because human capital or labour

are increasing. In the short run the aggregate supply has a positive slope.

This is related to the fact that in periods like two or three

years, and increase in the price level can induce firms

to produce more goods and services. This is so

because in the short run not all prices adjust at the same time.

Some theories emphasize that the price of some goods and

services adjust very slowly; it is called the theory of the sticky prices.

In these lessons, we will rely more on some other theories

that emphasize that nominal wages, the price of labour,

are slow to adjust to new economic conditions.

The assumption of sticky wages is realistic because, in general,

labour contracts define nominal wages for at least a year or two.

Then, if prices change unexpectedly, the cost of goods

and services change relative to workers earnings.

And this is important because for firms, the price of goods and

services are related with what they sell

while wages are related mainly with their costs.

To see better the relationship between sticky nominal wages

and the slope of the short run aggregate supply we will use a

graph. Imagine that the original at point (A) with (P) one and (Y) one

and there is an unexpected increase in the price of all

goods and services to (P) two. In this case,

the value of what a firms sells increases.

If wages are sticky, an important part of the costs of the firms

does not change. So, the revenues of the firm increase more

than the cost expanding the profit per unit produced.

This increase in the profit per unit induce firms to produce more.

If many firms are in the same situation, aggregate production

increases from (Y) one to (Y) two. We move from point (A) to point (B).

This makes the short run aggregate supply to be upward sloping.

But this situation cannot last for ever.

With time, workers and firms will renegotiate a new nominal

wage, consistent with the new price level. In the long run,

when all the prices are flexible, the aggregate supply will

be vertical at the long run level of output.

This is why we work with an aggregate supply for the short run

(upward sloped) and an aggregate supply for the long run (completely vertical).

The last step to understand the aggregate supply

is to incorporate the reasons of the shifts in the short run aggregate supply.

The short run aggregate supply shifts because of changes

in any other variable that affects firms’ profits.

An increase in the price of oil, for instance, can reduce firms’

profits for any given level of the price level

and therefore will shift the short run aggregate supply curve

to the left. A reduction in nominal wages

will reduce firms’ costs and therefore will result in an increase

in quantity produced and sold of goods and services

for any given price level.

We have already discussed why the aggregate demand is downward sloped,

and why it shifts to the right or to the left.

We have also seen why the long run aggregate supply is vertical

and why the short run aggregate supply is upward sloped.

We explained why both the long run and the short run aggregate

supplies shift. In the next video we will put all the three elements

together to explain the main features of the economic fluctuations.

I hope we see you there.

Hi! We have arrived at the end of the basic description of the model

of aggregate demand and aggregate supply. We have presented

the basic feature of that model with its three curves.

Then we have described the long run and the short run equilibria.

And then we have seen how the shifts in both the aggregate demand
and the short run aggregate supply

can move the economy into short run equilibrium but out from

a long run equilibrium. In those cases, we will have that both GDP and

unemployment are not in their long run level.

But at some point, an adjustment occurs.

One possibility is that the unusual levels of

unemployment produce a change in nominal wages

that induce a shift in the short run aggregate supply.

Another possibility is that the government or, as we will see,

the central bank decides to implement a policy to shift the

aggregate demand. In one way or another, the long run equilibrium

is restored. The fact that the government or the central bank

can change the aggregate demand opens the room for a very important question.

Can they systematically implement policies to prevent a

recession or, at least, to minimize its costs?

In the next lecture, we will try to answer this question.

The central bank has a very important potential role in fighting

the effects of recessions because monetary policies can have

relevant effect on real variables in the short run.

In general, one of the goals of central banks

is related to keeping unemployment low because, as we will see,

changes in the quantity of money can produce changes in the aggregate demand

and, therefore, changes in production and employment levels.

The analysis of the mechanism of monetary policies to smooth

recessions will be the first main topic of the next lecture.

For many economists, fiscal policies to prevent or minimize

recessions are also possible. But there is an open debate about

their precise effects and their costs. An advantage of the fiscal policies

is that there is a multiplier effect that magnifies

the initial incentives generated by the government.

A disadvantage is that there is a crowding-out effect that

dilutes some of their impacts. We will analyse both.

We will close our course with a debate of the advantages and shortcomings

of fiscal and monetary policies. We are very close to the end

of our course. I hope we see each other for the last lecture.

Welcome again. In this video we will combine the three curves of

the aggregate demand and aggregate supply model.

The main goal of this part is to understand what is an equilibrium

in this model, why the economy can move away from that equilibrium

and how the equilibrium is restored. A long run macroeconomic

equilibrium is a combination of price levels (P) and GDP (Y)

in which the short run aggregate supply,

the long run aggregate supply and the aggregate demand are equal.

In the graph this is represented in point (A).

If the short run aggregate supply (SRAS) or the aggregate demand (AD) shifts,

the economy can be at a short run equilibrium (where the short run

aggregate supply crosses the aggregate demand)

but not at a long run equilibrium because the point is not at the

long run or potential output (Y sub N). This is represented in point (B).

A short run equilibrium like this can not last forever.

As we will see, in one way or another one of the curves

(either the AD or the SRAS)

will shift to restore the long run equilibrium.

With all the concepts we have already developped,

now we can use the model of aggregate demand and aggregate supply

to try to understand the mechanisms underlying the observed

economic fluctuations. One possible source of economic fluctuation

is a change in the aggregate demand. Let us assume that there is

an increasing optimism among entrepreneurs,

that they are confident that the economic situation will be

favourable in the near future

and then, they decide to increase investment.

Remember that investment is a component of the aggregate demand.

This increase in investment for any given level of prices shifts

the aggregate demand to the right. The new short run equilibrium

will be at a point like (B) where the short run aggregate supply crosses

the new aggregate demand. In the new short run macroeconomic

equilibrium there will be higher prices and higher output.

In point (B) output is above its trend and unemployment

is below its natural rate. Eventually, the economy must come back

to a long-run equilibrium. The long run equilibrium cannot be at (B)

because there, GDP is above its long run level.

We have seen that when moving from point (A) to point (B) prices

increased but nominal wages did not change;

so, with time, nominal wages are renegotiated;

the increase in nominal wages increase the cost of the firms

and then the short run aggregate supply shifts to the left.

The new long-run macroeconomic equilibrium will be in point (C)

at the long run output (Y sub N) but with a higher price level,

(P3) in this case. So, if the aggregate demand shifts

to the right, we initially will have higher output,

higher prices and lower unemployment in point (B)

but, eventually, the short run aggregate supply will shift and then

the economy will end up in a point like (C) with

higher prices but the original level of GDP (Y sub N).

The other source of fluctuations is related with exogenous changes

in the short run aggregate supply. A quite typical

example of an exogenous change in the SRAS

is a change in the price of a relevant input used by firms;

for instance, oil. If there is an increase in the price of an input

like oil, the cost of firms will increase for any given price

and therefore, we will observe a shift to the left of the

short run aggregate supply. The new equilibrium will be at point

like (B) where the new aggregate supply intersects the aggregate demand.

At this point there will be higher prices at (P2) and lower

output at (Y2). If output is lower, unemployment is above

its natural rate. If the change in the input prices are temporary,

the long run aggregate supply (LRAS) does not change.

Hence, the economy needs an adjustment to return to a long run equilibrium.

In a situation of a short run equilibrium like

the one in (B), the high levels of unemployment induce a downward

adjustment of nominal wages which, as we have already discussed,

implies a reduction of the cost of the firms.

This reduction of firms’ costs is represented in our model as

a shift to the short run aggregate supply

to the right until GDP is at its long run level (Y sub N).

This shift goes together with a reduction of

prices until they are a at its original level (P1).

The economy is back again in the old long-run macroeconomic equilibrium.

This is point (A).

From the two previous examples we learn that if the economy

is out of the long run equilibrium, and the aggregate demand

does not change, the SRAS curve will shift

to put the economy back again in that equilibrium.

If the short run equilibrium is at a point where GDP is above potential GDP

and unemployment below its natural rate,

the graphical representation of the equilibrium will be in point (A)

at the right of (Y sub N). With time,

the low levels of unemployment will induce wages to go up

and the SRAS will shift to the left until

the long run equilibrium is restored. This long run equilibrium

must be on the long run aggregate supply like the point (B) in our graph.

If the economy’s short run equilibrium is at the left of

(Y sub N), GDP is at (Y sub 2), below the potential GDP

and unemployment is above its natural rate.

In this case, high unemployment levels induce wages

to go down, reducing firms’ costs and the short run aggregate

supply shifts to the right to restore the long run equilibrium.

This equilibrium will be in a point like (B) which is

on the long run aggregate supply curve. A moment ago,

we said that it is the short run aggregate supply the curve that shifts

to restore the long run equilibrium… IF THE AGGREGATE

DEMAND DOES NOT CHANGE. But, let us imagine that after an increase

in input prices and a shift of the short run aggregate

supply to the left, the economy moves from (A) to (B).

In the point (B), the economy is in a recession with low GDP and high unemployment.

We know that this undesirable situation will eventually

change because the high levels of unemployment

will push nominal wages down and the short run aggregate supply

will shift to the right. If this happens,

the long run equilibrium will be restored at the point (A).

But what happens if wage adjustment is slow

and the recession in (B) is too persistent? Is there any possibility

of minimizing the negative effects of a recession?

If the government wants to shorten the recession,

a feasible policy would be to expand the government expenditure in goods

and services. This is equivalent to increase (G) in the aggregate demand.

In this case, there will be a shift of the aggregate

demand to the right and, eventually the economy will return

more rapidly to the long-run macroeconomic equilibrium.

The new long run macroeconomic equilibrium will be in a point

like (C) with higher prices than the original equilibrium in (A) but,

eventually, with a more rapid transition and lower social costs

in terms of unemployment. This possibility of implementing policies

to shorten recessions or to minimize their negative consequences

will be the main topic of the next, and last, lecture of our course.

Hello! Welcome to the last lecture of our course in macroeconomics.

Today we will take the last step to understand the short run changes

of aggregated variables. In particular, we will use the model of aggregate

demand and aggregate supply for evaluating the possible impacts of

economic interventions by the public sector and the monetary

authorities on the length and duration of recessions.

We will see that the model of aggregate supply and aggregate demand

predicts that these interventions can reduce the negative impact

of the economic downturns. But the effect of these policies is not

always easy to assess with precision and many economists argue

that they have undesirable consequences on the long run.

Are these policies really effective? Are the plausible positive

effects on the short run valuable enough to pay the probably negative

effects on the long run? The debate around these two questions will be

the last part of our course. This lecture is structured

in three main parts. In the first one we will analyze monetary policies

implemented by the central bank. In the second part

we will present fiscal policies implemented by the government.

In the third part we will present the main elements of the discussion

on the advantages and shortcomings of these policies.

The first part will start with a description of the mechanisms

that link the monetary policy with the interest rate.

Given that aggregate investment depends on the interest rate,

these mechanisms give to the central bank the possibility

to influence aggregate demand, real output and unemployment.

The second part will be divided in three videos:

in the first one we will present the main definitions of the

fiscal policies. In the second one we will see that sometimes

the initial stimulus provided by the government is amplified

by what we call the multiplier. In the third video

we will discuss the crowding out effect

that goes in the opposite direction than the multiplier effect.

The third part will present the main arguments of the pros

and cons of the fiscal and monetary policies.

Welcome to the second video of this lecture.

In this video we will revisit the concept of the money demand introducing in

topic three. We will use this concept to discuss again the price-effect

which explains the negative slope of the aggregate demand.

But more importantly, will add the concept of the money demand

to our tool-box to set the basis of the analysis of monetary policies.

Given that the interest rate will play a very important role

in this lecture, it is convenient to recall some things

we studied in topic two. First, we will remember the difference between

the real interest rate and the nominal interest rate.

The real interest rate is adjusted for changes in prices over

the length of the loan while the nominal interest rate is not

adjusted for price changes. If you deposit one hundred euros

in a bank account for a given period at a nominal interest

rate of ten percent, you will receive one hundred ten euros at the end

of period; one hundred euros is your original capital

and ten euros is the ten percent of the one hundred.

This is independent of the possible changing prices taking

place in that period. However, are you able to buy ten percent more

goods than at the beginning of the period?

The answer, of course, depends on the evolution of the prices

during that period. Let's imagine that inflation in that period

is five percent. Then, in real terms, adjusted for the change in prices,

you receive less than ten percent. Actually,

the purchasing power of your initial capital will be only

five percent larger. The relationship between the nominal interest rate,

the real interest rate and the inflation rate

can be formalized with the following equation:

the real interest rate is equal to nominal interest rate minus

the inflation rate. If the nominal percentage increase of your

capital is the same than the inflation rate,

the real interest rate is zero. In many situations, making the

distinction between real and nominal interest rate is crucial.

However, in our analysis of the evolution of the economy in

the short run, we are assuming that prices do not change significantly

and therefore we can assume that the real and the nominal variables

move closely together and we can talk in general about THE

interest rate. In topic two we presented the market for loanable funds

and explain the determination of interest rate in that market.

The market for loanable funds is the tool we use to

understand the determinants of the interest rate

in the long run. To study the determinants of the interest rate

in the short run we use and alternative theory called the theory

of liquidity preference.

The theory of liquidity preference is related to the question:

why households hold money? Remember that money is an asset that can

be used as a medium of exchange. Other assets, like bonds or

some bank account balances cannot be used for buying things,

but they pay an interest. So, households want to incorporate money

in their portfolio because they want to use that money for buying things;

this is the preference for liquidity.

But, if they hold money, they must resign the interest they will

obtain if they transform the money into interest-bearing assets.

In this way, and the interest rate represents like an opportunity

cost of holding money; when the interest rate is large,

households prefer to hold less money and to put a larger part

of their wealth in an interest-bearing asset.

So, the quantity demanded for money is inversely related to

the interest rate. The interest rate is not the only variable

that affects the households' decisions of holding money.

Given that the main reason why households want to hold money is for

using it for buying goods and services, when households' income

increases, the quantity of money held by households

also increases. So, the quantity demanded for money is directly

related to households' income. Other element that influence

the quantity of money that households want to hold

is the price level. If the price level increases (keeping all

the other things constant) households need more money to try

to keep their level of consumption as unaffected as possible.

So, higher prices induce households to increase their money holdings.

Hence, the money demand depends on this three variables:

the price level P, the interest rate r

and households' income Y. We can assume that two of the variables are

constant (for instance, the interest rate and the income)

and graph the relationship between the other two

(the quantity of money and the price level).

This money demand in the graph is like the one we presented

in topic three. In that case, we implicitly assumed that interest

rate and income were exogenous variables and therefore the

money demand was an increasing function of the price level

(P) and a decreasing function of the value of money

(one over P). If instead of assuming that interest rate and income

are exogenous we assume that prices and income are exogenous,

we can graph the money demand as a function of the

interest rate. In this case, interest rate will go in the vertical

axis and the quantity of money demanded, M,

will be on the horizontal axis. With this form of the money demand

in mind we can formalize the interest rate effect.

Remember that the interest rate effect stated that if there is

an increase in the price level, households

want to have more money in cash for buying things

and they sell bonds to hold more money. As a result,

the interest rate increases. The higher interest rate generates

a lower aggregate investment. This produces a negative relationship

between the price level and the aggregate investment.

This interest rate effect, together with the wealth effect were

presented in topic five and helped us to understand why the

aggregate demand has a negative slope. Now, that we have a

more formal approach to the money demand,

we can analyze the interest rate effect with more detail.

We can use the graph of the money demand as a function of the

interest rate, which is the one that we have on the left of the slide.

Given the money supply, M one, and a given money demand,

the interest rate is r one. On the right side we have the graph

in which we want to include the aggregate demand:

the price level is in the vertical axis

and the aggregate production of goods and services is in the

horizontal axis. We make explicit that the economy is in a point like A

with a production level of Y one and the price level of P one.

What would be the effect of an increase in the price level?

First, in the graph the right, we observe a change from P one

to P two. Second, given that the money demand is a function of the

price level, this demand shift to the right.

In the money market, it implies an increase of the interest

rate to r two. Given that aggregate investment is a function

of the interest rate, aggregate investment decreases

and aggregate production moves to Y two. The economy

moves from point A to point B showing that the aggregate demand

is downward sloping.

This is a nice example of the combination of the money market

and the aggregate demand function. We will use this combination

to analyze monetary policies. In the next video,

we will use the relationship between the equilibrium in the money

market and the interest rate to understand the links between

the monetary policy, related to the money supply,

and the total production of goods and services.

Hello! In the previous video we have established the connections

among the most important variables involving the monetary policies:

the quantity of money, the interest rate,

the aggregate investment and the total production of goods

and services. In this part of the lecture

we will understand why the goal of many central banks is to keep

unemployment low. Why a central bank, responsible of monetary policy,

is asked to influence a real variable like unemployment?

Basically, as we will see, because the monetary policy conducted

by central banks influences the aggregate demand

and changes in the aggregate demand can produce effects

on GDP and unemployment. In lecture three we have said that central

banks conduct monetary policies that consists mostly and adjusting

the money supply. We already know that the central bank can

induce changes in the money supply by changing the discount

rate or by implementing open market operations.

An expansionary monetary policy can be identified with an expansion

of the money supply generated, for instance,

by a reduction of the discount rate or by buying government bonds

in an open market operation. A contractionary monetary policy

can be identified with a contraction of the money supply

generated, for instance, by an increase of the discount rate

or by selling government bonds in an open market operation.

Using our money market and the model of aggregate demand and

aggregate supply, we can see that an increase in the money supply

can produce a reduction of unemployment.

The money market is in the left while a graph representing

the model of aggregate demand and aggregate supply is on the right.

The money market has the money supply in red,

completely inelastic, and the money demand in blue with negative slope.

The quantity of money demanded is negatively related

to the interest rate. The market is in equilibrium with the

quantity of money, set by the central bank, M one,

and an interest rate of r one. The graph of the model of

aggregate demand and aggregate supply is in the right.

The economy is in a long run equilibrium in the point A

with a price level P one and an output level Y one.

An increase in the money supply implies a shift of the money

supply to the right. The new equilibrium in the money market

will be at a lower interest rate. A lower interest rate will induce

higher investment for any given price level

which implies a shift of the aggregate demand to the right.

In the new short run equilibrium, in the point B,

prices are higher, GDP is above its long run level

and unemployment is below its natural rate.

By moving the economy from the point A

to the point B, the central bank has achieve the goal of reducing

unemployment. We know that the point B is only a short run equilibrium

and that it cannot last forever... but at least for a while, the expansionary

policy has the expected effect. Let's see another example of

expansionary monetary policies. Let's assume

that an economy is in a recession (in a point like A)

in which the total production Y one is below its long run level

and the central bank wants to stimulate the economy to

shorten the recession. For expanding the money supply,

a feasible policy will be to reduce the discount rate

and lend more money to the commercial banks.

This increase in commercial banks' liquidity

generates a shift of the money supply to the right;

this shift to the right of the money supply

produces a new equilibrium with a lower interest rate.

We know that a lower interest rate induces a high level of

aggregate investment and a shift of the aggregate demand to the right.

This can lead the economy to a point like B

with higher prices but lower unemployment.

We have already seen two examples of expansionary monetary policies.

If the central bank expands the money supply,

the interest rate goes down and there is an acceleration of

economic activity. It is important to realize

that one consequence of these policies is the increase in the

price levels. So lower unemployment is achieved at the price

of higher inflation.

It is also possible to analyze contractionary monetary policies

related with a reduction of the money supply,

an increase in the interest rate and a deceleration of economic

activity at a lower price level. So lower inflation can be achieved

at the price of higher unemployment. We have presented the mechanisms

that link the monetary policies with the level of economic

activity and unemployment. We have understood why it is true

that very important statement in macroeconomics

that there is a trade-off between unemployment

and inflation. Expansionary monetary policies reduce unemployment

at the cost of higher prices. And vice versa.

The central banks have the delicate responsibility of choosing

the socially acceptable combination of the level of these two variables.

In the next video we move the second topic of this lecture:

fiscal policies.

Hi! Welcome to the fourth video on fiscal and monetary policies.

In this video we will present the main features of a simplified

version of fiscal policies. There are many ways in which the public
sector influences economic outcomes. In this course

we will focus on the macroeconomic implications of the public

policies and we will assume that these policies can be described

by changes into macroeconomic variables that depend on the decision

of the government. One these variables is the total amount

of government expenditure in goods and services.

This is the variable that we called G

when analyzing the components of GDP from the expenditure side.

A change in the government expenditure in goods and services

has a direct impact on aggregate demand

because this variable is one of its components.

So, an increase of the quantity of goods and services bought

by the government generates an immediate and direct increase

in the aggregate demand of goods and services.

The other variable is the one already presented in lecture two:

the total amount of taxes by the public sector called T.

The effects of a change in the level of taxation

depend on the specific type of tax that is being modified.

However, in general terms, we can say the main impact of a reduction

of taxes is the increase of households' disposable income.

If you remember topic two, when we talked about private savings,

we have said that households use their after-tax income

either for savings or for consumption.

So, a reduction in taxes means a higher disposable income

and a share of that disposable income is used for consumption.

The increase in aggregate consumption implies an increase of

the aggregate demand of goods and services.

Then, both T and G are policy variables defined by the government

and changes and either of them have an impact on aggregate demand.

An expansionary policy implemented by the government

is an increase of G or a reduction of T.

The increase in G expands the aggregate demand directly because

G is one of its components. The reduction of T

expands private consumption. Either of the two policies shift

the aggregate demand to the right. The new short run equilibrium

will be at point like A in which we have higher prices (at P two)

higher production of goods and services (at Y two)

and, given that unemployment is counter-cyclical variable, lower unenployment.

A reduction in G or an expansion in T

are called contractionary fiscal policies.

They produce a shift of the aggregate demand to the left

and generates a new short run equilibrium,

in a point like A, with lower levels of GDP,

lower price levels and higher unemployment.

Why the government would want a contractionary policy?

In this case, the policy is paying a price (lower GDP and higher

unemployment) for given priority to price control or low inflation.

Changes in taxes and government expenditure have an impact

on aggregate demand and they can be used for influencing the level

of output and unemployment and the price levels in the short run.

Are these changes large or small? Is the whole increase of G

and the reduction in T translated into larger aggregate demand?

In the next two videos we will introduce the two concepts (the multiplier effect

and the crowding out effect) that help to assess the

magnitude of these impacts with more precision.

Hi! Welcome to the fourth video on fiscal and monetary policies.

In this video we will present the main features of a simplified

version of fiscal policies. There are many ways in which the public
sector influences economic outcomes. In this course

we will focus on the macroeconomic implications of the public

policies and we will assume that these policies can be described

by changes into macroeconomic variables that depend on the decision

of the government. One these variables is the total amount

of government expenditure in goods and services.

This is the variable that we called G

when analyzing the components of GDP from the expenditure side.

A change in the government expenditure in goods and services

has a direct impact on aggregate demand

because this variable is one of its components.

So, an increase of the quantity of goods and services bought

by the government generates an immediate and direct increase

in the aggregate demand of goods and services.

The other variable is the one already presented in lecture two:

the total amount of taxes by the public sector called T.

The effects of a change in the level of taxation

depend on the specific type of tax that is being modified.

However, in general terms, we can say the main impact of a reduction

of taxes is the increase of households' disposable income.

If you remember topic two, when we talked about private savings,

we have said that households use their after-tax income

either for savings or for consumption.

So, a reduction in taxes means a higher disposable income

and a share of that disposable income is used for consumption.

The increase in aggregate consumption implies an increase of

the aggregate demand of goods and services.

Then, both T and G are policy variables defined by the government

and changes and either of them have an impact on aggregate demand.

An expansionary policy implemented by the government

is an increase of G or a reduction of T.

The increase in G expands the aggregate demand directly because

G is one of its components. The reduction of T

expands private consumption. Either of the two policies shift

the aggregate demand to the right. The new short run equilibrium

will be at point like A in which we have higher prices (at P two)

higher production of goods and services (at Y two)

and, given that unemployment is counter-cyclical variable, lower unenployment.

A reduction in G or an expansion in T

are called contractionary fiscal policies.

They produce a shift of the aggregate demand to the left

and generates a new short run equilibrium,

in a point like A, with lower levels of GDP,

lower price levels and higher unemployment.

Why the government would want a contractionary policy?

In this case, the policy is paying a price (lower GDP and higher

unemployment) for given priority to price control or low inflation.

Changes in taxes and government expenditure have an impact

on aggregate demand and they can be used for influencing the level

of output and unemployment and the price levels in the short run.

Are these changes large or small? Is the whole increase of G

and the reduction in T translated into larger aggregate demand?

In the next two videos we will introduce the two concepts (the multiplier effect

and the crowding out effect) that help to assess the

magnitude of these impacts with more precision.

Hello! How are the effects of the fiscal policies transmitted

to the overall economy? We have seen that the multiplier effect magnifies

the initial changes in the aggregate demand in general

and in the government spending or taxation levels in particular.

The crowding-out effect goes in the opposite direction than

multiplier effect. The crowding-out effect arises

because the increase in total income generated by fiscal policies

raises the money demand. A higher money demand implies a higher

interest rate discouraging investment which is one of the components

of the aggregate demand. The first way of discussing the crowding-out

effect is an example. Let's assume that the decision of the

government is to spend a total amount of two hundred million

of euros in new buses. We know that this will trigger the

multiplier effect. But, let's assume for a moment that there is

no multiplier effect to focus only on other kind of effects

related with the money market. The initial increase in government

spending of two hundred million will increase the aggregate

demand of goods and services and will expand total income.

If you remember the nature of the money demand we presented earlier in

this lecture, the demand for money depends on the price level,

the interest rate and income. The larger the income,

the higher the money demand. So, when the increase of the government

spending induces a larger total income, it is also expanding

the money demand. We also know that, if money demand increases,

ceteris paribus, the interest rate increases

and, as a result, aggregate investment decreases.

The last links in the chain are the shift of the aggregate

demand to the left and the consequent reduction in total output.

This is what we call the crowding-out effect.

The higher money demand generates a higher interest rate

and crowds out investment. The reduction in investment

will partially compensate the original expansion of the aggregate

demand of goods and services. Hence, if there is no multiplier effect,

the final increase in the aggregate demand

will be smaller than the initial increase in government expenditure.

The second way of discussing the crowding-out effect

is translating the example into two models that we have introduced

earlier in this course: the money market and the aggregate demand-

-aggregate supply model. Again, the money market is in the left

while a graph representing the model of aggregate demand and

aggregate supply is on the right. In the graph of the model

of aggregate demand and aggregate supply

we include only, for simplicity, the short run aggregate supply

with a positive slope and the aggregate demand with a negative slope.

The model is in a short run macroeconomic equilibrium

with the level of output equal to Y one.

If the government implements an expansionary fiscal policy

(like increasing G) the aggregate demand shifts to the right.

In the new situation the equilibrium is in a point like B

with higher total output in Y two.

Remember that the money demand depends on income

and an increase in income implies a shift of the money demand

to the right. In the new equilibrium in the money market

we have a high interest rate in r two.

This increase in the interest rate translates into a smaller aggregate

investment for any level of prices and this implies a shift

of the aggregate demand to the left. In the new situation

the equilibrium will be at point like C

with the level of production in Y three.

The green arrow shows the initial impact of the expansionary policy.

The red arrow shows the crowding-out effect that partially

compensates the original stimulus and reduces the total effect

of the policy on the aggregate demand.

The crowding-out effect also applies to fiscal policies based

on reductions of taxes. When taxes are cut,

households' consumption increases, aggregate demand increases

and aggregate output increases. This is the first effect of

the policy. However, the resulting increase in total income

generates an increase in the money demand

and in the equilibrium level of interest rates

and a reduction of aggregate investment.

The size of the crowding-out effect is difficult to assess.

It depends on how sensible is the money demand to changes in

total income and how sensible is the aggregate investment to

changes in the interest rate. So, in this course we cannot offer

a quantitative estimation of its magnitude like the one we

discuss for the multiplier effect. However,

we know that the crowding-out effect can be relevant and it

must be taken into account when discussing the possible effects

of fiscal policies.

We are already at the end of the analysis of fiscal policies.

We have seen that expansionary policies can stimulate the aggregate demand

and that they are affected by the multiplier effect

and the crowding-out effect. The first one expands the initial

impact of the policies while the second one atenuates it.

In the next, and last, video of the course we will summarize a debate

among macroeconomist and policy makers

about the pros and cons of the implementation of fiscal

and monetary policies. See you there.fy