ECS2602

Chain of events and diagrams:

Different macroeconomic models

The purpose of this summary is to show you how the various models developed in
this module are connected. This compliments the study plan laid out in the
Study Guide and does not replace it.

Two stabilisation policies:

Fiscal policy Monetary policy

Two policy instruments: G and T One policy instrument: i

An expansionary fiscal policy is An expansionary monetary

an increase in government
spending and/or decrease in
taxes to stimulate economic
activity by increasing the demand
for goods and the level of output
and income
A contractionary fiscal policy is
a decrease in government
spending and/or increase in taxes
to cool down economic activity by
decreasing the demand for goods
and the level of output and
income
policy is a decrease in the interest
(repo) rate by the SARB to
stimulate economic activity by
increasing the demand for goods
and the level of output and income
A contractionary monetary
policy is an increase in the
interest (repo) rate to cool down
economic activity by decreasing
the demand for goods and the
level of output and income

The goods market model

Only fiscal policy (G and/or T) is applicable in the goods market.

Other factors that could shift the ZZ curve are investment spending, investor
confidence and consumer confidence.

Chain of events in the goods market model and diagrams:

1
 Expansionary fiscal policy
An increase in G
A decrease in T
G  Z  Y
Or
T↓  YD↑  C  Z  Y
Other factors in the goods market:
An increase in investment spending
(I)
An increase in investor confidence
An increase in consumer
confidence
I  Z  Y
Investor confidence  Z  Y
Consumer confidence  Z  Y
Contractionary fiscal policy
A decrease in G
An increase in T
G↓  Z↓  Y↓
Or
T↑  YD↓  C↓  Z↓  Y↓
Other factors in the goods market:
A decrease in investment spending
(I)
A decrease in investor confidence
A decrease in consumer confidence
I↓  Z↓  Y↓
Investor confidence↓  Z↓  Y↓
Consumer confidence↓  Z↓  Y↓
2
 The financial market model
Only the monetary policy, a change in the interest (repo) rate, is applicable.

This financial market model is based on the assumption that the quantity of money is
endogenously determined (or demand-determined money) — it is determined within
or by the model, and it is assumed that the demand for money determines the
quantity of money. Therefore, according to this interpretation, there is no
independent money supply curve since the quantity of money depends on the
money demand and the interest rate (the cost of credit).

The central bank cannot directly influence the quantity of money since the quantity of
money is endogenously determined by the demand for money. However, the central
bank can indirectly influence the quantity of money by influencing the interest rate,
which, in return, affects the cost of credit and loans and the demand for money. A
lower interest rate decreases the cost of credit, and as more credit is extended to
households and firms, the money demand and the quantity of money increase.

As the money demand changes, so do the quantity of money. An increase in the

money demand leads to an increase in the quantity of money, and a decrease in the
demand for money leads to a decrease in the quantity of money.

Chain of events in the financial market model and diagrams:

Expansionary monetary policy Contractionary monetary policy

A decrease in the interest rate (i) An increase in the interest rate (i)

MonetaryExpansion  i  Md  M MonetaryContraction  i  Md  M

3
 The IS-LM model (in a closed economy)
The IS curve is derived from the goods market.

The LM curve is derived from the financial market.

Therefore changes in the goods market and the financial market will affect the IS-LM
model. Thus, both the fiscal policy (G and/or T) and monetary policy (i) are applicable

Fiscal policy will have an impact on the goods market first and then on the financial
market.
Monetary policy will impact the financial market first, then the goods market, and
back to the financial market.

Chain of events in the IS-LM model and diagrams:

Expansionary fiscal policy Expansionary monetary policy

An increase in G A decrease in the interest rate (i)
A decrease in T
Government spending increases Interest rate decreases

The impact on the goods market first The impact on the financial market
G  Z  Y MonetaryExpansion  i
Y  YD  C i↓  Md↑  M↑
Y  I
Impact on the goods market
Impact on the financial market i  I  Z  Y
i=𝑖 Y  I
Y  Md  M Y  YD  C

Back to the financial market

AND/OR Y↑  Md↑  M↑

Taxes decreases

The impact on the goods market first The end result is that an
T  YD  C  Z  Y expansionary monetary policy
Y  YD  C increase the output and income
Y  I level.

Then the impact on the financial market In the IS-LM model, the LM
i=𝑖 curve shifts downwards.
Y  Md  M

The end result is that at a given

interest rate, the increase in
government spending and/or
decrease in taxes leads to an
increase in the level of output and
income.

In the IS-LM model, the IS curve

shifts to the right.

4
 Contractionary fiscal policy Contractionary monetary policy
A decrease in G An increase in the interest rate (i)
An increase in T
Government spending decreases Interest rate increases

The impact is first on the goods market The impact is on the financial market
G↓  Z↓  Y↓ first:
Y↓  YD↓  C↓ MonetaryContraction  i
Y↓  I↓ i  Md  M

Impact on the financial market Impact on the goods market

i=𝑖 i  I  Z Y
Y↓  Md↓  M↓ Y  I
Y  YD  C

AND/OR Back to the financial market

Y  Md  M
Taxes increases

The impact is first on the goods market The end result is that a
T  YD  C  Z  Y contractionary monetary
Y  YD  C policy result in a decrease in
Y  I output and income level.

Then the impact on the financial market

i=𝑖
Y  Md  M

The end result is that at a

given interest rate, the
decrease in government
spending and/or the increase
in taxes leads to a decrease in
the level of output and income.

5
 In the IS-LM model, the IS In the IS-LM model, the LM
curve shifts to the left. curve shifts upwards.

The goods market in an open economy

The demand for goods equation is extended to include a foreign sector by adding
exports and imports to the equation. An open model the demand for domestic
goods that determines the level of output and income.

Thus in an open economy, the demand for domestic goods or expenditure on GDP =
C + I + G – IM + X. Imports must be subtracted while exports must be added.

The NX curve shows the relationship between the level of output and income and the
trade balance.

For a given demand for goods, equilibrium in the goods market is reached where the
domestic level of output and income is equal to the demand for domestic goods.

Given this equilibrium level of output and income, there is a corresponding trade
balance position which can be either

• a trade surplus (NX > 0) or

• a trade deficit (NX < 0) or
• a point where exports equal imports (NX = 0).

6
 Trade balance Trade deficit Trade surplus
(NX = 0) (NX < 0) (NX > 0)

Using this model, we can analyse the impact of a change in

(i) domestic demand,

(ii) a change in foreign demand and
(iii) a depreciation of the exchange rate

on the equilibrium level of output and income and the trade balance.

7
 A rise in domestic demand
(e.g. an increase in government
spending)
G  Z  Y  IM  NX
Since part of an increase in
government spending and the
resultant increase in the demand
for goods are on imported goods,
the multiplier effect of an increase
in government spending on the
equilibrium level of output and
income is smaller in an open
economy than in a closed
economy.
An increase in domestic demand
can also be due to an increase in,
for instance, autonomous
consumption or investment
spending.
An increase in foreign
demand
(an increase in exports)
X  Z  Y  IM
We assume that the positive
effect of an increase in exports
on the trade balance outstrips
the negative effect of an
increase in imports. The trade
balance thus improves (NX).
Depreciation of the real
exchange rate
The depreciation of the real
exchange rate impacts the
demand for domestic goods
through a change in exports
and imports has both a
positive and a negative effect
on the trade balance.
The condition under which a
real depreciation leads to an
increase in net exports (an
improvement in the trade
balance) is known as the
Marshall-Lerner. We assume
in this module that the
Marshall-Lerner condition
holds.
A real depreciation leads to
an increase in exports
because domestic goods are
now relatively cheaper and a
decrease in imports because
foreign goods are now
relatively more expensive:
E  X  NX
8
 E  IM  NX
which affects the trade
balance positively.

However, the rise in the price

of imports increases the
imports bill, which affects the
trade balance negatively.

Pimports  Imports Bill  NX

And the level of output and

income will increase due to
the increase in exports and
expenditure switching:

E  X  Z  Y
E  IM  Z  Y

However, the increase in

output and income level
leads to a secondary effect
on the trade balance as an
increase in the level of output
and income will increase
imports, which negatively
affects the trade balance.

Y  IM  NX

For the Marshall-Lerner

condition to hold, the positive
effect must outstrip the
negative effect, resulting in
an improvement in the trade
balance and an increase in
the domestic level of output
and income.

IS-LM model for an open economy

The first part of the chain of events will be the same for the IS-LM model in a closed
economy. Since we now operate in an open economy where goods and services can be
exported and imported, we add the impact on the exchange rate and trade balance

Summary of the impact of the nominal interest rate (i) on the goods market Impact of
the nominal exchange rate (E) on the goods market

9
Impact of the nominal interest rate (i) on the goods market

An increase in the interest rate leads to decreased

investment spending, the demand for goods, and
output and income level. i  I  Z  Y
The decrease in output and income is a multiple of
the decrease in investment spending. This is due to
the multiplier effect.

Impact of the nominal exchange rate (E) on the goods market

A depreciation of the exchange rate results in an

increase in exports and a decrease in imports due to E  X  NX  Z  Y
expenditure switching; thus, the trade balance E  IM  NX  Z  Y
improves. The increase in exports and expenditure
switching increases the demand for goods and the
level of output and income.

The change in the interest rate determines the impact on the exchange rate. Why?

Say, for instance, the central bank decreases the interest (repo) rate. A decline in the
interest rate causes a depreciation of the nominal exchange rate. The depreciation of
the nominal exchange rate results from the decrease in the domestic interest rate
relative to the interest rate in the rest of the world. This causes domestic bonds to be
less attractive, and a capital outflow occurs. This capital outflow reduces the domestic
currency demand (it increases the demand for foreign currency), and the exchange
rate depreciates. The depreciation of the exchange rate reduces the price of exports
and increases the price of imports, which positively impacts the trade balance. The
negative effects are that the imports bill is now higher and an increase in exports will
increase the demand for goods and the level of output and income, which will increase
imports.

i↓  Capitaloutflow  E↓

E↓  X↑  NX↑
E↓  IM↓  NX↑
Y  IM↑  NX↓
We assume this effect is outstripped, and overall, the trade balance improves (NX↑)

The opposite is also true: An increase in the interest rate causes an appreciation of
the exchange rate.

The increase in the interest rate causes an increase in capital inflows; the nominal
exchange rate increases, and the domestic currency appreciates (prices are
assumed to be fixed in the IS-LM model; therefore, a nominal appreciation of the
domestic currency will lead to a real appreciation of the domestic currency).

i  Capitalinflow  E

An appreciation of the domestic currency increases the price of exports, and the net
exports position worsens. Simultaneously, an appreciation decreases the price of
imports, and the net exports position worsens.
Chain of events in the IS-LM model for an open economy and diagrams:

10
 Expansionary fiscal policy
An increase in G
A decrease in T
Government spending increases
The impact on the goods market first
G  Z  Y
Y  YD  C
Y  I
Impact on the financial market
i=𝑖
Y  Md  M
Since the central bank sets the interest
rate, the interest rate will be unchanged
(i = 𝑖) and therefore, the exchange rate is
also unchanged.
The increase in the level of output and
income will increase the demand for
money and the quantity of money
Y  Md  M
Impact on the exchange rate and
trade balance
The increase in output and income level
results in an increase in imports and a
deterioration of the trade balance.
Y  IM  NX
AND/OR
Taxes decreases
The impact on the goods market first
T↓ YD↑  C  Z  Y
Impact on the financial market
i=𝑖
Y  Md  M
Since the central bank sets the interest
rate, the interest rate will be unchanged
(i = 𝑖) and therefore, the exchange rate is
also unchanged.
The increase in the level of output and
income will increase the demand for
money and the quantity of money
Y  Md  M
Expansionary monetary policy
A decrease in the interest rate (i)
The interest rate decreases
The impact is on the financial market
MonetaryExpansion  i
Impact on the goods market
i  I  Z  Y
Y  I
Y  YD  C
Impact on the exchange rate and
trade balance
The decrease in the interest rate
causes an increase in capital
outflows; the nominal exchange rate
decreases, and the domestic currency
depreciates (prices are assumed to be
fixed in the IS-LM model).
i  Capitaloutflow  E
A depreciation of the domestic
currency decreases the price of
exports, and the net exports position
improves. Simultaneously, a
depreciation increases the price of
imports, and the net exports position
improves.
E  X  NX
E  IM  NX
The impact of a decrease in the
interest rate on the level of output and
income is strengthened by the impact
of a depreciation – thus, overall, the
level of output and income increases.
E  X  Z  Y
E  IM  Z  Y
Y  IM  NX
The increase in the level of output and
income leads to a second-round
increase in imports and a decrease in
the trade balance. However, we
assume that the positive effect
resulting from the depreciation
overwhelms this effect and the trade
balance improves overall.
11

Impact on the exchange rate and
trade balance
The increase in output and income level
results in an increase in imports and a
deterioration of the trade balance.
Y  IM  NX
What will be the impact on the
financial account of the balance of
payments? The decrease in the
domestic interest rate relative to the
interest rate in the rest of the world
leads to a decrease in the demand for
domestic bonds, which creates a
capital outflow and thus a
deterioration of the financial account

Expansionary fiscal policy in an open economy

An increase in G and/or a decrease in T

The IS curve shifts to the right; the interest rate will be unchanged,
and therefore, the exchange rate is also unchanged

12
 Expansionary monetary policy in an open economy
A decrease in the interest rate (i)

The LM curve shifts downwards; the interest rate decreases,

and the exchange rate depreciates

Contractionary fiscal policy Contractionary monetary policy

A decrease in G An increase in the interest rate (i)
An increase in T

Government spending decreases The interest rate increases

The impact is first on the goods market The impact is on the financial market
G  Z  Y first:
Y  YD  C MonetaryContraction  i
Y  I
Impact on the goods market
Then the impact on the financial market i  I  Z  Y
i=𝑖 Y  I
Y  Md  M Y  YD  C

Since the central bank sets the interest
rate, the interest rate will be unchanged
(i = 𝑖) and therefore, the exchange rate
is also unchanged.
The decrease in output and income level
results in a decrease in the demand for
money and the quantity of money.
Y  Md  M
Impact on the exchange rate and
trade balance
i  Capitalinflow  E
An appreciation of the domestic
currency increases the price of exports,
and the net exports position worsens.
Simultaneously, an appreciation
decreases the price of imports, and the
net exports position worsens.

13
Impact on the exchange rate and
trade balance
The decrease in the level of output and
income results in a decrease in imports
and an improved trade balance.
Y  IM  NX
The exchange rate is unchanged.
Since exports are unchanged and
imports decrease net exports increase.
The trade balance (net exports)
improves.
AND/OR
Taxes increases
Impact is first on the goods market
T  YD  C  Z  Y
Y  YD  C
Y  I
Then the impact on the financial market
i=𝑖
Y  Md  M
Impact on the exchange rate and
trade balance
The decrease in the level of output and
income results in a decrease in imports
and an improved trade balance.
Y  IM  NX
The exchange rate is unchanged.
Since exports are unchanged and
imports decrease net exports increase.
The trade balance (net exports)
improves.
E  X  NX
E  IM  NX
The impact of an increase in the
interest rate on the level of output and
income is strengthened by the impact of
an appreciation. Thus, overall, the level
of output and income decreases.
E  X  Z  Y
E  IM  Z  Y
Y  IM  NX
The decrease in the level of output and
income leads to a second-round
decrease in imports and an increase in
the trade balance. However, we
assume that the negative effect
resulting from the appreciation
overwhelms this effect and the trade
balance deteriorates overall.
What will be the impact on the financial
account of the balance of payments?
The increase in the domestic interest
rate relative to the interest rate in the
rest of the world leads to an increase in
the demand for domestic bonds, which
creates a capital inflow and thus an
improvement of the financial account
14
 Contractionary fiscal policy
A decrease in G
An increase in T

The IS curve shifts to the left; the interest rate will be unchanged,
and therefore, the exchange rate is also unchanged

Contractionary monetary policy

An increase in the interest rate (i)

The LM curve shifts upwards; the interest rate increases,

and the exchange rate appreciates

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 THE IS-LM-PC MODEL

The IS-LM-PC model integrates our knowledge about the goods market, financial
market, labour market, price setting by firms in an imperfect market and the Phillips
curve.

THE PHILLIPS CURVE AND ITS MUTATIONS

According to economist AW Phillips, a negative relationship exists between the rate

of unemployment and inflation in the United Kingdom for each year from 1861 to
1957. This is known as the Phillips curve.

When unemployment was low, inflation was high (or positive). When unemployment
was high, inflation was low, even sometimes negative ‒ there was a short-run trade-
off between unemployment and inflation, and policymakers could use this trade-off in
policymaking.

For example, at a low unemployment rate of 2%, the inflation rate was 4%, but at a
higher unemployment rate of 4%, the inflation rate was only 1%. If policymakers were
to accept a higher inflation rate, they could achieve lower unemployment.

Later studies by Friedman and Phelps (using USA data from the 1970s) showed that
the apparent trade-off between the inflation rate and the unemployment rate
disappeared. This break down of the original Phillips curve's negative relationship is
that the wage setters or workers changed how they formed their expectations about
inflation because there was a change in inflation behaviour.

From the 1970s, the rate of inflation became more persistent. As inflation became
more persistent, workers and firms started changing the way they formed
expectations. They started assuming that if inflation had been high last year, inflation

16
was likely to be high this year as well and therefore, the unemployment rate does not
affect the inflation rate as such but rather the change in the inflation rate.

This negative relation between the change in inflation and the unemployment rate is
often called the modified Phillips curve, or the expectations augmented Phillips curve

For low unemployment, the change in inflation is positive. For high unemployment, the
change in inflation is negative ‒ high unemployment leads to decreasing inflation, and
low unemployment leads to increasing inflation.

THE PHILLIPS CURVE AND THE NATURAL RATE OF UNEMPLOYMENT

The natural rate of unemployment is the unemployment rate at which the actual
inflation rate is equal to the expected inflation rate (un  π = πe).

The natural rate of unemployment is influenced by factors that affect wage setting
(the catchall factor z) and the mark-up set by firms (m).

Suppose the inflation rate in the previous year is a good prediction of the expected
rate of inflation this year, then we can think about the Phillips curve as a relation
between the actual unemployment rate (ut), the natural unemployment rate un, and
the change in the inflation rate (πt – πt-1), where πt is the expected rate of inflation
this year and πt-1 the previous year's inflation rate.

The change in the inflation rate (πt – πt-1) depends on the difference between the
actual unemployment rate this year (ut) and the natural unemployment rate (un).

When the actual When the actual When the actual

unemployment rate is equal
to the natural unemployment
rate, change in inflation is
zero decreases
(ut = un: inflation zero)
unemployment rate is unemployment rate is lower
higher than the than the natural
natural unemployment unemployment rate, change
rate, change in in inflation increases
inflation decreases (ut < un: inflation ↑).
(ut > un: inflation ↓);

The natural rate of unemployment is the rate of unemployment required to keep the
inflation rate constant.

The Phillips curve (PC curve) in terms of output

To build and work with the IS-LM-PC model, we must rewrite our Phillips curve in
terms of output. Since we are concerned about the determination of output In this
module.
The relationship between unemployment, employment and output are central to the
IS-LM-PC model.

From unemployment to employment to output

If we know what the natural rate of unemployment is, we can derive the natural level
of employment and, from the natural level of employment through a production
function, we can derive the natural level of output or the potential output level.

17
As the natural unemployment rate changes, the natural level of employment and
natural level of output (potential output) will also change.

For a given labour force, the natural rate of unemployment determines the level of
employment, and that, given the production function, the level of employment
determines the level of output. Thus, associated with the natural rate of
unemployment is the potential level of output.

The difference between actual output and potential output is called the output gap.

The following relations between output and employment (known as Okun's law) are
important. :

If the unemployment rate If the unemployment rate is If unemployment is

is equal to the natural
rate of unemployment,
output is equal to
potential output, and the
output gap is equal to
zero.
(If u = un; Y = Yn 
output gap is zero 
change in inflation is
zero.)
above or higher than the
natural rate of
unemployment, output is
below potential output, and
the output gap is negative.
If the output gap is
negative, inflation
decreases.
(If u > un; Y < Yn  output
gap is negative  inflation
↓.)
below or lower than the
natural rate of
unemployment, output is
above potential output,
and the output gap is
positive. If the output
gap is positive, inflation
increases.
(If u < un; Y > Yn 
output gap is positive 
inflation ↑.)

The positive relation between output and the change in inflation is drawn as the
upward sloping PC curve, where output (Y) is measured on the horizontal axis. The
change in inflation (πt – πt-1) is measured on the vertical axis.

When output is equal to potential (or when the output gap is equal to zero), the
change in inflation is equal to zero. Thus, the Phillips curve crosses the horizontal
axis at the point where output is equal to potential.

The Phillips curve in terms of output (positive output gap)

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 In the short run, the output gap can be at potential, positive or negative.

An IS-LM-PC model An IS-LM-PC model showing a An IS-LM-PC model showing

showing point a where positive output gap at point a a negative output gap at
output is at potential in in the short run point a in the short run
the short run

HOW AN ECONOMY MOVES FROM A SHORT-RUN EQUILIBRIUM POSITION TO

A MEDIUM-RUN POSITION

In the short-run, the equilibrium level of output and income can deviate from the
natural level of output and income. In other words, a negative or positive output gap
may exist and not necessary at potential.

This short-run deviation from the natural level of output and income may be due to
fiscal policy, monetary policy, consumer confidence or investor confidence.

A non-constant inflation rate will eventually prompt the central bank into action,
resulting in an adjustment to the medium-run where output is equal to the natural
level of output, unemployment is equal to the natural rate of unemployment, inflation
is constant, and the real interest rate is equal to the so-called "natural rate of
interest".

Short-run equilibrium position where Short-run equilibrium position where

the output gap is positive (above the output gap is negative (below
potential) at point a. potential) at point a.

Y is larger than Yn, meaning that output Y is lower than Yn, meaning that output is
is above potential and inflation is below potential and inflation is
increasing. At output level Y, the change decreasing. At output level Y, the change

19
in inflation is positive, and there is an
upwards pressure on inflation.
To influence the output level and the
change in the inflation rate, policymakers
use the real interest rate (r).
Since the inflation rate increases,
policymakers will at a certain point react
to this increasing inflation by increasing
the interest rate in order to decrease
output back to potential output. If output
is equal to potential output and the output
gap is equal to zero, there is no pressure
on inflation.
Top figure: The central bank decided to
increase the interest rate in reaction to
this high inflation. The LM curve shifts
upwards, and over time there is an
upward movement along the IS curve
from a to a1 and output decreases.
in inflation is negative, and there is a
downwards pressure on inflation.
To influence the level of output and the
change in the inflation rate, policymakers
use the real interest rate (r).
Since the inflation rate decreases,
policymakers will, at a certain point, react
to this decreasing inflation by decreasing
the interest rate in order to increase
output back to potential output. If output
is equal to potential output and the output
gap is equal to zero, there is no pressure
on inflation.
Top figure: The central bank decided to
decrease the interest rate in reaction to
this low inflation. The LM curve shifts
downwards, and over time there is a
downward movement along the IS curve
from a to b and output increases.
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Bottom figure: As output decreases, the
economy moves down the PC curve from
point a to a1, and at point a1, the policy
rate is equal rn, output is equal to Yn, and
at this point, inflation is by implication
constant. This is the medium-run
equilibrium position.
Bottom figure: As output increases, the
economy moves up the PC curve from
point a to b, and at point b, the policy rate
is equal rn, output is equal to Yn, and at
this point, inflation is by implication
constant. This is the medium-run
equilibrium position.

THE IMPACT OF FISCAL POLICY IN THE ECONOMY AND HOW MONETARY

POLICY CAN BE USED TO INCREASE THE OUTPUT LEVEL IN THE ECONOMY

Assume that the government decreases government spending and/or increases

taxes to deal with its budget deficit in the economy.

A decrease in government An increase in taxes

spending (G) (T)
Chain of events: SHORT-RUN Chain of events: SHORT-RUN
(the movement from point a to (the movement from point a to
point a1) point a1)
Impact on the goods market Impact on the goods market
G  Z  Y T  YD  C  Z  Y

The IS curve shifts to the left The IS curve shifts to the left from
from IS to IS1 IS to IS1

Y  YD  C Y  YD  C
Y  I Y  I

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Impact on the financial market
i=𝑖
Y  Md  M
Impact on the exchange rate
The exchange rate is
unchanged because i = 𝑖
Impact on the trade balance
Y  IM  NX
Impact on the labour market
The question states that output
is lower than potential.
If u > un; Y < Yn  output gap is
negative  inflation↓
MEDIUM-RUN ADJUSTMENT
(movement from point a1 to
point a2)
A non-constant inflation rate will
eventually prompt the central
bank into action. A negative
change in inflation will prompt
the central bank to decrease the
interest rate to increase the
output level so that it
approaches the natural level of
output.
Impact on the financial market
MonetaryExpansion  r
The LM curve shifts downwards
from LM to LM1
Impact on the goods market
Y  Yn
r  I  Z  Y
Y  I
Y  YD  C
The situation in the medium-run
compared to the initial position
(point a2 compared to point a)
rn
Y  Yn
r   I  Z Y
Y  I
Y  YD  C
G
The level of output is now back to
its natural level. The real interest
Impact on the financial market
i=𝑖
Y  Md  M
Impact on the exchange rate
The exchange rate is
unchanged because i = 𝑖
Impact on the trade balance
Y  IM  NX
Impact on the labour market
The question states that output
is lower than potential.
If u > un; Y < Yn  output gap is
negative  inflation↓
MEDIUM-RUN ADJUSTMENT
(movement from point a1 to
point a2)
A non-constant inflation rate will
eventually prompt the central
bank into action. A negative
change in inflation will prompt
the central bank to decrease the
interest rate to increase the
output level so that it
approaches the natural level of
output.
Impact on the financial market
MonetaryExpansion  r
The LM curve shifts downwards
from LM to LM1
Impact on the goods market
Y  Yn
r  I  Z  Y
Y  I
Y  YD  C
The situation in the medium-run
compared to the initial position
(point a2 compared to point a)
rn
Y  Yn
r   I  Z Y
Y  I
Y  YD  C
T
The level of output is now back to
its natural level. The real interest
22
rate needed to maintain the natural
output level, which is now lower
than before, means that investment
spending is even higher than
before the contractionary fiscal
policy.
In other words, the decrease in
consumption is offset by an
increase in investment.
Consumption spending is back to
its initial level, so demand, by
implication, is unchanged.
Government spending is lower.
rate needed to maintain the natural
output level, which is now lower
than before, means that investment
spending is even higher than
before the contractionary fiscal
policy.
In other words, the decrease in
consumption is offset by an
increase in investment.
Consumption spending is back to
its initial level, so demand, by
implication, is unchanged.
Taxes are higher.
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