Apuntes

1.
TOPIC 1
Macroeconomics: Objectives and

instruments
Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective PowerPoints on the Web, 2nd edition © Pearson Education Limited 2014
CONTENTS
1.2
1. The objectives of macroeconomics

2. Economic models
3. The instruments of economic policy
4. Some figures from around the world
Slide
1.3
1. The objectives of Macroeconomics
Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
1.4
Microeconomics: deals with the behaviour of individual economic

units (consumers, firms, markets…).
- Explains how and why these units make economic decisions

- Focuses on individual variables.
1.5
Macroeconomics: is the study of the economy as a whole.

- focuses on aggregate variables and the relationships between
them.
Objectives of macroeconomics
- Explain overall behaviour of the economy

- Elaborate and evaluate economic policy measures.
Principal macroeconomic variables
1.6
Aggregate output
It is the main determinant of the standard of living of the
population.
Rate of unemployment
Employment in the main source of individuals’ income.
Rate of inflation
A sustained raise in the general level of prices.
 It lowers the purchasing power of wages.
 It generates uncertainty and reduces the marginal propensity to save
→ lower investment.
 If has a negative effect on national firms’ competitiveness.
Principal macroeconomic variables
1.7
 Sources of data
 Instituto Nacional de Estadística: www.ine.es
 Eurostat: ec.europa.eu/eurostat/data/database
 World Bank: data.worldbank.org
Slide
1.8
2. Economic models
1.9
• The real world is very complex
• Economists try to understand the economy by using simplified

theories, called models.
− Models summarize, often in mathematical terms, the relationships
among economic variables.
− Models are useful because they help us to dispense with the irrelevant
details and to focus on important connections more clearly.
Methodology in economics
1.10
• The departure point is a set of assumptions
• Simplification allows to:

− Understand (interpret) reality
− Make predictions
• Statistics and econometrics measure the accuracy of our

predictions
• The validity of a model depends on whether it succeeds in

explaining and predicting the set of phenomena that it is
intended to explain and predict.
− if it fails, it will be modified or discarded.
1.11
• The role of assumptions:
– Assumptions are used to make the world more understandable

and simple.
– A big part scientific thought is knowing which assumptions we

need to use
– Economists use different assumptions in order to study

different topics.
1.12
Complex
Abstraction
world
MODEL
Functional
Variables relationships
Endogenous Exogenous Y = F(X)
(Y) (X)
1.13
 VARIABLES  RELATIONSHIPS
 Endogenous & exogenous  Identities: definitions
 Flow & stock  Functional equations
 Real & nominal  Behavioural
 Technological
 Institutional
 Equilibrium conditions
• EQUILIBRIUM
• Existence, stability
• Comparative statics - dynamics
1.14
Exogenous versus endogenous variables

− Endogenous variables are those whose value is determined within the
model
− Exogenous variables are those that are determined outside the model
Stock versus flow variables
− Stock variables are measured at a point in time, and represents a
quantity at a point in time, which may have accumulated in the past (eg
stock of capital, …)
− Flow variables are measured per unit of time (eg GDP, aggregate
consumption,…)
Nominal versus real variables
− Nominal variables are measured at prices prevailing at the time of
measurement (variables measured in monetary units)
− Real variables involve adjustment to nominal values to take into account
changes in the price level (variables measured in physical units)
Relation between economic agents:
Circular Flow of Income
Slide
1.15
Firms
Factor Payments Consumption Goods

Markets to factors (€) Markets
(€)
Households
Relation between economic agents:
Circular Flow of Income
Slide
1.16
Direct flows
Inflows
Firms
Investment (I) Govt. Exp. (G) Exports (X)
Payments Consumption Financial Govt. Rest of

to factors (C) markets World
(Y)
Savings (S) Taxes (T) Imports (M)
Households
Outflows
Slide
1.17
3. The Instruments of Economic Policy
1.18
Macroeconomic policy instruments are variables controlled by

the economic authorities (government and Central Bank) that are
used to deal with the main macroeconomic problems
(unemployment, inflation, recession, trade deficits,...)
Economic Policy Instruments
1.19
Fiscal policy: deliberate use of government spending and taxes

to stimulate or slow down the economy
- it is controlled by the Government.
Monetary policy: influencing the economy through changes in

the banking system’s reserves that influence money supply,
interest rates, and credit available in the economy.
- it is controlled by the Central Bank (ECB, Fed, BoE,...)
Economic Policy Instruments
1.20
Supply side policies: labour market reforms, educational

system reforms, policies to encourage R&D,…
Exchange rate policy
Main macroeconomic problems
1.21 Problems Objectives of economic policy
 Unemployment: existence of idle  Creation of new jobs (reduction of

factors of production unemployment rates)
 Inflation: sustained rise in the  Stability of the general level of prices
general level of prices (reduce the rate of inflation)
 Recession: a slowdown in economic  Economic growth avoiding business cycles
activity (sustained increase of the GDP)
 Trade deficit with the Rest of the  Healthy trade balance (Exports>Imports?)
World
 Budget Deficit of the public sector  Budget stability
There may be conflict between objectives:

- inflation vs. unemployment trade-off (‘Phillips curve’)
1.22
4. Some figures from around the world
1.23
When macroeconomists study an economy, they first look at

three variables:
• Output
• The unemployment rate
• The inflation rate
The Crisis
1.24
• From 2000 to 2007, the world economy had a sustained

expansion.
• In 2007, U.S. housing prices started declining, leading to a major
financial crisis.
• The financial crisis turned into a major economic crisis with falling
stock prices.
• In the third quarter of 2008, U.S. output growth turned negative
and remained so in 2009.
• Through the trade and financial channels, the U.S. crisis quickly
became a world crisis.
1.25
Figure 1. Output Growth Rates for the World Economy, for Advanced
Economies, and for Emerging and Developing Economies, 2000–2014
1.26
Figure 2. Stock prices in the United States, the Euro area, and
emerging economies, 2007–2010
The Euro Area
1.27
• The European Union (EU) is a group of 28 European counties

with a common market.
• In 1999, the EU formed a common currency area called the
Euro area, which replaced national currencies in 2002 with the
euro.
• The Euro area faces two main issues today:
- How to reduce unemployment?
- How to function efficiently as a common currency area?
The Euro Area
1.28
• While the United States recovered from the 2008–2009 crisis, output
growth in the Euro area remained close to zero between 2010 and 2014.
• In 2015, output growth was below the pre-crisis average and the
unemployment rate was 11.1%.
Table 1-3. Growth, Unemployment, and Inflation in the Euro Area, 1990–2015
The Euro Area
1.29
• While the average unemployment rate for the Euro area was
11.1% in 2015, countries like Spain had an unemployment
rate of 23%.
• Much of the high unemployment rate was the result of the
crisis.
• Even when Spain had its lowest unemployment rate of 9%, it
was nearly twice that of the United States.
• Some economists believe labor market rigidities with too
much protection for workers are the main problem.
The Euro Area
1.30
Figure 3. Unemployment in Spain since 1990
The Euro Area
1.31
• Supporters of the euro argue:

- economic advantages due to no more changes in exchange rates
- its contribution to the creation of a large economic power
• Others argue:
- the drawback of a common monetary policy across euro countries
- the loss of the exchange rate as an adjustment instrument within the
euro area
The United States
1.32
• The U.S. economy in 2015 was in decent shape, leaving much of the effects
of the 2008-2009 crisis behind.
Table 1-1. Growth, Unemployment, and Inflation in the United States, 1990–2015
The United States
1.33
• Productivity growth is important for a sustained increase in income per person,

but since 2010, it has been only about half as it was in the 1990s.
• The slowdown in productivity growth is worrisome because the standard of
living especially for the poor may not increase.
Table 1-2. Labor Productivity Growth, by Decade
China
1.34
• China’s rapid output growth has been driven by high accumulation of capital
and technological progress.
• The slowdown after the crisis is considered to be desirable as more of output
would go to consumption instead of investment.
Table 1-4. Growth, unemployment and Inflation in China, 1990–2015
2.1
Topic 2
Principal Macroeconomic Aggregates
CONTENTS
2.2
1. Fundamental Identities
2. Measuring unemployment
3. Measuring inflation
Dornbusch et al. (2014), chapter 2.

Blanchard (2013), chapter 2.
2.3
1. Fundamental Identities
Aggregate output
2.4
• National income and product accounts are an accounting

system used to measure aggregate economic activity.
• The measure of aggregate output in the national income

accounts is Gross Domestic Product, or GDP.
GDP: Production and Income
2.5
GDP is the total value of the final goods and services produced in
the economy during a given period.
 “…total value…”
 Production is valued at market prices
 Those goods and services that do not have market value are not
included.
 “…final goods and services…”

 In order to avoid double counting, intermediate goods, or goods that
are used as inputs in the production of other goods, are not included.
 “…during a given period”

 It is a flow
 The sale of goods produced in previous years is not included.
Real vs. Nominal GDP
2.6
GDP =  (Prices of goods × Quantities of goods)

GDP can increase:
• if prices are increasing,
• if quantities are increasing,
• if both prices and quantities are increasing…
If all the increase in GDP has been due to an increase in prices, can
we say that the standard of living increased?
Clearly, no!
We need to know the Real GDP, which holds prices constant.
Real vs. Nominal GDP
2.7
• Nominal GDP (at current prices) in year 𝒕 is the sum of the

quantities of the 𝑵 final goods produced in year 𝒕 multiplied by
their current (i.e., year 𝒕) prices:
𝑵
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷𝒕 = ෍ 𝑷𝒊𝒕 𝑸𝒊𝒕

𝒊=𝟏
• Real GDP (at constant prices of some year 𝟎) is constructed as

the sum of the quantities of the 𝑵 final goods produced in year 𝒕
multiplied by their constant (i.e., year 𝟎) prices:
𝑵
𝑹𝒆𝒂𝒍 𝑮𝑫𝑷𝒕 = ෍ 𝑷𝒊𝟎 𝑸𝒊𝒕

𝒊=𝟏
Price Index: The GDP deflator
2.8
• The GDP deflator is a price index:
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷𝒕
𝑷𝒕 =
𝑹𝒆𝒂𝒍 𝑮𝑫𝑷𝒕
• The inflation rate for period 𝒕 can be calculated as the

(percentage) change in the GDP deflator (or some other price
index such as the Consumer Price Index):
𝑷𝒕 − 𝑷𝒕−𝟏
𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆𝒕 = × 𝟏𝟎𝟎%
𝑷𝒕−𝟏
Computing nominal GDP
2.9
Pizzas Cappuccinos
Year P Q P Q
2012 10 € 400 2.00 € 1000
2013 11 € 500 2.50 € 1100
2014 12 € 600 3.00 € 1200
Nominal GDP each year: Rate of change

2012: 10€ x 400 + 2 € x 1000 = 6000
37.5%
2013: 11€ x 500 + 2.50 € x 1100 = 8250
30.9%
2014: 12€ x 600 + 3 € x 1200 = 10800
Computing real GDP
2.10
Pizzas Cappuccinos
Year P Q P Q
2012 10€€
10 400 2,00 €
2.00€ 1000
2013 11€ 500 2.50 € 1100
2014 12€ 600 3.00 € 1200
Real GDP choosing year 2012 as the base year

Rate of change
2012: 10€ x 400 + 2€ x 1000 = 6000 €
20.0%
2013: 10€ x 500 + 2€ x 1100 = 7200 €
16.7%
2014: 10€ x 600 + 2€ x 1200 = 8400 €
Computing nominal and real GDP
2.11
Nominal Real
Year GDP GDP
2012 6000€ 6000€
37.5% 20.0%
2013 8250€ 7200€
30.9% 16.7%
2014 10800€ 8400€
The change in the nominal GDP reflects both changes in

quantities and prices
The change in the real GDP reflects the change in GDP if prices
remained constant
Real GDP corrects for inflation
Computing the GDP deflator 𝑷𝒕 =
2.12
Nominal GDP
Year GDP Real GDP deflator
2012 6000 6000 100.0
14.6%
2013 8250 7200 114.6
12.2%
2014 10800 8400 128.6
Inflation
GDP deflator: rates
2012: 100 x (6000/6000) = 100.0

2013: 100 x (8250/7200) = 114.6
2014: 100 x (10800/8400) = 128.6
Production and income
2.13
Three ways of defining GDP
1. GDP is the value of the final goods and services produced in the
economy during a given period.
2. GDP is the total expenditure required to purchase the goods and

services produced in the economy
3. GDP is the sum of incomes in the economy during a given period
Supply of goods and services
Goods
market
2.14
Goods and services

(= GDP) Firms
(sellers)
Pay salaries,
Spend income
on goods and
Circular interest, rents
services flow of and profits
Expenditure income
(= GDP) Income
(= GDP)
Households
(buyers)
Monetary flows
Real flows
Factor
markets
Supply of factors (labour, capital, land, etc)
2.15 Agents
 Households:
- They are the owners of the factors of production and of firms
- They buy final goods and services (consumption units)
 Firms:
- Produce goods and services
- Demand labour and other factors of production
- Make investment decisions
2.16
Agents
 Public sector:
• Obtains revenues:
- Direct taxes (TD)
- Indirect taxes (Ti)
• Makes expenditure:
- Government spending (G)
 Purchases of goods and services by the national, regional and local
governments (including public investment)
- Transfers to households (TR) and subsidies to firms (Sb)
 Transfer payments are not included in the GDP, as they are one-
way payment of money for which no money, good, or service is
received in exchange.
2.17
Agents
 External sector:
• Balance of payments
2.18
Source: Macroeconomics (9th ed.),

Abel, Bernanke and Croushore (2017),
Balance of Payments
2.19
Balance of payments: accounting record of all transactions

between a country and the rest of the world:
• Current Account
a) Goods Trade balance (X - M)
b) Services
c) Income Income balance = (Income Receipts - Income Payments)
d) Current transfers Net current transfers = TRE
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒄𝒄𝒐𝒖𝒏𝒕 𝑩𝒂𝒍𝒂𝒏𝒄𝒆 = 𝑿 − 𝑴 + 𝑰𝑹 − 𝑰𝑷 + 𝑻𝑹𝑬
• Capital Account
• Financial Account
Balance of Payments
2.20
The Current Account
• Trade Balance: registers the value of exports (X) and imports

(M) of goods and services
• Income Balance: registers the employees compensations (wages)
and payments associated with holdings of financial assets and
liabilities (investment income)
• Transfers Balance: registers transfers which do not involve a
quid pro quo in economic value (international cooperation,
migrants remittances, transfers within the European Union,…)
Balance of Payments
2.21
The Financial Account
• The financial account records trades in existing assets, either

real (e.g., houses) or financial (e.g., stocks and bonds)
• When home country sells assets to a foreign country, there is
a capital inflow for the home country and an increase in the
financial account balance
• When assets are purchased from a foreign country, there is
a capital outflow from the home country and a decrease in
the financial account balance
Balance of Payments
2.22
• Financial Inflow
- Increase in financial account
- Sale of U.S. assets to foreigners
• Financial Outflow
- Decrease in financial account
- Purchase of foreign assets by U.S. residents
Balance of Payments
2.23
The Balance of Payments
• Transactions in official reserve assets are conducted by

central banks of countries
• Official reserve assets are assets (foreign government
securities, bank deposits, and SDRs of the IMF, gold) used in
making international payments
• Central banks buy (or sell) official reserve assets with (or to
obtain) their own currencies
Balance of Payments
2.24
The Balance of Payments
• Balance of Payments is equal to the net increase in a

country’s official reserve assets
• For the United States, the net increase in official reserve
assets is the rise in U.S. government reserve assets minus
foreign central bank holdings of U.S. dollar assets
• Having a balance of payments surplus means a country is
increasing its official reserve assets; a balance of payments
deficit is a reduction in official reserve assets
Balance of Payments
2.25
• Current Account balance (CA) + Financial Account balance (FA) = 0

• CA + FA = 0
• Every transaction with the exterior involves offsetting effects.
Balance of Payments
2.26
Net foreign assets and the balance of payments accounts
• Net foreign assets are a country’s foreign assets minus its foreign
liabilities
- Net foreign assets may change in value (e.g., change in stock
prices)
- Net foreign assets may change through acquisition of new
assets or liabilities
Balance of Payments
2.27
• Net foreign assets are a country’s foreign assets minus its foreign
liabilities
- Net foreign assets may change in value (e.g., change in stock
prices)
- Net foreign assets may change through acquisition of new assets
or liabilities
- The net increase in foreign assets equals a country’s current
account surplus
- A current account surplus implies a financial account deficit, and
thus a net increase in holdings of foreign assets (a financial
outflow)
- A current account deficit implies a financial account surplus, and
thus a net decline in holdings of foreign assets (a financial inflow)
Balance of Payments
2.28
• Foreign direct investment: a foreign firm buys or builds

capital goods
- Causes an increase in financial account balance
• Portfolio investment: foreigners acquire U.S. securities
- Also increases financial account balance
Balance of Payments
2.29 Equivalent measures of a country’s international trade and lending
• Each of the following describes the same situation

- Current account surplus of €10 billion
- Financial account deficit of €10 billion
- Net acquisition of foreign assets of €10 billion
- Net foreign lending of €10 billion
- Net exports of €10 billion (if Income Balance and net unilateral
transfers are zero)
2.30
1. The production side
GDP is…
… the value of the final goods produced in the economy
or
…the sum of value added in the economy during a given period.
Value added equals the value of a firm’s production minus

the value of the intermediate goods it uses in production.
2.31
1. The production side
Steel company (Firm1) Car company (firm 2)

Revenues from sales 100€ Revenues from sales 200€
Expenses 80€ Expenses 170€
Wages 80€ Wages 70€
Steel 100€
Profit 20€ Profit 30€
The value of the final goods produced in the economy is 200€ (steel is an intermediate
good).
2.32
1. The production side (computing value added)
Steel company (Firm1) Car company (firm 2)

Revenues from sales 100€ Revenues from sales 200€
Expenses 80€ Expenses 170€
Wages 80€ Wages 70€
Steel purchases 100€
Profit 20€
Value added (VA) 100€ Profit 30€
Value added 100€
𝐺𝐷𝑃 𝑓𝑟𝑜𝑚 𝑡ℎ𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑠𝑖𝑑𝑒 = ෍ 𝑉𝐴 = 100€ + 100€ = 200€
2.33
2. Expenditure side (demand)
GDP is equal to the total expenditure on the economy’s final goods

and services (national expenditure)
𝑮𝑫𝑷  𝑪 + 𝑰 + 𝑮 + (𝑿 − 𝑴)
Consumption (𝑪): consists of the goods and services bought by households

during the period.
Investment (𝑰): purchase by firms of capital goods that are used in the
production process. It includes residential investment, the purchase by people
of new houses.
Government spending (𝑮): purchases of goods and services by the government
during the period.
Net exports: Purchases of domestic goods and services by foreigners (𝑿) minus
purchases of foreign goods and services by domestic agents (𝑴).
2.34
2. Expenditure side (demand)
Types of investment:
 Residential investment
 Fixed investment: expenditure in order to maintain (𝑫𝑷) and increase
the capital stock ( 𝑵𝑰 ) of the economy (new machines, plants,
computers,…)
 Inventory investment (𝑰𝒔): the difference between goods produced
and goods sold in a given year.
Gross investment (𝑮𝑰)  Net investment (𝑵𝑰) + Depreciation (𝑫𝑷)
𝑮𝑰 = 𝑵𝑰 + 𝑫𝑷
𝑵𝑰 = 𝑮𝑰 − 𝑫𝑷
2.35
Gross Domestic Product vs. Net Domestic Product
 Gross Domestic Product (GDP): total value of the goods

produced within a country, including those goods that have
been used to maintain the stock of capital (depreciation).
 Net Domestic Product (NDP) total value of the goods

produced within the country, excluding depreciation.
𝑮𝑫𝑷  𝑵𝑫𝑷 + 𝑫𝑷
2.36 GDP at market prices (𝑮𝑫𝑷𝒎𝒑 ) vs. GDP at factor cost (𝑮𝑫𝑷𝒇𝒄)
 Which prices do we consider?
• The price paid by consumers (market prices) for many goods and
services is not the same as the sales revenue received by the
producer (factor cost):
𝑮𝑫𝑷𝒎𝒑  𝑮𝑫𝑷𝒇𝒄 + 𝑰𝒏𝒅𝒊𝒓𝒆𝒄𝒕 𝒕𝒂𝒙𝒆𝒔 (𝑻𝒊) – 𝑺𝒖𝒃𝒔𝒊𝒅𝒊𝒆𝒔 (𝑺𝒃)
2.37
National Product vs. Domestic Product
Domestic Product: Total value of the goods produced within a

country in a given period (regardless of the nationality of the
factors of production used).
National Product: Total value of the goods produced during the

period, within or outside the country, by factors of production
supplied by the residents of a country.
𝑵𝒂𝒕𝒊𝒐𝒏𝒂𝒍 𝑷𝒓𝒐𝒅𝒖𝒄𝒕  𝑫𝒐𝒎𝒆𝒔𝒕𝒊𝒄 𝑷𝒓𝒐𝒅𝒖𝒄𝒕 + (𝑰𝑹 − 𝑰𝑷)
𝑰𝑹: Income received by domestic factors of production abroad

𝑰𝑷: Income received by foreign factors of production in Spain
2.38
3. Income side
GDP is the sum of incomes in the economy during a given period
(wages, interest, rents and profits).
What we usually call National Income is 𝑵𝑵𝑷𝒇𝒄 and is denoted by 𝒀.
Disposable income ( 𝒀𝑫 ): the amount of income left after

consumers have received transfers from the government and
paid their taxes, and is available for consumption and saving.
Uses of disposable income:

 Consumption (𝑪)
 Saving ( 𝑺 ): income that households do not devote to

consumption.
2.39
3. Income side
𝒀𝑫  𝑪 + 𝑺  𝒀 – 𝑺𝑭 – 𝑻𝑫 + 𝑻𝑹 + 𝑻𝑹𝑬
𝑆𝐹 = Firm’s savings (undistributed profits)

𝑇𝑅𝐸 = Net transfers from the Rest of the World
𝒀 = 𝑪 + 𝑺 + 𝑺𝑭 + 𝑻𝒅 − 𝑻𝑹 − 𝑻𝑹𝑬
𝑵𝒂𝒕𝒊𝒐𝒏𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆  𝑵𝑵𝑷𝒇𝒄  𝒀  𝑵𝑵𝑷𝒎𝒑 + 𝑺𝒃 – 𝑻𝒊

𝑵𝑵𝑷𝒎𝒑  𝑪 + 𝑺 + 𝑻 − 𝑻𝑹𝑬
where 𝑻  𝑻𝒅 + 𝑻𝒊 − 𝑺𝒃 − 𝑻𝑹
2.40
Equality of the two methods (simplified)
Expenditure side: Income side:
𝒀 𝑪+𝑰+𝑮+𝑿−𝑴 𝒀 𝑪+𝑺+𝑻
Excess of private domestic saving

over investment is lent to the
𝑺 – 𝑰 = (𝑮 – 𝑻) + (𝑿 – 𝑴) government to finance the budget
deficit or to the exterior to finance
the trade surplus
Investment is financed by some

𝑰 = 𝑺 + (𝑻 – 𝑮) + (𝑴 – 𝑿) combination of private domestic
saving, government saving and
foreign saving
Private saving finances

𝑺 = 𝑰 + (𝑮 – 𝑻) + (𝑿 – 𝑴) investment, budget deficit
and trade surplus
Identities revisited (Dornbusch et al., 2014)
2.41
 Assume national income equals GDP

  use terms income and output interchangeably (convenience)
Begin with a simple economy: closed economy with no public sector:
𝑌 ≡𝐶+𝐼 (4)
 Only two things can do with income - consume and save:
𝑌 ≡𝐶+𝑆 (5)
 where S is private saving. Now, combine (4) and (5):
 𝐶+𝐼 ≡ 𝑌 ≡ 𝐶+𝑆 (6)
Demand Income
 Rearranging:
 𝐼 ≡𝑌−𝐶 ≡𝑆 (7)
INVESTMENT = SAVING

Identities revisited (Dornbusch et al., 2014)
When adding the government and the foreign sector:
2.42
𝑌 ≡ 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋 (8)
Disposable income, 𝑌𝐷, is what consumers split between 𝐶 and 𝑆:
𝑌𝐷 ≡ 𝐶 + 𝑆 (9)
When we have a public sector:
𝑌𝐷 = 𝑌 + 𝑇𝑅 − 𝑇𝐴 (10)
where 𝑇𝑅 is transfer payments and 𝑇𝐴 is taxes.
If rearrange (10) and substitute (8) for Y, then:
𝑌𝐷 − 𝑇𝑅 + 𝑇𝐴 ≡ 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋 (11)
Substituting (9) into (11):
𝐶 + 𝑆 − 𝑇𝑅 + 𝑇𝐴 ≡ 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋 (12)
Rearranging: 𝑆 − 𝐼 ≡ 𝐺 + 𝑇𝑅 − 𝑇𝐴 + 𝑁𝑋 (13)
2.43
Saving, Investment, Government Budget and Trade
𝑆−𝐼 ≡ 𝐺 + 𝑇𝑅 − 𝑇𝐴 + 𝑁𝑋
Budget deficit Trade surplus
where 𝐺 + 𝑇𝑅 is total government expenditures and 𝑇𝐴 is

government income
Difference between expenditures and income is the government
budget deficit
2.44 Saving, Investment, Government Budget Deficit and Trade Surplus
 Excess of saving over investment (𝑆 > 𝐼) in the private

sector is equal to the government budget deficit plus the
trade surplus
 Any sector that spends more than it receives in income

has to borrow to pay for the excess spending
 Private sector can dispose of saving (𝑆) in three ways:

1. Make loans to the government (𝐺)
2. Private sector can lend to foreigners (𝑁𝑋)
3. Private sector can lend to firms who use the funds
for Investment (𝐼)
GDP: Level vs. Growth Rate
2.45
GDP per capita is the ratio of real GDP to the population of the country.
GDP growth rate is equal to:
𝑌𝑡 − 𝑌𝑡−1
≅ 𝑙𝑛 𝑌𝑡 − 𝑙𝑛 𝑌𝑡−1
𝑌𝑡−1
 Periods of positive GDP growth are called expansions.

 Periods of negative GDP growth are called recessions.
Of interest for welfare comparison purposes is GDP per capita:
𝑌𝑡
𝐺𝐷𝑃 𝑝𝑒𝑟 𝑐𝑎𝑝𝑖𝑡𝑎𝑡 =
𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛𝑡
GDP: Level vs. Growth Rate
2.46
Figure 2.2 Growth rate of GDP in the EU-15 and in the USA since 1970
Since 1970, both the EU-15 and the US economies have gone through a series of expansions, interrupted by short
recessions. The recession associated with the current crisis has been particularly deep.
Source: http://stats.oecd.org/
GDP as a measure of welfare
2.47
 GDP is the best indicator of the value of output produced in an economy,

but it is an imperfect measure of well-being.
 There are many factors that contribute to wefare that are left out of GDP:
1) GDP does not include leisure.

2) GDP excludes activities that take place outside markets (household
work, volunteer work, …), underground economy (from informal
activities to ilegal activities).
3) GDP excludes the quality of the environment.
4) GDP says nothing about the distribution of income.
Then, why do we care about GDP?
2.48
 Citizens of countries with a large GDP tend to lead a good life

(have access to more and better goods).
 Countries with a large GDP can afford better healthcare,
educational systems, environmental policies, etc.
 In sum, GDP does not not directly measure those things that make
life worthwhile, but it measures our ability to obtain many of the
inputs into a worthwhile life (Mankiw, 2012).
Then, why do we care about GDP?
2.49
2.50
2. Measuring Unemployment
Unemployment
2.51
Some definitions
 Labour force (𝑳): people aged 16 and over who are either working or
looking for work:
◦ Employment (𝑵): is the number of people who have a job.

◦ Unemployment (𝑼): is the number of people who do not have a job but
are looking for one.
𝑳 = 𝑵 + 𝑼
 Economically inactive people: are not in work and do not meet the
internationally agreed definition of unemployment. They are people without a
job who are not actively seeking work and/or are not available to start work.
People without jobs who give up looking for work are known as discouraged
workers.
Unemployment
2.52
The Unemployment rate
• The unemployment rate: the ratio of the number of people

who are unemployed to the number of people in the labour
force:
𝑵𝒐. 𝒐𝒇 𝑼𝒏𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
𝑼𝒏𝒆𝒎𝒑𝒍𝒐𝒚𝒎𝒆𝒏𝒕 𝒓𝒂𝒕𝒆 =
𝑳𝒂𝒃𝒐𝒖𝒓 𝒇𝒐𝒓𝒄𝒆
• Participation rate: the ratio of the labour force (𝐿) to the

population of working age:
𝑳𝒂𝒃𝒐𝒖𝒓 𝒇𝒐𝒓𝒄𝒆
𝑷𝒂𝒓𝒕𝒊𝒄𝒊𝒑𝒂𝒕𝒊𝒐𝒏 𝒓𝒂𝒕𝒆 =
𝑷𝒐𝒑𝒖𝒍𝒂𝒕𝒊𝒐𝒏 𝒐𝒇 𝒘𝒐𝒓𝒌𝒊𝒏𝒈 𝒂𝒈𝒆
Unemployment
2.53 Surveys to compute the unemployment rate in Spain
 Registered Unemployment - Instituto Nacional de Empleo
(INEM).
 The Labour Force Survey (LFS) – Instuto Nacional de Estadística

(INE): quarterly sample survey covering the population in
private households.
 It relies on interviews to a representative sample of individuals. (Random

sample of 60.000 households, extrapolation to the population is done).
 Each individual is classified as employed if he has worked for at least
one hour during the week preceeding that of the interview.
 An individual is classified as unemployed if he has not worked and has
been seeking a job in the previous four weeks.
Unemployment
2.54
Figure 2.3 Unemployment rates in the euro area, UK and USA since 1993
Since 1993, the unemployment rate has fluctuated between 4% and 11%, going down during
expansion and going up during recessions. The effect of the crisis is highly visible, with the
unemployment rate close to 10%.
Source: Eurostat
Unemployment
2.55
Unemployment
2.56 Why do economists care about unemployment?
Economists care about unemployment for two reasons:
 Because of its direct effects on the welfare of the

unemployed
→ personal or health problems, violence, poverty,…..
 Because it provides a signal that the economy may not be

using some of its resources efficiently
→ idle resources, restrictions on labour mobility,
employment mismatch.
2.57
3. Measuring Inflation
Inflation
2.58
Inflation is a sustained rise in the general level of prices (i.e., the

price level).
- The inflation rate is the rate at which the price level increases.
Deflation is a sustained decline in the price level. It corresponds

to a negative inflation rate.
- Deflation episodes are rare. For instance, Japan experienced

deflation during the 1990s.
Inflation
2.59 How do we measure the general level of prices?
 The general level of prices in an economy is measured by

prices indexes.
 A price index (𝑷𝒕 ) is a weighted average of the prices of

a set of goods during a period 𝒕.
 Most common measures of the level of prices:

- GDP deflator
- Consumer price index (CPI)
Inflation
2.60 GDP deflator
Recall from earlier that the GDP deflator in year 𝑡, 𝑃𝑡 , is defined as the ratio of
nominal GDP to real GDP in year 𝑡 :
𝑷𝒕 =
The GDP deflator is what is called an index number and is set equal to 100 in
the base year.
The rate of change in the GDP deflator equals the rate of inflation:
𝑷𝒕 − 𝑷𝒕−𝟏
𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆𝒕 = × 𝟏𝟎𝟎%
𝑷𝒕−𝟏
Nominal GDP is equal to the GDP deflator multiplied by real GDP.
Inflation
2.61 The consumer price index
 The GDP deflator measures the average price of all goods and services
produced in the economy.
 The Consumer Price Index (CPI) measures the average price of

consumption, or equivalently, the cost of living. It includes only the goods
and services bought by consumers.
 The CPI measures the cost in euro of a specific list of goods and services
over time, which attempts to represent the consumption basket of a typical
urban consumer.
 To calculate inflation using the CPI, simply replace the GDP deflator in
the previous slide with the CPI – the percentage change in the CPI
represents the inflation rate…
Inflation
2.62 The consumer price index
The set of goods produced in the economy is not the same as the set of goods
purchased by consumers, for two reasons:
• Some of the goods are sold to firms, to the government or to foreigners.
• Some of the goods are not produced domestically but are imported from
abroad.
Inflation
2.63
Figure 2.4 Inflation rate, using the HICP and the GDP deflator in the euro area since 1996
The inflation rates, computed using either the HICP or the GDP deflator, are largely similar.
Source: http://stats.oecd.org/
Inflation
2.64 Inflation rate in Spain (harmonised CPI)
Source: INE
Inflation
2.65 Inflation rate in Spain (harmonised CPI)
Source: INE
Inflation
2.66 Why do economists care about inflation?
Economists care about inflation for two reasons:
• During periods of inflation, not all prices and wages rise

proportionately, inflation affects income distribution.
• Inflation leads to other distortions.
The short run, the medium run and the long run
2.67
The level of aggregate output in an economy is determined by:
• Demand in the short run, say, a few years.
• The level of technology, the capital stock and the labour force in
the medium run, say, a decade or so.
• Factors such as education, research, saving and the quality of

government in the long run, say, a half century or more.
Topic 3
Income and Spending:

The Goods Market
1
Introduction
• Why does output fluctuate around its potential level?
– In business cycle booms and recessions, output rises and falls relative to the
trend of potential output
• Model in this topic assumes a mutual interaction between output and

spending:
spending determines output and income, …
… but output and income also determine spending
• The Keynesian model develops the theory of Aggregate Demand (AD)

– Assume that prices do not change at all and that firms are willing to sell any
amount of output at the given level of prices → Aggregate Supply (AS)
curve is flat
– Key finding: increases in autonomous spending generate additional

increases in AD
2
Aggregate Supply-Aggregate Demand (AS-AD) Model with Fixed Prices
(vs. AS-AD Model with Flexible Prices)
Price level
General Model with
AS flexible prices
𝑃𝑃1
𝑃𝑃0 = 𝑃𝑃� AS
AD1
AD0
Output (= Income)
Y0 Y1
3
Some simplifying assumptions
• There are no indirect taxes, then:
GDPmp = GDPfc
• Capital goods do not wear out: DP = 0

• Firms do not save: SF = 0
• Hence:
GDP = NDP
Output = GDP = Y = Income
4
Aggregate Demand and Equilibrium
Output
• AD is the total amount of goods demanded in the economy:
𝐴𝐴𝐴𝐴 = 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺 + 𝑁𝑁𝑁𝑁 (1)
• Output is at its equilibrium level when the quantity of output
produced is equal to the quantity demanded, or:
𝑌𝑌 = 𝐴𝐴𝐴𝐴 = 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺 + 𝑁𝑁𝑁𝑁 (2)
• When AD is not equal to output there is unplanned inventory
investment or disinvestment (IU):
𝐼𝐼𝐼𝐼 = 𝑌𝑌 − 𝐴𝐴𝐴𝐴 (3)
where IU is unplanned additions to inventory
– If IU > 0, firms cut back on production until output and AD are
again in equilibrium
– If IU < 0, firms increase production until output and AD are
again in equilibrium 5
The Consumption Function
• Consumption is the largest component of AD
– Consumption increases with income
– The relationship between consumption and income is described
by the consumption function
– If C is consumption and Y is income, the consumption function
is:
𝐶𝐶 = 𝐶𝐶̅ + 𝑐𝑐𝑐𝑐 (4)
where 𝐶𝐶̅ > 0 and 0 < 𝑐𝑐 < 1

– The intercept of equation (4) is the level of consumption when
income is zero: this is greater than zero since there is a
subsistence level of consumption
– The slope of equation (4), 𝑐𝑐 , is known as the marginal
propensity to consume (MPC)
MPC is the increase in consumption per unit increase in income 6
The Consumption Function
7
Consumption and Saving
• Income is either spent or saved
− A theory that explains consumption is equivalently explaining the
behavior of saving
– More formally, the budget constraint can be written as:
𝑆𝑆 ≡ 𝑌𝑌 − 𝐶𝐶 (5)
• Combining (4) and (5) yields the savings function:

𝑆𝑆 ≡ 𝑌𝑌 − 𝐶𝐶 = 𝑌𝑌 − 𝐶𝐶̅ − 𝑐𝑐𝑐𝑐 = −𝐶𝐶̅ + 1 − 𝑐𝑐 𝑌𝑌 (6)
where 1 − 𝑐𝑐 = 𝑠𝑠 > 0 is the marginal propensity to save (MPS).

• As 𝑠𝑠 = 1 − 𝑐𝑐 is positive, saving is an increasing function of income
− e.g., if MPS = 0.1, for every extra euro of income, saving increases by
€0.10 (equivalently, consumers save 10% of an extra euro of income)
8
Consumption, AD, and
Autonomous Spending
• Now we incorporate the other components of AD, which we assume
are autonomous (i.e., do not depend on income)
• These components are government spending (G), Investment (I),
taxes (𝑇𝑇 ≡ 𝑇𝑇𝑇𝑇 − 𝑇𝑇𝑇𝑇), and foreign trade (NX)
• Disposable income is:
𝑌𝑌𝑌𝑌 = 𝑌𝑌 − 𝑇𝑇 = 𝑌𝑌 − 𝑇𝑇𝑇𝑇 + 𝑇𝑇𝑇𝑇 (7)
• Consumption depends on disposable income:
𝐶𝐶 = 𝐶𝐶̅ + 𝑐𝑐𝑐𝑐𝑐𝑐 = 𝐶𝐶̅ + 𝑐𝑐(𝑌𝑌 + 𝑇𝑇𝑇𝑇 − 𝑇𝑇𝑇𝑇) (8)
• AD then becomes
𝐴𝐴𝐴𝐴 = 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺 + 𝑁𝑁𝑁𝑁
= 𝐶𝐶̅ + 𝑐𝑐 𝑌𝑌 + 𝑇𝑇𝑇𝑇 − 𝑇𝑇𝑇𝑇 + 𝐼𝐼 + 𝐺𝐺 + 𝑁𝑁𝑁𝑁
= 𝐶𝐶̅ − 𝑐𝑐 𝑇𝑇𝑇𝑇 − 𝑇𝑇𝑇𝑇 + 𝐼𝐼 + 𝐺𝐺 + 𝑁𝑁𝑁𝑁 + 𝑐𝑐𝑐𝑐
= 𝐴𝐴̅ + 𝑐𝑐𝑐𝑐 (9)
where 𝐴𝐴̅ is autonomous spending (i.e., spending that is
independent of the level of income)
9
Consumption, AD, and
Autonomous Spending
10
Equilibrium Income and Output
11
Equilibrium Income and Output
• Equilibrium occurs where 𝑌𝑌 = 𝐴𝐴𝐴𝐴, which is illustrated by the

45° line
• In the graph, equilibrium occurs at point E
• The arrows show how the economy reaches equilibrium
– At any level of output below Y0, firms’ inventories decline,

and they increase production
– At any level of output above Y0, firms’ inventories increase,
and they decrease production
12
The Formula for Equilibrium Output
• Can solve for the equilibrium level of output, Y0,
algebraically:
– The equilibrium condition is:
𝑌𝑌 = 𝐴𝐴𝐴𝐴 (10)
– Substituting (9) into (10) yields:
𝑌𝑌 = 𝐴𝐴̅ + 𝑐𝑐𝑐𝑐 (11)
– Solve for Y to find the equilibrium level of output:
𝑌𝑌 − 𝑐𝑐𝑐𝑐 = 𝐴𝐴̅
𝑌𝑌(1 − 𝑐𝑐) = 𝐴𝐴̅

1
𝑌𝑌0 = 𝐴𝐴̅ (12)
(1−𝑐𝑐)
13
The Formula for Equilibrium
Output
• Equation (12) shows the equilibrium level of output as a function of the
MPC (c) and Autonomous spending (𝐴𝐴)̅
– Frequently we are interested in knowing how a change in some

component of autonomous spending would change output
– Changes in output due to changes in autonomous spending can be
calculated from:
1
∆𝑌𝑌 = ∆𝐴𝐴̅ (13)
(1−𝑐𝑐)
1
• Example. If the MPC is 𝑐𝑐 = 0.9, then = 10
(1−𝑐𝑐)
 an increase in government spending by €1 billion results in an

increase in output by €10 billion
• Recipients of increased government spending increase their own
spending, the recipients of that spending increase their spending,… and
so on…..
14
Saving and Investment
15
• In equilibrium, planned investment equals saving in an
economy with no government or trade
– Vertical distance between the AD and consumption
schedules equal to planned investment spending, I
– The vertical distance between the consumption schedule and

the 45° line measures saving at each level of income
→ at Y0 the two vertical distances are equal and S = I
16
• The equality between planned investment and saving can be seen directly from
national income accounting
– Income is either spent or saved: 𝑌𝑌 = 𝐶𝐶 + 𝑆𝑆
– Without government spending (G) or trade (NX): 𝑌𝑌 = 𝐶𝐶 + 𝐼𝐼
– Putting the two together:

𝐶𝐶 + 𝑆𝑆 = 𝐶𝐶 + 𝐼𝐼
𝑆𝑆 = 𝐼𝐼
17
• With government and foreign trade in the model:
– Income is either spent, saved, or paid in taxes:
𝑌𝑌 = 𝐶𝐶 + 𝑆𝑆 + 𝑇𝑇𝑇𝑇 − 𝑇𝑇𝑇𝑇
– Complete aggregate demand is:

– Putting the two together:
𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺 + 𝑁𝑁𝑁𝑁 = 𝐶𝐶 + 𝑆𝑆 + 𝑇𝑇𝑇𝑇 − 𝑇𝑇𝑇𝑇
𝐼𝐼 = 𝑆𝑆 + (𝑇𝑇𝑇𝑇 − 𝑇𝑇𝑇𝑇 − 𝐺𝐺) − 𝑁𝑁𝑁𝑁 (14)
18
The Multiplier
• By how much does a €1 increase in autonomous spending raise the
equilibrium level of income?
• The answer is not €1
– Out of an additional euro in income, €c is consumed
– Output increases to meet increased expenditure, where the change in
output = 1+c
– Expansion in output and income results in further increases
19
The Multiplier
• If we write out the successive rounds of increased spending,
starting with the initial increase in autonomous demand, we
have:
∆𝐴𝐴𝐴𝐴 = ∆𝐴𝐴̅ + 𝑐𝑐∆𝐴𝐴̅ + 𝑐𝑐 2 ∆𝐴𝐴̅ + 𝑐𝑐 3 ∆𝐴𝐴̅ + ⋯
= ∆𝐴𝐴̅ 1 + 𝑐𝑐 + 𝑐𝑐 2 + 𝑐𝑐 3 + ⋯ (15)
• This is a geometric series, where 𝑐𝑐 < 1, that simplifies to:

1
∆𝐴𝐴𝐴𝐴 = ∆𝐴𝐴̅ = ∆𝑌𝑌0 (16)
(1−𝑐𝑐)
• Multiplier: the amount by which equilibrium output changes

when autonomous aggregate demand increases by 1 unit:
Δ𝑌𝑌 1
= 𝛼𝛼 = (17)
Δ𝐴𝐴̅ (1−𝑐𝑐)
20
The Multiplier
∆A
21
The Multiplier
• Effect of an increase in autonomous spending on the
equilibrium level of output:
– The initial equilibrium is at point 𝐸𝐸, with income at 𝑌𝑌0
– If autonomous spending increases, the AD curve shifts up

by ∆𝐴𝐴̅ and income increases to 𝑌𝑌𝑌
– The new equilibrium is at 𝐸𝐸𝐸 with income at ∆𝑌𝑌0 = 𝑌𝑌0′ − 𝑌𝑌0
22
The Government Sector
• The government affects the level of equilibrium output in
two ways:
1. Government expenditures (component of AD)
2. Taxes and transfers
• Fiscal policy is the policy of the government with regards to

G, TR, and TA:
– Assume G and TR are constant, and that there is a proportional
income tax (t).
– The consumption function becomes:
𝐶𝐶 = 𝐶𝐶̅ + 𝑐𝑐 𝑌𝑌 + 𝑇𝑇𝑇𝑇 − 𝑡𝑡𝑡𝑡
= 𝐶𝐶̅ + 𝑐𝑐𝑐𝑐𝑐𝑐 + 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 (19)
23
The Government Sector
• Combining (19) with AD:
= 𝐶𝐶̅ + 𝑐𝑐𝑐𝑐𝑐𝑐 + 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 + 𝐼𝐼 + 𝐺𝐺 + 𝑁𝑁𝑁𝑁
= 𝐴𝐴̅ + 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 (20)
• Using the equilibrium condition, Y=AD, and equation (19),

the equilibrium level of output is:
𝑌𝑌 = 𝐴𝐴̅ + 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌
𝑌𝑌 − 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 = 𝐴𝐴̅
𝑌𝑌 1 − 𝑐𝑐 1 − 𝑡𝑡 = 𝐴𝐴̅
𝐴𝐴̅
𝑌𝑌0 = (21)
1−𝑐𝑐 1−𝑡𝑡
• The presence of the government sector flattens the AD curve

1
and reduces the multiplier to .
24
Income Taxes as an Automatic Stabilizer
• An automatic stabilizer is any mechanism in the economy that automatically (i.e.,
without case-by-case government intervention) reduces the amount by which
output changes in response to a change in autonomous demand
– One explanation of the business cycle is that it is caused by shifts in autonomous
demand, especially investment
– Swings in investment demand have a smaller effect on output when automatic

stabilizers (eg., proportional income tax) are in place
• Unemployment benefits are another example of an automatic stabilizer
• They enable unemployed to continue consuming even though they do not have a job
25
Effects of a Change in Fiscal
Policy
26
Effects of a Change in Fiscal Policy
• Suppose government expenditures increase

– Results in a change in autonomous spending and shifts the AD
schedule upward by the amount of that change
– At the initial level of output, Y0, the demand for goods > output,
and firms increase production until reach new equilibrium (E’)
• How much does income expand? The change in equilibrium

income is:
1
∆𝑌𝑌0 = ∆𝐺𝐺̅ = 𝛼𝛼𝐺𝐺 ∆𝐺𝐺̅ (22)
1−𝑐𝑐(1−𝑡𝑡)
27
Effects of a Change in Fiscal
Policy
28
1
∆𝑌𝑌0 = ∆𝐺𝐺̅ = 𝛼𝛼𝐺𝐺 ∆𝐺𝐺̅ (22)
1−𝑐𝑐(1−𝑡𝑡)
• A €1 increase in G will lead to an increase in income in excess

of a euro
– If c = 0.80 and t = 0.25, the multiplier is 2.5
→ A €1 increase in G results in an increase in equilibrium

income of €2.50
→ ∆G, ∆Y are shown in Figure 10-3
29
• Suppose government increases TR instead
– Autonomous spending would increase by only 𝑐𝑐∆𝑇𝑇𝑇𝑇, so output would increase by
α𝐺𝐺 𝑐𝑐 ∆𝑇𝑇𝑇𝑇
– The multiplier for transfer payments is smaller than that for G by a factor of c
• Part of any increase in TR is saved (since considered income)
• If the government increases marginal tax rates, two things happen:

– The direct effect is that AD is reduced since disposable income decreases, and thus
consumption falls
– The multiplier is smaller, and the shock will have a smaller effect on AD
30
The Budget
• Government budget deficits have been the norm in the U.S. since
the 1960s
• Is there a reason for concern over a budget deficit?
– The fear is that the government’s borrowing makes it difficult for
private firms to borrow and invest → slows economic growth
29
The Budget
• The budget surplus is the excess of the government’s revenues, TA,
over its initial expenditures consisting of purchases of goods and
services and TR:
𝐵𝐵𝐵𝐵 ≡ 𝑇𝑇𝑇𝑇 − 𝐺𝐺 − 𝑇𝑇𝑇𝑇 (24)
– A negative budget surplus is a budget deficit
30
The Budget
• If 𝑇𝑇𝑇𝑇 = 𝑡𝑡𝑡𝑡, the budget surplus is defined as:
𝐵𝐵𝐵𝐵 ≡ 𝑡𝑡𝑡𝑡 − 𝐺𝐺 − 𝑇𝑇𝑇𝑇 (24a)
• Figure 10-6 plots the BS as a function of the level of income for given
G, TR, and t:
– At low levels of income, the budget is in deficit since spends more
than it receives in income
– At high levels of income, the budget is in surplus since the
government receives more in income than it spends
31
The Budget
• Figure 10-6 shows that the budget deficit depends on the government’s policy choices (G, t,
and TR) and also anything else that shifts the level of income
– Example. Suppose that there is an increase in I demand that increases the level of output
→ budget deficit will fall as tax revenues increase
32
Effects of Government Purchases
and Tax Changes on the BS
• How do changes in fiscal policy affect the budget?
OR
• Must an increase in G reduce the BS?
– An increase in G reduces the surplus, but also increases income, and thus tax
revenues
→ Possibility that increased tax collections > increase in G
33
Effects of Government Purchases
and Tax Changes on the Budget Surplus
• The change in income due to increased G is equal to:

∆𝑌𝑌0 = 𝛼𝛼𝐺𝐺 ∆𝐺𝐺
• A fraction of this is collected in taxes

- tax revenues increase by ∆𝑇𝑇𝑇𝑇 = 𝑡𝑡 � 𝛼𝛼𝐺𝐺 ∆𝐺𝐺
• The change in the Budget Surplus (BS) is:
∆𝐵𝐵𝐵𝐵 = ∆𝑇𝑇𝑇𝑇 − ∆𝐺𝐺

= 𝑡𝑡𝛼𝛼𝐺𝐺 ∆𝐺𝐺 − ∆𝐺𝐺
=− ∆𝐺𝐺 < 0 (25)
34
Introducing the Interest Rate into
the Income-Expenditure Model
11-37
The Goods Market and the IS Curve
• In Topic 5 we will look at the so-called ‘IS curve’ in detail:
The IS curve shows combinations of interest rates and

levels of output such that planned spending equals income
• We will derive it now and come back to it in Topic 5.
• Derived in two steps:

1. Link between interest rates and investment
2. Link between investment demand and AD
11-38
1. Investment and the Interest Rate
• Investment is no longer treated as exogenous, but

dependent upon interest rates (endogenous)
– Investment demand is lower the higher are interest
rates
• Interest rates are the cost of borrowing money
• Increased interest rates raise the price to firms of
borrowing for capital equipment
→ reduce the quantity of investment demand
11-39
Investment spending function
• The investment spending function can be specified as:
𝐼𝐼 = 𝐼𝐼 ̅ − 𝑏𝑏𝑏𝑏 , 𝑏𝑏 > 0
where:
− 𝑖𝑖 is the rate of interest
− 𝑏𝑏 is the responsiveness of investment spending to
the interest rate
− 𝐼𝐼 ̅ is autonomous investment spending
11-40
Investment schedule (graph)
Figure 11-4
11-41
Investment Schedule
• Negative slope reflects assumption that a reduction in 𝑖𝑖
increases the quantity of 𝐼𝐼
• The position of the 𝐼𝐼 schedule is determined by:
– The slope, 𝑏𝑏
 If investment is highly responsive to 𝑖𝑖, the investment
schedule is almost flat
 If investment responds little to 𝑖𝑖, the investment schedule is
close to vertical
– Level of autonomous spending
 An increase in 𝐼𝐼 ̅ shifts the investment schedule out
 A decrease in 𝐼𝐼 ̅ shifts the investment schedule in
11-42
2. Investment Demand and AD:
The IS Curve
• Need to modify the AD function from earlier to reflect the new
planned investment spending schedule:
= 𝐶𝐶̅ + 𝑐𝑐𝑇𝑇𝑇𝑇 + 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 + 𝐼𝐼 ̅ − 𝑏𝑏𝑏𝑏 + 𝐺𝐺̅ + 𝑁𝑁𝑁𝑁
= 𝐴𝐴̅ + 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 − 𝑏𝑏𝑏𝑏
• An increase in 𝑖𝑖 reduces AD for a given level of income:
─ at any given level of 𝑖𝑖, we can determine the equilibrium
level of income and output as in the Income-Spending
model without interest rates
─ a change in 𝑖𝑖 will change the equilibrium
11-43
The Interest Rate and AD: The IS Curve
𝐴𝐴𝐴𝐴 = 𝐴𝐴̅ + 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 − 𝑏𝑏𝑏𝑏

• For a given interest rate, 𝑖𝑖1, the last term in the
equation is constant
→ AD function has intercept of 𝐴𝐴̅ − 𝑏𝑏𝑏𝑏1
• Equilibrium level of income is 𝑌𝑌1 at point 𝐸𝐸1
• Plot the pair (𝑖𝑖1, 𝑌𝑌1) in the bottom panel as point 𝐸𝐸1
• This is a point on the IS curve: it is a combination of

𝒊𝒊 and 𝒀𝒀 that clears the goods market
11-44
• Consider a lower interest rate, 𝑖𝑖2

• Shifts the AD curve upward to AD’ with an
intercept of 𝐴𝐴̅ − 𝑏𝑏𝑏𝑏2
• Given the increase in AD, the equilibrium
shifts to point 𝐸𝐸2, with an associated income
level of 𝑌𝑌2
• Plot the pair (𝑖𝑖2, 𝑌𝑌2) in panel (b) for another
point on the IS curve
11-45
• We can apply the same procedure to all
levels of 𝑖𝑖 to generate additional points
on the IS curve
– All points on the IS curve represent
combinations of 𝑖𝑖 and income at
which the goods market clears
→ goods market equilibrium schedule
• Figure 11-5 shows the negative
relationship between 𝑖𝑖 and 𝑌𝑌
– Downward sloping IS curve
11-46
• We can also derive the IS curve using the goods market equilibrium
condition:
𝑌𝑌 = 𝐴𝐴𝐴𝐴 = 𝐴𝐴̅ + 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 − 𝑏𝑏𝑏𝑏
𝑌𝑌 − 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 = 𝐴𝐴̅ − 𝑏𝑏𝑏𝑏
𝑌𝑌 1 − 𝑐𝑐 1 − 𝑡𝑡 = 𝐴𝐴̅ − 𝑏𝑏𝑏𝑏
𝑌𝑌 = 𝛼𝛼𝐺𝐺 𝐴𝐴̅ − 𝑏𝑏𝑏𝑏
1
where 𝛼𝛼𝐺𝐺 =
11-47
• We can also derive the IS curve using the goods market equilibrium
condition:
𝑌𝑌 = 𝐴𝐴𝐴𝐴 = 𝐴𝐴̅ + 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 − 𝑏𝑏𝑏𝑏
𝑌𝑌 − 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 = 𝐴𝐴̅ − 𝑏𝑏𝑏𝑏
𝑌𝑌 1 − 𝑐𝑐 1 − 𝑡𝑡 = 𝐴𝐴̅ − 𝑏𝑏𝑏𝑏
𝑌𝑌 = 𝛼𝛼𝐺𝐺 𝐴𝐴̅ − 𝑏𝑏𝑏𝑏
1
where 𝛼𝛼𝐺𝐺 =
11-48
Appendix: The Paradox of Saving
• Before going to Topic 4, a final result of the simple Income-Expenditure
model is known as the Paradox of Saving (or Paradox of Thrift):
Paradox of Thrift: As people attempt to save more, there is a decline in

output (and hence income) and unchanged saving!
• We can see this from our results on slide 14-16 above which show that the
equilibrium condition 𝑌𝑌 = 𝐴𝐴𝐴𝐴 can be expressed equivalently as saving
equals investment.
• Ignoring foreign trade and denoting net taxes by 𝑇𝑇 = 𝑇𝑇𝑇𝑇 − 𝑇𝑇𝑇𝑇, equation (14)
becomes:
𝐼𝐼 = 𝑆𝑆 + (𝑇𝑇 − 𝐺𝐺) (14’)
49
Appendix: The Paradox of Saving
• The savings function is given by equation (6) on slide 6:
𝑆𝑆 ≡ 𝑌𝑌 − 𝐶𝐶 = 𝑌𝑌 − 𝐶𝐶̅ − 𝑐𝑐𝑐𝑐 = −𝐶𝐶̅ + 1 − 𝑐𝑐 𝑌𝑌 (6)

• Assume that consumers decide to decrease consumption and increase saving
at every level of disposable income, so that 𝐶𝐶̅ falls.
• In equilibrium, equation (14’) holds: as there has been no change in taxes,
government spending or investment, then private saving, S, cannot have
changed!
• Thus, in the short run, a desire to consume less and save more leads to a
decrease in output, i.e., a recession.
• This does not mean that saving is bad – in the medium and long runs,
increased saving rates will likely lead to increases in overall saving and
economic growth. 50
TOPIC 4
Financial Markets
CONTENTS
1. The demand for money

2. Money, the banking system and the money supply
3. Equilibrium in the money market
Blanchard et al., Chapter 4.

Dornbusch et al., Chapters 16 and 17.
Money
• An economy without money: a barter economy.
− Goods and services are directly exchanged for other goods or services.
− Trade requires the double coincidence of wants.
− A barter economy permits only simple economic transactions.
• Money reduces transaction costs (barter is inefficient).

• Money facilitates specialization:
− Without money, exchange would be too costly, incentives to
specialization would be small and households units would be induced
to be self-sufficient.
Money
What is money?
Money is the stock of assets that can be readily used to make

transactions.
• Functions of money:
• Medium of exchange: money is what we use to buy goods and

services.
• Store of value: money is a way to transfer purchasing power

from the present to the future.
• Unit of account: money provides the terms in which prices are

quoted and debts are recorded.
Demand for money
Physical properties of money
• Portability: money must be easy to carry.
• Divisibility: money must be easily divided into small parts, so people can
purchase goods and services of any price.
• Recognizability: money must have certain distinct marks which nobody can
mistake.
• Durability: money must be able to withstand the wear and tear of many
people using it.
• Uniformity: money should be uniform and identical wherever it can be used.
• Scarcity: money must be scarce or hard for people to obtain.
• Stable in value: its value must remain constant over long periods of time.
The types of money
Commodity money
− Anything that serves both as money and as a commodity, i.e.
a commodity with some intrinsic value (eg. gold, silver)
Fiat money
− Money that has no intrinsic value and it is established as
money by government decree, i.e. money not redeemable for
any commodity; its status as money is conferred by the
government
Money, income and wealth
• Income is what you earn from working plus what you receive in
interest and dividends. It is a flow - that is, it is expressed per unit of
time.
• Saving is that part of after-tax income that is not spent. It is also a
flow. Savings is sometimes used as a synonym for wealth (not done
in the book).
• Your financial wealth, or simply wealth, is the value of all your
financial assets minus all your financial liabilities.
• In contrast to income or saving, which are flow variables, financial
wealth is a stock variable.
• Investment is a term economists reserve for the purchase of new
capital goods, from machines to plants to office buildings. When you
want to talk about the purchase of shares or other financial assets,
you should refer them as a financial investment.
Liquidity and expected returns of an asset
Assume that there are two types of financial assets: money and bonds.
Money, which you can use for transactions, pays no interest.
There are two types of money:

- currency (coins and banknotes)
- demand deposits (bank deposits on which you can write cheques).
Bonds pay a positive interest rate…

… but they cannot be used for transactions.
Liquidity and expected returns of an asset
• Money is liquid, but pays little or no return
- all other assets are less liquid but pay a (higher) return.
• Liquidity is the capability of an asset to be readily converted into cash

- the easier it is to convert an asset the greater its liquidity.
• The main benefit of holding money comes from its liquidity.
• Households and firms hold money because it is the easiest way of financing
their everyday purchases.
The interest rate paid by bonds measures the opportunity cost of holding
money rather than (interest-bearing) bonds.
The return on bonds (I)
Price of bonds and the interest rate
• Treasury bills, or T-bills are issued by the US government promising
payment in a year or less.
• If you buy the bond today and hold it for a year, the rate of return
(or interest) on holding a €100 bond for a year is:
€100 − €𝑃𝑃𝐵𝐵
€𝑃𝑃𝐵𝐵
• If we are given the interest rate, we can figure out the price of the
bond using the same formula.
€100 − €𝑃𝑃𝐵𝐵 €100

𝑖𝑖 = ⇒ €𝑃𝑃𝐵𝐵 =
€𝑃𝑃𝐵𝐵 1 + 𝑖𝑖
There is a negative relationship between bond
prices and the interest rate
The return on bonds (II)
More generally, a bond holder has an expected return on the bond from
two sources: the bond’s coupon (the fixed interest payment it receives) and
a potential capital gain (an increase in the price of the bond from the time
he buys it to the time he sells it).
The market rate of return on the bond (i) is the ratio of the coupon
payment (V) to the price of the bond (𝑃𝑃𝐵𝐵 ):
V
i=
PB
The expected capital gain is the percentage increase in the price from the
purchase price (𝑃𝑃𝐵𝐵 ) to the expected sale price (𝑃𝑃𝐵𝐵′ ):
P' B − PB
PB
V P' B − PB
Total return on a bond: g= +
PB PB
The price of bonds
Assume a bond pays a fixed interest payment (coupon), 𝑉𝑉, annually for 𝑇𝑇 years.
Its face value, to be returned at maturity, is 𝐹𝐹.
Its price will be equal to its net present value (NPV), calculated as:
𝑉𝑉 𝑉𝑉 𝑉𝑉 𝐹𝐹
𝑃𝑃𝐵𝐵 = + +…+ +
1+𝑖𝑖 (1+𝑖𝑖)2 (1+𝑖𝑖)𝑇𝑇 (1+𝑖𝑖)𝑇𝑇
Using the formula for a geometric series, it can be shown that:
𝑉𝑉 1 𝐹𝐹
𝑃𝑃𝐵𝐵 = 1− +
𝑖𝑖 (1+𝑖𝑖)𝑇𝑇 (1+𝑖𝑖)𝑇𝑇 Note the negative
relationship
between bond
Two things to note: price and the
𝑉𝑉 interest rate
1) If 𝑖𝑖 = , then 𝑃𝑃𝐵𝐵 = 𝐹𝐹
𝑃𝑃𝐵𝐵
𝑉𝑉
2) If the bond is a perpetuity (consol) so that 𝑇𝑇 = ∞, then 𝑃𝑃𝐵𝐵 =
𝑖𝑖
The demand for money
The demand for money is the is amount of money (currency and

deposits) that people desire to hold.
Holding money has an opportunity cost, then why do people demand

money? Three reasons:
(a) Transactions motive
(b) Precautionary motive
(c) Speculative motive
(a) Transactions demand for money:
• People hold money to buy goods and services

- money is a medium of exchange)
• This demand depends on the level of income: as income rises, the

level of transactions increases and the demand for money rises.
(b) Precautionary demand for money:
• People hold money for emergencies. The demand for money rises with
income.
(c) Speculative demand for money (portfolio balance approach):
• Money is an asset that brings no return, but has no risk (other than
inflation).
• Bonds are assets that have a positive rate of return , but there is a risk
associated with bonds (there is uncertainty about the future price of
the bond).
• Agents can choose to keep their financial wealth in money or bonds.
They demand money in order to diversify their porfolio, so as to
balance risk and return.
• The higher the interest rate, the higher the return on bonds (the higher
the opportunity cost of holding money) and the lower the demand for
money (the higher the demand for bonds).
The demand for money is negatively related to the interest rate.
Aggregate money demand: The total demand for money by all households and
firms in the economy. It is determined by two main factors:
• The level of transactions, that can be proxied by the level of income

(positive relation: a higher level of income leads to a higher level of
transactions, leading to a higher demand for money).
• The interest rate (negative relation: a rise in the interest rate increases the
opportunity cost of holding money, and the demand for money decreases).
M d = (P·Y ) ⋅ L(i )
M d = €Y ⋅ L(i )
The demand for money is usually expressed as the demand for real money
balances (i.e. in terms or the quantity is goods and services it can buy):
Md
= Y ⋅ L(i )
P
Shifts in the demand for money
Interest rate, i
𝑀𝑀𝑑𝑑 ′
𝑌𝑌 > 𝑌𝑌
𝑃𝑃
𝑀𝑀𝑑𝑑
imin 𝑌𝑌
𝑃𝑃
Money, M/P
Minimum transactions
demand
Money supply
The money supply is the total value of financial assets in the

economy that are considered money. We consider the
narrowest definition:
• Currency: banknotes and coins. It is legal tender (by law it

must be accepted as a medium of payment)
• Demand (‘checkable’) deposits: the bank deposits on which

you can write cheques.
− They are commercial-bank money (cheques are not legal tender
but are generally accepted; banks have the legal obligation to
return funds held in demand deposits immediately upon demand).
Money supply
The monetary system
The monetary system is the set of institutions in an economy that

can create money:
Commercial banks → create commercial-bank money
Central Bank (CB) → issues legal tender

Money supply
Monetary Base
Monetary Base (H) (base money or high-powered money) is the

amount of legal tender issued by the Central Bank.
It has two components:
(i) Currency in circulation (CU): Banknotes and coins held by

households and non-financial firms.
(ii) Bank reserves (R): The reserves are held partly in cash and
partly in an account the banks have at the Central Bank.
Money supply
Money supply
The money supply (M) is the total amount of money available in an

economy at a particular point in time (a stock).
Currency in circulation (CU)
Checkable deposits (demand deposits) (D)
𝑴𝑴 = 𝑪𝑪𝑪𝑪 + 𝑫𝑫
Money supply
In an economy there are several alternative definitions of money supply. The ECB's
definition of euro area monetary aggregates:
Narrow money (M1) includes currency (CU) as well as balances which can
immediately be converted into currency or used for cashless payments, i.e.
overnight deposits (D).
"Intermediate" money (M2) comprises M1 and deposits with a maturity of up to

two years and deposits redeemable at a period of notice of up to three
months.
Broad money (M3) comprises M2 and marketable instruments issued by the MFI
sector. Certain money market instruments, in particular money market fund
(MMF) shares/units and repurchase agreements are included in this aggregate.
As we move down the list, the liquidity of the added assets decrease, while their
interest yield increases.
Money supply
What banks do
Financial intermediaries are institutions that receive funds from people

and firms, and use these funds to buy bonds or stocks, or to make loans
to other people and firms.
Banks are one type of financial intermediary: their liabilities are

money.
Banks receive funds from people and firms who either deposit funds
directly or have funds sent to their checking accounts. The liabilities of
the banks are therefore equal to the value of these checkable deposits.
Banks keep as reserves some of the funds they receive.

Money supply
What banks do
Banks hold reserves for three reasons:
1. On any given day, some depositors withdraw cash from their

checking accounts, while others deposit cash into their accounts.
2. On any given day, people with accounts at the bank write cheques
to people with accounts at other banks, and people with accounts
at other banks write checks to people with accounts at the bank.
3. Banks are subject to reserve requirements. The actual reserve
ratio – the ratio of bank reserves to bank checkable deposits – is
about 2% in the EU today.
Reserves R
Reserve ratio: θ= =
Deposits D
Money supply
What banks do
Liabilities are a bank's sources of funds.
Assets are a bank's uses of funds
Commercial bank balance sheet

Assets Liabilities
Reserves Deposits
Cash
Deposits at the CB
Bonds Loans from the CB and
(other intermediaries)
Loans and other assets Other liabilities
Money supply
How banks create money
Bank lending is the channel through which the monetary base expands to
an effective money supply considerably larger than the monetary
base.
The excess of the deposits of the public over bank reserves is lent out in
the form of bank loans, purchases of bonds etc.
The public then deposits a fraction of these loans on checking accounts.

Next, the banks lend out a fraction of these and so on. This process is
named the money multiplier process.
Suppose that the Central Bank increases the monetary base by 1000€.
Suppose that the reserve ratio is 10% (θ = 0.1)

Money supply
 Suppose banks hold 10% of deposits in reserve, making loans
with the rest.
 Bank A will make 900€ in loans.
The money supply now
equals 1900€:
Assets Bank A Liabilities The depositor still has
(Reserves) 100 (Deposits) 1000 1000€ in demand deposits,
(Loan) 900 but now the borrower holds
900€ in currency.
Thus, banks create money.

Money supply
 Suppose the borrower deposits the 900€ in Bank B.
 Then Bank B will loan 90% of this deposit (holding 10% of
deposits in reserve)
Assets Bank B Liabilities This 810€ may eventually be

(Reserves) 90 (Deposits) 900 deposited in Bank C.
(Loan) 810 Bank C will keep 10% of it in
reserve, and loan the rest
out…
Money supply
Original deposit = € 1000
+ Bank A lending = € 900
+ Bank B lending = € 810
+ Bank C lending = € 729
+ other lending…
∆𝑀𝑀 = 1000 + 900 + 810 + ⋯

= 1000 + 0.9 ∗ 1000 + 0.92 ∗ 1000 + ⋯
= 1000 ∗ (1 + 0.9 + 0.92 + ⋯ )
1
= 1000 ∗
(1 − 0.9)
1
⇒ ∆𝑀𝑀 = ∗ ∆𝐻𝐻
(1−0.9)
1 1
𝑖𝑖. 𝑒𝑒., ∆𝑀𝑀 = ∗ ∆𝐻𝐻 = ∗ ∆𝐻𝐻
1− 1−θ θ
Money supply
The money multiplier
Recall that the reserve ratio (the fraction of deposits that banks hold in reserve) is:
𝑅𝑅
𝜃𝜃 =
𝐷𝐷
We define the currency-deposit ratio (the preferences of the public about how much money
to hold in the form of currency and how much to hold in the form of demand deposits) as:
𝐶𝐶𝐶𝐶
𝛾𝛾 =
𝐷𝐷
Hence, the monetary base can be expressed as:
𝐻𝐻 = 𝐶𝐶𝐶𝐶 + 𝑅𝑅 = 𝛾𝛾𝛾𝛾 + 𝜃𝜃𝜃𝜃 = 𝛾𝛾 + 𝜃𝜃 𝐷𝐷 (A)

1
So 𝐷𝐷 = 𝐻𝐻 (B)
(𝛾𝛾+𝜃𝜃)
The money supply can be expressed as:
𝑀𝑀 = 𝐶𝐶𝐶𝐶 + 𝐷𝐷 = 𝛾𝛾𝛾𝛾 + 𝐷𝐷 = 1 + 𝛾𝛾 𝐷𝐷 (C)
Substituting (B) into (C):

1+𝛾𝛾
𝑀𝑀 = 𝐻𝐻
𝛾𝛾+𝜃𝜃
Money supply
So, the relationship between the money supply and the monetary base is given by:
1 + 𝛾𝛾
𝑀𝑀 = 𝐻𝐻
𝛾𝛾 + 𝜃𝜃
1+𝛾𝛾
The expression is called the money multiplier.
𝛾𝛾+𝜃𝜃
It can be considered as the ratio of the money supply to the monetary base, or as
the change in the money supply for a given change in the monetary base:
1 + 𝛾𝛾 𝑀𝑀 ∆𝑀𝑀
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 = = =
𝛾𝛾 + 𝜃𝜃 𝐻𝐻 ∆𝐻𝐻
1+𝛾𝛾
i.e., ∆𝑀𝑀= ∆𝐻𝐻
𝛾𝛾+𝜃𝜃
Money supply
1 + 𝛾𝛾
𝑀𝑀 = 𝐻𝐻
𝛾𝛾 + 𝜃𝜃
The lower the reserve ratio (𝜃𝜃), the more loans banks make, and the more money
banks create
⇒ a decrease in 𝜃𝜃 raises the money multiplier and the money supply.
The lower the currency-deposit ratio (𝛾𝛾), the fewer the euros of the monetary base the
public holds as currency (and therefore the more it holds as deposits), and the
more money banks can create
⇒ a decrease in 𝛾𝛾 raises the money multiplier and the money supply.
1
Note that 𝛾𝛾 = 0 → 𝑀𝑀 = 𝐻𝐻
𝜃𝜃
The equilibrium in the money market
Equilibrium in the money market requires that the supply of

money equals the demand for money, i.e. 𝑀𝑀 𝑠𝑠 = 𝑀𝑀𝑑𝑑 .
Supply of money (𝑴𝑴𝒔𝒔 ) = Demand for money (𝑴𝑴𝒅𝒅 )
This equilibrium condition is called the LM relation.
In nominal terms: M s = €Y ⋅ L(i )
Ms
In real terms: = Y ⋅ L(i )
P
Equilibrium in the money market
The determination of the interest rate
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑜𝑜𝑜𝑜 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
(𝑀𝑀 𝑠𝑠 /𝑃𝑃)
The equilibrium interest
rate is such that the supply
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟, 𝑖𝑖
of money (which is
independent of the
interest rate) is equal to
the demand for money
(which depends negatively • 𝐴𝐴
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑓𝑓𝑓𝑓𝑓𝑓 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
on the interest rate).
(𝑀𝑀𝑑𝑑 /𝑃𝑃)
𝑀𝑀 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀, 𝑀𝑀/𝑃𝑃

Effect of an increase in the real income
Supply of money
(𝑀𝑀 𝑠𝑠 /𝑃𝑃)
An increase in real
income shifts the
demand for
money to the right, 𝑖𝑖𝑖 • 𝐴𝐴𝐴
leading to a rise
in the interest rate. Demand for money
𝑀𝑀𝑑𝑑𝑑
(𝑌𝑌𝑌 > 𝑌𝑌)
𝑖𝑖 • 𝐴𝐴 𝑃𝑃
Demand for money
𝑀𝑀 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 (𝑀𝑀⁄𝑃𝑃)

Effect of an increase in the supply of money
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑜𝑜𝑜𝑜 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑜𝑜𝑜𝑜 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚

(𝑀𝑀 𝑠𝑠 /𝑃𝑃) (𝑀𝑀 𝑠𝑠 ′/𝑃𝑃) > (𝑀𝑀 𝑠𝑠 /𝑃𝑃)
An increase in the
supply of money
shifts leads to a 𝑖𝑖 • 𝐴𝐴
reduction in the
interest rate.
𝑖𝑖𝑖 • 𝐴𝐴𝐴 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑓𝑓𝑓𝑓𝑓𝑓 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚

𝑀𝑀 𝑀𝑀’ 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀, (𝑀𝑀⁄𝑃𝑃)

Money supply
The Economic and Monetary Union (EMU)
The Economic and Monetary Union (EMU) is an area that shares the
same market, the same currency and a single monetary policy. Its
creation has involved:
• For domestic economic policies:
• The loss of the exchange rate as an adjustment mechanism to combat
possible declines in competitiveness.
• The impossibility of changing domestic interest rates.
• For the various markets:

• The reduction of transaction costs.
• A decrease in the uncertainties related to monetary, exchange rate and
financial conditions.
• The tendency towards the integration of both financial and goods
markets.
Money supply
The Economic and Monetary Union (EMU)
The European System of Central Banks (ESCB) comprises the European Central
Bank (ECB) and the national central banks (NCBs) of all EU Member States
whether they have adopted the euro or not.
The Eurosystem comprises the ECB and the NCBs of those countries that have
adopted the euro.
Monetary policy decisions are centralised at the ECB (the Governing Council is
the main decision-making body), so that monetary policy at the European
level is unique.
The National Central Banks enact the decisions made centrally by the Governing
Council of the ECB.
Money supply
Monetary Policy
Monetary Policy is the use of the money stock by the Central Bank to affect
interest rates and, by implication, economic activity and inflation.
The primary objective of the ECB’s monetary policy is to maintain price stability.
The ECB aims at inflation rates of below, but close to, 2% over the medium
term.
Without prejudice to the objective of price stability, the Eurosystem shall also
support the general economic policies in the Union with a view to contributing
to the achievement of the objectives of the Union. These include inter alia "full
employment" and "balanced economic growth".
The Federal Reserve sets the nation’s monetary policy to promote the objectives
of maximum employment, stable prices, and moderate long-term interest
rates.
Money supply
Monetary policy: transmission mechanism
Change in official interest rates: The central bank provides funds to the banking
system and charges interest. Given its monopoly power over the issuing of
money, the central bank can fully determine this interest rate.
The change in the official interest rates affects directly money-market interest
rates and, indirectly, lending and deposit rates, which are set by banks to
their customers.
Changes in interest rates affect saving and investment decisions of households

and firms. For example, everything else being equal, higher interest rates
make it less attractive to take out loans for financing consumption or
investment.
Changes in consumption and investment will change the level of domestic demand
for goods and services relative to domestic supply. When demand exceeds
supply, upward price pressure is likely to occur.
Money supply
The Eurosystem’s monetary policy instruments
1- Open market operations: play an important role in steering

interest rates, managing the liquidity situation in the market and
signalling the monetary policy stance. They are initiated by the
ECB, which decides on the instrument and on the terms and
conditions. It is possible to execute open market operations on
the basis of standard tenders, quick tenders or bilateral
procedures.
For standard tenders, a maximum of 24 hours elapses between the tender
announcement and the certification of the allotment result. Quick tenders are normally
executed within a time frame of 90 minutes.
Money supply
Four types of open market operations:
1.1 Main refinancing operations are regular liquidity-providing reverse
transactions with a frequency and maturity of one week. They are
executed by the NCBs on the basis of standard tenders and according to
a pre-specified calendar. The main refinancing operations provide the
bulk of refinancing to the financial sector.
1.2 Longer-term refinancing operations are liquidity-providing reverse
transactions that are regularly conducted with a monthly frequency and a
maturity of three months.
1.3 Fine-tuning operations can be executed on an ad hoc basis to manage
the liquidity situation in the market and to steer interest rates.
1.4 Structural operations can be carried out by the Eurosystem through
reverse transactions, outright transactions and issuance of debt
certificates.
Money supply
Main refinancing operations:

In these operations, the ECB, through the national central banks, lends money for a
week to the commercial banks, which bid for it in a weekly tender procedure.
This is known as providing liquidity to the market. On these loans, banks pay
interest and have to provide the Eurosystem with a guarantee in the form of
appropriate financial assets. When the transaction reaches maturity the banks
pay back the loans and the assets used as guarantees are returned to them.
The ECB sets what’s called a minimum bid rate for the main refinancing
operations, meaning that it won’t provide liquidity to banks at a lower rate.
The minimum bid rate is set once a month by the ECB Governing Council.
Money supply
Main refinancing operations:

Banks need liquidity to finance their operations, so they bid for it in a weekly
tendering procedure. These bids are normally collected from Monday
afternoon through to early Tuesday morning. They are first analyzed by
liquidity committee. The liquidity committee submits a proposal to the
Executive Board, which evaluates it and then sets the total amount of funds to
be allocated.
The banks offering the highest interest rates in return for liquidity will be served
first, until the full amount has been allocated. The banks that fail to obtain
funds from the CB have to borrow them in the money market. However, the
rates in the money market are usually quite close to the minimum bid rates,
proving that this is an effective instrument with which to influence market rates.
Money supply
2- Standing facilities aim to provide and absorb overnight liquidity, signal the general
monetary policy stance and bound overnight market interest rates. Two standing
facilities are available to eligible counterparties on their own initiative.
2.1 Marginal lending facility: Counterparties can use the marginal lending facility to
obtain overnight liquidity from the NCBs against assets given as a guarantee. The
interest rate on the marginal lending facility normally provides a ceiling for the
overnight market interest rate. There are no limits on access to these facilities,
except for the collateral requirements. The interest rate on the marginal lending
facility normally provides a ceiling for the overnight market interest rate.
2.2 Deposit facility: Counterparties can use the deposit facility to make overnight
deposits with the NCBs. There are no limits on access. The interest rate on the
deposit facility normally provides a floor for the overnight market interest rate.
Money supply
3- Minimum reserves:
The ECB requires credit institutions established in the euro area to hold deposits
on accounts with their national central bank. These are called "minimum" or
"required" reserves. The minimum reserve requirement of each institution is
determined in relation to its balance sheet.
To satisfy their minimum reserve requirements banks must, on average, over one
month, hold a sufficient amount of reserves
The interest rates applied to reserves are those of the Eurosystem's main
refinancing operations
Money supply
Central Bank balance sheet
Assets Liabilities
Gold and claims denominated in foreign currency Banknotes in circulation (CU)
General government debt denominated in euro Deposits of the banking system Monetary
Base
Minimum reserves (R)
Lending to credit institutions related to monetary Excess reserves (RV)
policy operations
- Main refinancing operations Deposit facilities
- Marginal lending facilities Non-
- Other loans Capital and Reserves Monetary
liabilities
Other assets Other liablities
Money supply
Central Bank balance sheet
The liabilities of the CB can be divided into:

- monetary liabilities (Monetary Base)
- non- monetary liabilities.
The monetary base is the total amount of total assets minus non-monetary liabilities.
There are two types of factors that can affect the monetary base:
• Some are controlled by the CB (e.g., changes in lending to credit institutions).

• Some are not controlled by the CB (changes in the amount of foreign
exchange reserves, changes in non-monetary liabilities).
Money supply
Monetary policy
1 + 𝛾𝛾
𝑀𝑀 = 𝐻𝐻
𝛾𝛾 + 𝜃𝜃
The ECB influences the money supply through:

 The monetary base, using main refinancing operations
(‘open market operations’) and marginal facilities
 The money multiplier, through the reserve ratio
5.1
Chapter 5
The determination of income in a

closed economy with fixed prices
Contents
5.2
1. The goods market and the IS relation

2. The financial markets and the LM relation
3. The IS-LM model
4. Fiscal policy
5. Monetary policy
The goods market and the IS relation
5.3
• Equilibrium in the goods market exists when production, Y, is

equal to the demand for goods, Z. This condition is called the
IS relation.
• In the simple model developed in Topic 3, the interest rate

did not affect the demand for goods. The equilibrium
condition was given by:
Y  C(Y  T )  I  G
5.4
Investment, Sales and the Interest Rate
Investment depends primarily on two factors:

• The level of sales (+)
• The interest rate (-)
I  I(Y , i )
(  , )
5.5
Determining Output
Taking into account the investment relation, the equilibrium

condition in the goods market becomes:
Y  C (Y  T )  I (Y , i)  G
For a given value of the interest rate, i, demand is an increasing

function of output, for two reasons:
• An increase in output leads to an increase in income and also
to an increase in disposable income.
• An increase in output also leads to an increase in investment.
5.6
Determining Output
Note two characteristics of ZZ:
• Because it’s assumed that the consumption and investment

relations in Equation (5.2) are linear, ZZ is, in general, a curve
rather than a line.
• ZZ is drawn flatter than a 45-degree line because it’s

assumed that an increase in output leads to a less than one-
for-one increase in demand.
5.7
Determining Output
Figure 5.1 Equilibrium in the goods market

The demand for goods is an increasing function of output. Equilibrium requires that the
demand for goods be equal to output
5.8
Deriving the IS Curve
(a) An increase in the interest rate
decreases the demand for goods at
any level of output, leading to a
decrease in the equilibrium level of
output.
(b) Equilibrium in the goods market implies

that an increase in the interest rate
leads to a decrease in output. The IS
curve is therefore downward sloping.
The IS curve sets out all the possible

combinations of real income (Y) and
the interest rate (i) consistent with
equilibrium in the goods market
Figure 5.2 The derivation of the IS curve
5.9
Shifts of the IS Curve
We have drawn the IS curve, taking as given the values of taxes,

T, and government spending, G. Changes in either T or G will shift
the IS curve.
To summarise:
• Equilibrium in the goods market implies that an increase in the
interest rate leads to a decrease in output. This relation is
represented by the downward-sloping IS curve.
• Changes in factors that decrease the demand for goods, given
the interest rate, shift the IS curve to the left. Changes in
factors that increase the demand for goods, given the interest
rate, shift the IS curve to the right.
5.10
Shifts of the IS Curve
T  Yd  C  Z
 Excess supply  Y
 c1
dY  dT
1 c1
Figure 5.3 Shifts in the IS curve

An increase in taxes shifts the IS curve to the left
Financial Markets and the LM Relation
5.11
The interest rate is determined by the equality of the supply of

and the demand for money:
M  €YL(i)
M = nominal money stock; €YL(i) = nominal demand for money
€Y = nominal income; i = nominal interest rate
The equation M  €YL(i) gives a relation between money, nominal

income and the interest rate.
The LM relation: In equilibrium, the real money supply is equal to
the real money demand, which depends on real income, Y, and the
interest rate, i:
 YL i 
M
P
5.12
Deriving the LM Curve
a) An increase in income leads, at a given b) Equilibrium in the financial
interest rate, to an increase in the markets implies that an
demand for money. Given the money increase in income leads to an
supply, this increase in the demand for increase in the interest rate.
money leads to an increase in the The LM curve is therefore
equilibrium interest rate. upward sloping.
Figure 5.4 The derivation of the LM curve

5.13
Deriving the LM Curve
• Figure 5.4(b) plots the equilibrium interest rate, i, on the

vertical axis against income on the horizontal axis.
• This relation between output and the interest rate is

represented by the upward sloping curve in Figure 5.4(b).
This curve is called the LM curve.
• The LM curve sets out all of the possible combinations of real

output, Y, and the rate of interest, i, consistent with equilibrium
in the money market.
5.14
Shifts of the LM Curve
Figure 5.5 Shifts in the LM curve

An increase in money causes the LM curve to shift down
5.15
Shifts of the LM Curve
Equilibrium in financial markets implies that, for a given real

money supply, an increase in the level of income, which increases
the demand for money, leads to an increase in the interest rate.
This relation is represented by the upward-sloping LM curve.
• An increase in the money supply shifts the LM curve down; a

decrease in the money supply shifts the LM curve up.
Putting the IS and the LM Relations Together
5.16
IS relation: Y  C(Y  T )  I (Y , i )  G
M
LM relation:  YL(i )
P
Equilibrium in the goods market
implies that an increase in the
interest rate leads to a decrease in
output. This is represented by the
IS curve. Equilibrium in financial
markets implies that an increase in
output leads to an increase in the
interest rate. This is represented by
the LM curve. Only at point A,
which is on both curves, are both
goods and financial markets in
equilibrium.
Figure 5.7 The IS–LM model
In the IS-LM model, the level of output (Y) and the interest rate (i) are determined simultaneously
5.17
Fiscal Policy, Activity and the Interest Rate
• Fiscal contraction, or fiscal consolidation, refers to fiscal policy

that reduces the budget deficit.
• An increase in the deficit is called a fiscal expansion.
• Taxes affect the IS curve, not the LM curve.
5.18
Fiscal Policy, Activity and the Interest Rate
Interest rate, i
An increase in LM
government spending
An increase in government i’
C
spending, shifts the IS curve A
B
to the right and the i
economy moves upward IS’
along the LM curve.
An increase in government
spending leads to an
increase in the equilibrium
level of output and the Income, Y
equilibrium interest rate. Y Y’ Y’’
5.19
An increase in government spending
Initial equilibrium at A: An increase in government spending leads to an increase
in demand  excess demand for goods (Is<0)  through the multiplier (C+I)
output and income increase (shift of the IS curve).
The increase in output increases the demand for money. In the money market
there is an excess demand for money, leading to a rise in the interest rate.
As the interest rate increases, investment falls (lower increase in investment),

leading to a lower increase in income. This is the crowding-out effect.
Crowding-out effect: the offset in aggregate demand that results when

expansionary fiscal policy raises the interest rate and thereby reduces
investment spending.
Y , C, i & probably  I

MS=constant, Md transactions, Md as an asset
5.20
Monetary Policy, Activity and the Interest Rate
• Monetary contraction, or monetary tightening, refers to a

decrease in the money supply.
• An increase in the money supply is called monetary expansion.
• Monetary policy does not affect the IS curve, only the LM

curve. For example, an increase in the money supply shifts the
LM curve down.
5.21
Monetary Policy, Activity and the Interest Rate
Figure 5.9 The effects of a monetary expansion

A monetary expansion leads to higher output and a lower interest rate
5.22
A monetary expansion
The ECB increases the monetary base through principal refinancing operations
and, through the creation of deposits, the real supply of money (M/P) increases
 excess supply of money, and the interest rate (i) falls. The lower interest rate
increases the demand for money  equilibrium in the money market (the LM
curve shifts down).
As the interest rate decreases, investment increases, leading to an excess

demand in the goods market (Is<0) and through the multiplier (C + I) , output
and income increase.
As output increases, the demand for money increases, leading to an increase in

the interest rate  lower fall in the interest rate.
Y , i , C , I
Using a Policy Mix
5.23
• The combination of monetary and fiscal polices is known as the

monetary-fiscal policy mix, or simply, the policy mix.
• Sometimes, the right mix is to use fiscal and monetary policy in
the same direction.
• Sometimes, the right mix is to use the two policies in opposite
directions - for example, combining a fiscal contraction with a
monetary expansion.
Using a Policy Mix
5.24
Interest rate, i
LM Combination of a fiscal
expansion and a monetary
expansion
B
i’
A monetary expansion
LM’
reinforces the effect of a
fiscal expansion on income.
C The interest rate may remain
i constant.
A
Investment increases.
IS’
IS
Income, Y
Y Y’ Y’’
5.1
Chapter 5
An analytical version of the IS-LM

model
(see Blanchard book)
The IS curve
5.2
The IS curve graphically represents all the combinations of output

and interest rate for which the goods market is in equilibrium
(demand for goods equals the supply of goods).
Y  C (Y  T )  I (Y , i )  G
Let’s begin by deriving the general expression for the multipliers.
The IS curve (Multipliers)
5.3
Y  C (Y  T )  I (Y , i )  G
C C I I
dY  dY  dT  dY  di  dG
Y T Y i
 C I  C I
1  Y  Y  dY   T dT  i di  dG
 
1  C I 
dY    dT  di  dG 
C I  T i 
1 
Y Y
The IS curve
5.4
Now let’s assume simple linear forms for the consumption and
investment functions.
C  c0  c1 (Y  T ) c0  0 , 0  c1  1
I  I 0  d1Y  d 2i d1  0 , d 2  0
The IS curve
5.5
Now we can derive an expression for the IS curve:
Y  c0  c1 (Y  T )  I 0  d1Y  d 2i  G
1 d2
Y A i , A   c1T  I 0  G
1  c1  d1 1  c1  d1
1 1  c1  d1
IS Curve: i A Y
d2 d2
The IS curve
5.6
Multipliers (di = 0) i
Changes in autonomous
spending cause a parallel
shift of the IS curve.
A
B
i
1
dY  dG IS’
 C I 
1  Y  Y  IS
1 Y
dY  dG
1  c1  d1  Y Y’
The IS curve
5.7
Slope of the IS curve
di 1  C Y  I Y  1  c1  d1  i
  0
dY I / i d2
The slope of the IS curve depends on

I / i
the extent to which the equilibrium level dY 
of output varies following a change in 1  C Y  I Y 
the interest rate:
- The larger the sensitivity of
di
investment to the interest rate (∂I/∂I
= d2) the greater the change in
dY
output required to restore IS
equilibrium. If ∂I/∂i is high, the IS
curve is flat and the greater the
response of output to changes in the Y
interest rate.
- The variation of Y is large if ∂C/∂Y
and ∂I/∂Y are high.
The LM curve
5.8
The LM curve graphically represents all the combinations of output

and interest rate for which the money market is in equilibrium.
MS Md
  L(Y , i) 
P P
The LM is curve is drawn for a given level of the money supply so
the money supply is constant. We use this to derive a general
expression for the slope. So, differentiating, the slope of the LM
curve is:
L L  L
0 dY  di 
di
 Y  0
Y i dY L
MS  i
d    0
 P 
The LM curve
5.9
Assuming a simple linear functional form for the demand for money:
Md
 L(Y , i )  f1Y  f 2i f1  0, f2  0
P
f1 1 M
i Y
f2 f2 P
So the slope of the LM curve in this case is:
di f1
 0
dY f 2
The LM curve
5.10
Slope of the LM curve
di f1
 0 i
dY f 2
When the LM curve is flat, a small change in LM
the interest rate implies that output must
grow enough to restore equilibrium in the
money market:
- If the demand for money is very sensitive
to the interest rate (i.e., L i   f 2 is very
large in absolute terms), then a small di
increase in the interest rate is sufficient to dY
cause a sharp drop in demand for money.
- If the demand for money is not very
sensitive to changes in income ( L Y  f1 is
very small), production must increase Y
enough to ensure sufficient growth in
demand for money necessary to balance
the money market.
6.1
Topic 6
The IS-LM Model in an Open Economy
CONTENTS
6.2
1. Openness in goods markets: exports, imports and the exchange

rates
2. Openness in financial markets: the balance of payments, interest
rates and exchange rates
3. The equilibrium in the goods market in an open economy
4. The equilibrium in financial markets in an open economy
5. Putting goods and financial markets together in an open
economy
Blanchard (2013), chapters 6 & 7.

Background
6.3
Openness has three distinct dimensions:
1. Openness in goods markets. The ability of consumers and firms to

choose between domestic goods and foreign goods. Free trade
restrictions include tariffs and quotas.
1. Openness in financial markets. The ability of financial investors to

choose between domestic assets and foreign assets. Capital controls
place restrictions on the ownership of foreign assets.
3. Openness in factor markets. The ability of firms to choose where to

locate production, and workers to choose where to work. The EU is the
biggest ever common market among sovereign countries, with 28 member
states.
Openness in Goods Markets
6.4
Imports and Exports
Figure 6.1 UK exports and imports as ratios of GDP since 1960

Since 1948, exports and imports have increased by around 10 percentage points in relation to GDP
Source: UK Office for National Statistics
6.5
Imports and Exports
The behaviour of exports and imports in the United Kingdom is characterised by:
• The UK economy has become more open over time. Exports and imports,
which were around 20% of GDP in 1960 are now equal to about 30% of
GDP (29% for exports, 32% for imports).
• Although imports and exports have broadly followed the same upward trend,
they have also diverged for long periods of time, generating sustained trade
surpluses and trade deficits.
• A good index of openness is the proportion of aggregate output composed of
tradable goods - or goods that compete with foreign goods in either domestic or
foreign markets.
• With exports around 30% of GDP, it is true that the UK has one of the smallest
ratios of exports to GDP among the rich countries of the world.
6.6
Imports and Exports
35.0
30.0
Porcentaje del PIB
25.0
20.0
15.0
Exportaciones Importaciones
Spain’s exports and imports as ratios of GDP from 1995 to 2009

Source: INE
6.7
Imports and Exports
Table 6.1 Ratios of exports to GDP (%) for selected OECD countries, 2010
Source: Eurostat.
The main factors behind differences in export ratios are geography and
country size:
• Distance from other markets.
• Size also matters: The smaller the country, the more it must specialise in
producing and exporting only a few products and rely on imports for other
products.
The balance of payments
6.8
Balance of payments: accounting record of all transactions between a country

and the rest of the world.
Any transaction resulting in a payment to foreigners is entered as a debit (-)
Any transaction resulting in a receipt from foreigners is entered as a credit (+)
Three types of international transactions are recorded:
1. Transactions that arise from the export and import of goods and services
(current account)
2. Transactions that arise from the purchase or sale of financial assets
(financial account)
3. Transfers of wealth between countries (capital account)
Current account + Capital account + Financial account = 0
Open economy
6.9
The Current Account
• Goods and Services Balance: registers the value of exports (X)

and imports (IM) of goods and services
• Income Balance: registers the employees compensations

(wages) and payments associated with holdings of financial
assets and liabilities (investment income)
• Transfers Balance: registers transfers which do not involve a

quid pro quo in economic value (international cooperation,
migrants remittances, transfers within the European Union)
Open economy
6.10
The Current Account
The sum of net payments to and from the rest of the world is the
current account balance.
The current account measures the size and direction of

international borrowing:
- when a country imports more than it exports, it must finance

its current account deficit, by borrowing the difference from
foreigners.
- when a country is running a current account surplus, it is

earning more from exports than it spends on imports. This
country is lending to its trading partners.
Open economy
6.11
It measures the difference between sales of assets to foreigners

and purchases of assets located abroad.
Financial inflow (capital inflow)

A loan from foreigners with a promise that they will be repaid.
Financial outflow (capital outflow)

A transaction involving the purchase of an asset from
foreigners.
If a country is running a current account deficit, it will be running a

financial account surplus (+). The net foreign holdings of
domestic financial assets have to increase by the same amount.
Open economy
6.12
UK Balance of Payments 2008
Table 6.3 The UK balance of payments, 2008 (in billions of pounds)
The foreign exchange market
6.13
The nominal exchange rate
The determination of the exchange rate
6.14
Exchange rate regimes
1) Flexible exchange rates: The exchange rate is determined by supply

and demand in the foreign exchange market. The exchange rate is
allowed to fluctuate in response to changing economic conditions.
2) Fixed exchange rates: These countries maintain a fixed exchange

rate in terms of some foreign currency. Some peg their currency to
the dollar. The Central Bank guarantees to buy or sell its domestic
currency at a fixed rate.
3) Some countries operate under a crawling peg. These countries

typically have inflation rates that exceed the US inflation rate.
4) Some countries maintain their bilateral exchange rates within some

bands.
6.15
The demand for pounds (supply of foreign currency) is generated by:
1) Exports of goods and services: Foreigners offer foreign

currency (euros) in exchange for pounds to buy goods in the UK.
2) Capital inflows: Foreign investors demand pounds (offer euros)
to buy UK financial assets.
The supply of pounds (demand for foreign currency) is generated by:
1) Imports of goods and services: UK citizens offer domestic

currency (pounds) in exchange for euros to buy goods abroad.
2) Capital outflows: Domestic financial investors offer pounds
(demand euros) to buy foreign financial assets.
6.16
Supply of £
A
E*
Demand for £
Pounds
£
6.17
Flexible exchange rate
S£ An appreciation of the
domestic currency is an
increase in the price of the
domestic currency in terms
of the foreign currency,
E1 B which corresponds to an
increase in the exchange rate.
E0 D’£
A
D£
Pounds (£)
6.18
Flexible exchange rate
E= €/£
S£ A depreciation of the
S’£
domestic currency is a
decrease in the price of the
domestic currency in terms
of the foreign currency, or a
A decrease in the exchange
E0 rate.
B
E1
D£
Pounds (£)
6.19
Fixed exchange rate
When countries operate under fixed exchange rates (i.e. maintain a constant exchange rate
between them) the Central Bank guarantees to buy or sell domestic currency at a fixed
exchange rate.
E= €/£ S£ In order to intervene in the markets, the Central

Bank holds reserves of foreign currency.
If there is an excess demand for domestic currency,

the Central Bank buys foreign currency, increasing
its reserves.
If there is an excess supply of domestic currency,

the Central Bank sells foreign currency, running
down its reserves.
E0
An increase in the exchange rate is called a
revaluation (rather than an appreciation)
D£
A decrease in the exchange rate is called a
devaluation (rather than a depreciation)
Openness in goods markets
6.20
Nominal exchange rates
Note the two main characteristics of the

figure:
• The trend decrease in the exchange

rate - there was a depreciation of
the pound vis-à-vis the euro over the
period.
• The large fluctuations in the exchange
rate - there was a very large
appreciation of the pound at the end
of the 1990s, followed by a large
depreciation in the following decade.
Figure 6.2 The nominal exchange rate between the British pound and the euro since 1999
Source: European Central Bank.
6.21
The choice of domestic goods and foreign goods
• When goods markets are open, domestic consumers must

decide not only how much to consume and save but also
whether to buy domestic goods or foreign goods.
• Central to the second decision is the price of domestic goods

relative to foreign goods, or the real exchange rate.
• Real exchange rates are not directly observable, what we find

in the newspaper is the nominal exchange rate.
6.22
From nominal to real exchange rates
Let’s look at the real exchange rate between the UK and the euro area (i.e., the
price of UK goods in terms of European goods).
• If the price of a Jaguar in the UK is £30,000, and a pound is worth 1.15

euros, then the price of a Jaguar in euros is:
£30,000*1.15€/£ = €34,500
• If the price in euros of a Mercedes is €50,000, then the price of a Jaguar in

terms of a Mercedes is:
€34,500 /€ 50,000 = 0.69
A UK consumer can substitute one Jaguar for only 0.69 Mercedes.
To generalise this example to all of the goods in the economy, we use a price
index for the economy, or the GDP deflator.
6.23
Figure 6.3 The construction of the real exchange rate
P = price of UK goods in pounds (GDP deflator for the UK)

P* = price of European goods in euro (GDP deflator for the euro area)
EP
 
P *
6.24
Like nominal exchange rates, real exchange rates move over time:
• An increase in the relative price of domestic goods in terms of

foreign goods is called a real appreciation, which corresponds to
an increase in the real exchange rate, .
• A decrease in the relative price of domestic goods in terms of

foreign goods is called a real depreciation, which corresponds to
a decrease in the real exchange rate, .
6.25
Note the two main characteristics of

Figure 6.4:
• The large nominal and real

appreciation of the pound at the
end of the 1990s and the
collapse of the pound in 2008–
2009.
• The large fluctuations in the
nominal exchange rate also show
up in the real exchange rate.
Figure 6.4 Real and nominal exchange rates in the UK since 1999
The nominal and the real exchange rates in the UK have moved largely together since 1999.
Source: ECB, Eurostat, Bank of England.
6.26
From bilateral to multilateral exchange rates
Bilateral exchange rates are exchange rates between two countries.
Multilateral exchange rates are exchange rates between several

countries.
For example, to measure the average price of UK goods relative to the average
price of goods of UK trading partners, we use the UK share of import and export
trade with each country as the weight for that country, or the multilateral real UK
exchange rate.
Equivalent names for the relative price of foreign goods vis-á-vis UK goods are:
• The real multilateral UK exchange rate.
• The UK trade-weighted real exchange rate.
• The UK effective real exchange rate.
Openness in financial markets
6.27
• The purchase and sale of foreign assets implies buying or selling foreign
currency - foreign exchange.
• Openness in financial markets allows financial investors to diversify - to hold

both domestic and foreign assets and speculate on foreign interest rate
movements.
• Openness in financial markets allows countries to run trade surpluses and

deficits - a country that buys more than it sells must pay for the difference
by borrowing from the rest of the world.
• The country borrows by making it attractive for foreign financial investors to

increase their holdings of domestic assets.
6.28
The choice of domestic assets and foreign assets
The decision or whether to invest abroad or at home depends not only on
interest rate differences but also on your expectation of what will happen to
the nominal exchange rate.
Figure 6.6 Expected returns from holding one-year UK bonds or one-year US bonds
6.29
If both UK bonds and US bonds are to be held, they must have the same
expected rate of return, so that the following arbitrage relation must hold:
 Et 
1  it   (1  i ) e  *
t
 Et 1 
This is the uncovered interest parity relation, or interest parity condition.
The assumption that financial investors will hold only the bonds with the highest
expected rate of return is obviously too strong, for two reasons:
• It ignores transaction costs.
• It ignores risk.
6.30 The interest rate and arbitrage
UK bonds US bonds
Price of UK bonds S Price of US bonds
P0 A
B
P1 B
P1
D P0 D’
D’
A
D
UK bonds US bonds
Interest rate in the UK = Interest rate in the US

6.31
The relation between the domestic nominal interest rate, the foreign nominal
interest rate and the expected rate of depreciation of the domestic currency is
stated as:
(1  it* )
1  it  
 
1  Ete1  Et / Et  
A good approximation of the equation above is given by:
E e
 Et
it  it*  t 1
Et
Arbitrage implies that the domestic interest rate must be (approximately)
equal to the foreign interest rate plus the expected appreciation rate of the
domestic currency.
Note that if E te1  E t , then i t  i t*.
6.32
Should you hold UK bonds or US bonds?
UK bonds US bonds Expected rate Adjusted

interest rate interest rate of appreciation interest rate of
(i) (i*) of the pound US bonds
Scenario 1 2% 1% -1% 2%
Scenario 2 2% 1% -2% 3%
Scenario 3 2% 1% -0.5% 1.5%
Scenario 4 2% 1% 2% -1%
If the uncovered interest parity condition holds (Scenario 1) and the interest
rate in the UK is 1 percentage points above the US interest rate, it must be
that financial investors expect a depreciation of the pound vis-á-vis the dollar
of 1%.
6.33
In Scenario 1, should you hold UK bonds or US bonds?
• It depends whether you expect the pound to depreciate

vis-á-vis the dollar over the coming year.
• If you expect the pound to depreciate by more than 1.0%, then investing in
UK bonds is less attractive than investing in US bonds.
• If you expect the pound to depreciate by less than 1.0% or even to

appreciate, then the reverse holds, and UK bonds are more attractive than
US bonds.
The arbitrage relation between interest rates and exchange rates suggests
that, unless countries are willing to tolerate large movements in their exchange
rates, domestic and foreign interest rates are likely to move very much
together.
6.34
Figure 6.7 Three-months nominal interest rates in the USA and in the UK since 1970
UK and US nominal interest rates have largely moved together over the past 40 years.
The IS Relation in an Open Economy
6.35
When the market for goods is open, we must be able to distinguish

between the domestic demand for goods and the demand for
domestic goods:
Some domestic demand falls on foreign goods, and some of the demand for
domestic goods comes from foreigners.
In an open economy, the demand for domestic goods is given by:
Z  C  I  G  X  IM
Domestic + Net exports
demand
Demand for domestic goods
The Determinants of C, I and G
6.36
Domestic Demand:
Z  C (Y  T )  I (Y , i )  G
( ) (  , )
The real exchange rate affects the composition of consumption

and investment, but not the overall level of these aggregates.
The determinants of imports
6.37
IM  IM Y ,   IM IM
 0, 0
Y ε
EP
 * IM  IM Y , P, P* , E  
P
 , , ,
• As domestic income (output) rises, demand for imports increases.
• As the real exchange rate rises (so that domestic goods become more
expensive in terms of foreign goods), demand for imports rises.
The determinants of exports
6.38
X X
X  X Y *, ε   0, 0
Y * ε
EP
 * 
X  X Y * , P, P* , E 
P
 , , , 
• As foreign income (output), Y*, rises, demand for exports increases.
• As the real exchange rate rises (so that domestic goods become
more expensive in terms of foreign goods), demand for exports falls.
Putting the components together
6.39
Figure 6.8 The Demand for Domestic Goods and Net Exports
The domestic demand for goods is an

increasing function of income (output) -
Panel (a)
The domestic demand for domestic

goods is obtained by subtracting the
value of imports from domestic demand
- Panel (b)
6.40
Two facts about the line AA (representing domestic demand

for domestic goods):
 AA is flatter than DD. As income increases, the domestic

demand for domestic goods increases less than total
domestic demand.
 As long as some of the additional demand falls on

domestic goods, AA has a positive slope.
6.41
Figure 6.8 The Demand for Domestic Goods and Net Exports
The demand for domestic goods

is obtained by subtracting the
value of imports from domestic
demand, and then adding
exports - Panel (c)
The trade balance is a

decreasing function of output -
Panel (d)
Equilibrium output and the trade balance
6.42
The goods market is in equilibrium when domestic output equals

the demand – both domestic and foreign – for domestic goods:
Y Z
Expressed in terms of its components and their determinants:
Y  C (Y  T )  I (Y , i )  G  IM (Y ,  )  X (Y ,  )
*
We define net exports as:

NX (Y , Y * , P, P* , E )  X (Y , P, P* , E )  IM (Y , P, P* , E )
*
  
6.43
Y  C (Y  T )  I (Y , i)  G  NX (Y , Y * , P, P* , E )
NX (Y , Y * , P, P* , E )  X (Y , P, P* , E )  IM (Y , P, P* , E )
*
The main implication of this equation is that both the interest rate (i) and the
real exchange rate () affect demand and, in turn, equilibrium output:
 An increase in the interest rate leads to a decrease in investment

spending and a decrease in the demand for domestic goods.
 An increase in the real exchange rate leads to a shift in demand toward
foreign goods and, as a result, to an increase in net exports.
6.44
Figure 6.9 Equilibrium Output and Net Exports
The goods market is in equilibrium

when domestic output is equal to
the demand for domestic goods.
At the equilibrium level of output,

the trade balance may show a
deficit or a surplus.
The LM Relation in an Open Economy
6.45
Money versus bonds
The money market equilibrium requires that the real money

supply is equal to the real money demand, which depends on
real income, Y, and the interest rate, i:
 YLi 
M
P
This determines interest rate in an open economy (and in a

closed economy).
6.46
Domestic bonds versus foreign bonds
If financial investors go for the highest expected rate of return, the
arbitrage relation must hold:
 Et 
1  i t   1  i t* 
 e 
E 
 t 1 
This means that in equilibrium, the uncovered interest parity

relation, or interest parity condition must hold.
This just says that domestic and foreign bonds must have the same
expected return.
6.47
Domestic bonds versus foreign bonds
A higher domestic interest rate leads Figure 6-10. The relation between the interest rate
and exchange rate implied by interest parity
to a higher exchange rate
(appreciation), given foreign interest
rates and the expected future
exchange rate.
If i = i*, then E = Ee.
1 i
E  Ee
1  i*
The exchange rate, E, increases when:

- the domestic interest rate increases
- the expected future exchange rate increases
- the foreign interest rate falls
Putting Goods and Financial Market Together in an Open Economy
6.48
Figure 6.11 The IS–LM model in an open economy
An increase in the interest rate reduces output both directly and indirectly
(through the exchange rate): the IS curve is downward sloping.
Given the real money stock, an increase in output increases the interest rate:
the LM curve is upward sloping.
6.1
Topic 7
Economic Policy in an Open Economy
CONTENTS
6.2
1. Changes in demand, domestic or foreign

2. The effects of fiscal policy in an open economy
3. The effects of monetary policy in an open economy
4. Economic policy and the Exchange rates
Recall: The IS-LM model in an open economy
6.3
Equilibrium output:
IS: Y  C (Y  T )  I (Y , i)  G  XN (Y , Y * , P, P* , E )
Equilibrium interest rate:
M
LM:  YL(i )
P
The interest parity condition implies a positive relation between
the domestic interest rate and the exchange rate:
1 i
E  Ee
1  i*
6.4
Using the interest parity condition to substitute for the nominal

exchange rate in the goods market equilibrium condition gives:
1 i e
IS: Y  C (Y  T )  I (Y , i)  G  XN (Y , Y , P, P , E ) * *
1 i *
M
LM:  YL(i )
P
6.5
IS relation: Interest rates have a direct effect (through

investment) and an indirect effect (through the exchange rate) on
output.
Both effects work in the same direction - the IS curve is

downward sloping (an increase in the interest rate leads to lower
output), and it is flatter than in a closed economy.
LM relation: The same as in a closed economy - the LM curve is

upward sloping.
6.6
The IS-LM model in an Open Economy

Increases in demand, domestic or foreign
6.7
Increases in domestic demand
How do changes in demand affect

output in an open economy?
Figure 7.3 The effects of an increase in

government spending
An increase in government spending leads to

an increase in output and to a trade deficit
Z  C  I  G  IM  X
Domestic
demand
Demand for domestic
goods
6.8
Increases in domestic demand
There are two important differences we should note between

open and closed economies:
• There is now an effect on the trade balance. The increase in

output from Y to Y’ leads to a trade deficit equal to BC.
Imports go up, and exports do not change.
• The effect of government spending on output is smaller than it

would be in a closed economy. This means the multiplier is
smaller in the open economy.
6.9
Increases in foreign demand
Figure 7.4 The effects of an increase in

foreign demand
An increase in foreign demand leads to an

increase in output and to a trade surplus
6.10
Increases in foreign demand
The direct effect of the increase in foreign output is an increase in

UK exports by some amount, which we shall denote by X :
• For a given level of output, this increase in exports leads to an

increase in the demand for UK goods by X, so the line shifts
by X from ZZ to ZZ’.
• For a given level of output, net exports go up by X. So the

line showing net exports as a function of output in Panel (b)
also shifts up by X, from NX to NX’.
Fiscal policy revisited
6.11
We have derived two basic results so far:
• An increase in domestic demand leads to an increase in

domestic output, and also leads to a deterioration of the
trade balance.
• An increase in foreign demand leads to an increase in

domestic output and an improvement in the trade balance.
Implication: Demand shocks in one country affect other countries

 need for coordination of macroeconomics policies.
Fiscal policy revisited
6.12
The so-called G7 – the seven major countries of the world – meet

regularly to discuss their economic situation; the communiqué at
the end of the meeting rarely fails to mention coordination.
The fact is that there is very limited macro-coordination among
countries. Here’s why:
• Some countries might have to do more than others and may not
want to do so.
• Countries have a strong incentive to promise to coordinate, and

then not deliver on that promise.
Fiscal Multipliers in an Open Economy
6.13
Consider a world of two countries, namely Home and Foreign.
The multiplier of Home’s fiscal policy: Y 1


G 1  c  m
 1
• In an open economy the fiscal multiplier is lower than in a closed

economy (1/(1 − c1)).
• Countries with higher import propensities have lower fiscal
multipliers.
Y m *
The multiplier of Foreign’s fiscal policy: 

G 1  c  m
*
1

Fiscal stimuli abroad have expansionary effects also at home.

Fiscal Multipliers in an Open Economy
6.14
Figure 7.3 Fiscal multipliers and import penetration
Depreciation, the trade balance and output
6.15
The Marshall-Lerner condition
Recall that the real exchange rate is given by:

EP
ε
P*
What effect will a real depreciation have on the trade balance?
NX  X (Y ,  )  IM (Y ,  ) / 
The real depreciation affects the trade balance through three separate channels:
• Exports (X) increase.

• Imports (IM) decrease.
• The relative price of foreign goods in terms of domestic goods (1/) increases.
Depreciation, the trade balance and output
6.16
The Marshall-Lerner condition
The Marshall-Lerner condition is the condition under which a real

depreciation (i.e., a decrease in ) leads to an increase in net
exports.
From here on we assume that this condition is satisfied, i.e., a real

depreciation will be assumed to lead to an increase in net exports.
Thus:
The (real) depreciation leads to a shift in demand, both foreign and

domestic, toward domestic goods. This shift in demand leads in turn
to both an increase in domestic output and an improvement in the
trade balance.
The effects of a depreciation
6.17
Figure 7.4
The depreciation leads to a shift

in demand, both foreign and
domestic, toward domestic goods.
This shift in demand leads, in turn,
to both an increase in domestic
output and an improvement in the
trade balance.
XN  XN (Y , Y ,  )
*
  
Depreciation, the Trade Balance and Output
6.18
Combining exchange rate and fiscal policies
If the government wants to eliminate the trade deficit without

changing output, it must do two things:
• It must achieve a depreciation sufficient to eliminate the

trade deficit at the initial level of output.
• The government must reduce government spending.
Table 7.1 Exchange rate and fiscal policy combinations
Looking at Dynamics: The J-Curve
6.19
A depreciation may lead to an initial deterioration of

the trade balance;  increases, but neither X nor IM
adjusts very much initially.
Eventually, exports and imports respond, and

depreciation leads to an improvement of the trade
balance.
6.20
Figure 7.5 The J-curve
A real depreciation leads initially to a deterioration and then

to an improvement of the trade balance.
6.21
Turning to the trade deficit, which is expressed as a ratio to

GDP, two facts are clear:
- Movements in the real exchange rate were reflected in

parallel movements in net exports.
- There were lags in the response of the trade balance to
changes in the real exchange rate.
Saving, Investment and the Trade Balance
6.22
The alternative way of looking at equilibrium from the condition

that investment equals saving has an important meaning:
Y  C  I  G  IM /   X
Subtract C + T from both sides and use the fact that private
saving is given by S = Y – C – T to get
S  I  G  T  IM /   X
Use the definition of net exports, NX  X  IM / 
and reorganise, to get:
NX  S  (T  G)  I
Saving, Investment and the Trade Balance
6.23
NX  S  (T  G)  I
From the equation above, we conclude:
• An increase in investment must be reflected in either

an increase in private saving or public saving, or in a
deterioration of the trade balance.
• An increase in the budget deficit must be reflected in an

increase in either private saving, or a decrease in investment
or a deterioration of the trade balance.
• A country with a high saving rate must have either a high

investment rate or a large trade surplus.
The effects of policy in an open economy
6.24
The effects of fiscal policy in an open economy
Figure 7.8 The effects of an increase in government spending

An increase in government spending leads to an increase in output, an increase in the interest
rate and an appreciation
6.25
An increase in government spending leads to an increase in demand, leading to
an increase in output (the IS curve shifts to the right by the amount of the
increase in G multiplied by the multiplier. Recall that in an open economy the
multiplier is smaller than in a closed economy: imports increase following the
rise in income).
As output increases, the demand for money increases, leading to a rise in the
interest rate. The increase in the interest rate has two effects:
1. As the interest rate increases, investment decreases, leading to a decrease in
demand and in output.
2. The increase in the interest rate makes domestic bonds more attractive,
leading to an appreciation. The higher nominal exchange rate leads to a
decrease in net exports, leading to a fall in demand and output.
6.26
What happens to the various components of demand?
• Consumption goes up because of the increase in income.
• Government spending goes up by assumption.
• The effect of government spending on investment remains ambiguous in

an open economy: output goes up, leading to an increase in investment;
the interest rate goes up, leading to a decrease in investment.
• Both the increase in output (leading to an increase in imports) and the

appreciation (leading to an increase in imports and a decrease in
exports) combine to decrease net exports.
6.27
The effects of a monetary policy in an open economy
Figure 7.9 The effects of a monetary contraction

A monetary contraction leads to a decrease in output, an increase in the interest rate and an
appreciation
6.28
A decrease in the (real) stock of money, leads to an excess demand for money,
leading to an increase in the interest rate. Now, at any given level of output
the interest rate is higher (the LM curve shifts up).
The increase in the interest rate has two effects:

1. As the interest rate increases, investment decreases, leading to a decrease in
demand and in output.
2. The increase in the interest rate makes domestic bonds more attractive,
leading to an appreciation (IPR). The higher nominal exchange rate leads to
a decrease in net exports, leading to a fall in demand and output.
6.29
What happens to the various components of demand?
• Consumption decreases because of the decrease in income.
• Investment decreases: output decreases and the interest rate goes up,
both leading to a decrease in investment.
• The effect on net exports is ambiguous. The decrease in output leads to a

decrease in imports, and net exports increase. The appreciation leads to
an increase in imports and a decrease in exports, leading to decrease
net exports.
Fixed exchange rates
6.30 Pegs, crawling pegs, bands, the EMS and the Euro
Central banks act under implicit and explicit exchange rate

targets, and use monetary policy to achieve those targets.
Some countries operate under fixed exchange rates. These

countries maintain a fixed exchange rate in terms of some
foreign currency. Some peg their currency to the dollar.
Some countries operate under a crawling peg. These countries

typically have inflation rates that exceed the US inflation rate.
6.31 Pegs, crawling pegs, bands, the EMS and the Euro
• Some countries maintain their bilateral exchange rates within

some bands. The most prominent example is the European
Monetary System (EMS).
• Under the EMS rules, member countries agreed to maintain

their exchange rate vis-á-vis the other currencies in the
system within narrow limits or bands around a central parity.
• Some countries moved further, agreeing to adopt a common

currency, the euro, in effect, adopting a ‘fixed exchange
rate’.
6.32 Pegging the exchange rate and monetary control
The interest parity condition is:
 Et 
1  i t   1  i t* 
 e 
E 
 t 1 
Pegging the exchange rate turns the interest parity relation into:
1  it    *
1  it  *
it  it
Under a fixed exchange rate and perfect capital mobility,

the domestic interest rate must be equal to the foreign interest rate.
Increases in the domestic demand for money must be matched

by increases in the supply of money in order to maintain the
interest rate constant, so that the following condition holds:
M
P
 YL i *
 
Under fixed exchange rates, the central bank gives up monetary

policy as a policy instrument.
Figure 7.10 The effects of a fiscal expansion under fixed exchange rates
Under flexible exchange rates, a fiscal expansion increases output from YA to YB. Under
fixed exchange rates, output increases from YA to YC .
6.35 The effects of a fiscal expansion
An increase in government spending leads to an increase in demand and through

the multiplier to an increase in output (the IS curve shifts to the right).
As output increases, the demand for money increases, and this would lead to a
rise in the interest rate (i>i*) and to an appreciation.
To avoid appreciation the Central Bank must accommodate this increased

demand for money by increasing the money supply (the LM curve shifts
down).
The equilibrium moves to C with higher output and unchanged interest and
exchange rates.
Fiscal policy is more effective under fixed exchange rates.

There are a number of reasons why countries choosing to fix its exchange rate
appears to be a bad idea:
• By fixing the exchange rate, a country gives up a powerful tool for

correcting trade imbalances or changing the level of economic activity.
• By committing to a particular exchange rate, a country also gives up control

of its interest rate, and they must match movements in the foreign interest
rate risking unwanted effects on its own activity.
• Although the country retains control of fiscal policy, one policy instrument is
not enough. A country that wants to decrease its budget deficit cannot,
under fixed exchange rates, use monetary policy to offset the
contractionary effect of its fiscal policy on output.

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1.

Macroeconomics: Objectives and

1. The objectives of macroeconomics

1. The objectives of Macroeconomics

Microeconomics: deals with the behaviour of individual economic

- Explains how and why these units make economic decisions

Macroeconomics: is the study of the economy as a whole.

- Explain overall behaviour of the economy

 Instituto Nacional de Estadística: www.ine.es

 World Bank: data.worldbank.org

• The real world is very complex

• Economists try to understand the economy by using simplified

• The departure point is a set of assumptions

• Simplification allows to:

• Statistics and econometrics measure the accuracy of our

• The validity of a model depends on whether it succeeds in

• The role of assumptions:

– Assumptions are used to make the world more understandable

– A big part scientific thought is knowing which assumptions we

– Economists use different assumptions in order to study

Exogenous versus endogenous variables

Factor Payments Consumption Goods

Payments Consumption Financial Govt. Rest of

3. The Instruments of Economic Policy

Macroeconomic policy instruments are variables controlled by

Fiscal policy: deliberate use of government spending and taxes

Monetary policy: influencing the economy through changes in

Supply side policies: labour market reforms, educational

Exchange rate policy

 Unemployment: existence of idle  Creation of new jobs (reduction of

There may be conflict between objectives:

4. Some figures from around the world

When macroeconomists study an economy, they first look at

• The unemployment rate

• The inflation rate

• From 2000 to 2007, the world economy had a sustained

• The European Union (EU) is a group of 28 European counties

Figure 3. Unemployment in Spain since 1990

• Supporters of the euro argue:

• Productivity growth is important for a sustained increase in income per person,

Table 1-2. Labor Productivity Growth, by Decade

Table 1-4. Growth, unemployment and Inflation in China, 1990–2015

Principal Macroeconomic Aggregates

Dornbusch et al. (2014), chapter 2.

• National income and product accounts are an accounting

• The measure of aggregate output in the national income

 “…final goods and services…”

 “…during a given period”

GDP =  (Prices of goods × Quantities of goods)

• Nominal GDP (at current prices) in year 𝒕 is the sum of the

𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷𝒕 = ෍ 𝑷𝒊𝒕 𝑸𝒊𝒕

• Real GDP (at constant prices of some year 𝟎) is constructed as

𝑹𝒆𝒂𝒍 𝑮𝑫𝑷𝒕 = ෍ 𝑷𝒊𝟎 𝑸𝒊𝒕

• The GDP deflator is a price index:

• The inflation rate for period 𝒕 can be calculated as the

Nominal GDP each year: Rate of change

Real GDP choosing year 2012 as the base year

The change in the nominal GDP reflects both changes in

2012: 100 x (6000/6000) = 100.0

2014: 100 x (10800/8400) = 128.6

2. GDP is the total expenditure required to purchase the goods and

3. GDP is the sum of incomes in the economy during a given period

Goods and services

Source: Macroeconomics (9th ed.),