1.

National Accounts Relationship and Its Link with the BOP Accounts
Total GDP or, simply, GDP: The letter “G” stands for Gross, indicating that the investment component is gross, i.
e. depreciation of capital stock is not yet subtracted or netted off. After being subtracted or netted off, it would
become NDP. The letter “D” stands for Domestic, indicating that it covers only (and all) production or economic
activities within the boundary of the economy, i.e. it includes rewards to factors of production (wages, interest
and profits) accruing to non-residents because the factors of production are used in the economy and excludes
similar rewards accruing to residents or “nationals” from outside the economy because such factors of
production are used outside the economy. After excluding such rewards to factors of production owned by non-
residents that are used in the economy and including rewards to factors of production owned by residents but
used outside the economy, it will become GNP.

Real GDP is nominal GDP/P (where P is the price level) while per capital GDP is the GDP/population

Thus, on the whole, we have nominal GDP, nominal NDP, nominal GNP, nominal NNP, real GDP, real NDP, real
GNP, real NNP, per capita nominal GDP, per capita nominal NDP, per capita nominal GNP, per capita nominal
NNP, per capita real GDP, per capita real NDP, per capita real GNP, and per capita real NNP. The expression
“National Income” or NI can loosely refer to any of these but, technically, it should refer to NNP typology (viz:
nominal NNP, real NNP, per capita nominal NNP and per capita real NNP).

Depending on the context, economic growth can refer to growth of any of the above 8 variants of real output
(viz: real GDP, real NDP, real GNP, real NNP, per capita real GDP, per capita real NDP, per capita real GNP, and
per capita real NNP). It does not have much meaning to refer to economic growth as growth of any of the 8
nominal variants (viz: nominal GDP, nominal NDP, nominal GNP, nominal NNP, per capita nominal GDP, per
capita nominal NDP, per capita nominal GNP, and per capita nominal NNP).

Growth rate of a variable Y over two successive periods t and t-1 is given loosely by (Yt – Yt-1)/Yt-1 = Yt /Yt-1- 1 or,
more technically and more precisely, as ln(Yt/Yt-1) = lnYt – lnYt-1. Using this more technical definition (viz: lnYt –
lnYt-1), growth rate of A x B = growth rate of A + growth rate of B and growth rate of A/C = growth rate of A
minus growth rate of C. Accordingly, growth rate of nominal income is given as growth rate of real income plus
growth rate of price level (which is also called inflation rate). In the same vein, growth rate of per capita income
= growth rate of total income minus growth rate of population. This relationships also hold, though only
approximately, when growth rates are calculated loosely as (Yt – Yt-1)/Yt-1.

Two commonest variants of price level are the computer price index (CPI) and implicit GDP (or GNP or NDP or
NNP) deflator. It is the implicit deflator that should be used in converting the nominal GDP (or GNP or NDP or
NNP) to the real one and vice versa because it covers the C, I, G and X – M components, as opposed to the CPI
that covers only the C component. The growth rate of the price level or price index - whether the CPI, the GDP
(or GNP or NDP or NNP) implicit deflator or any other price level variant - is known as the inflation rate.

There is a relationship between the (X – M) expression in the national accounts and the current account (CA)
balance in the BOP account. The CA balance is the sum of exports of physical goods and (factor and non-factor)
services as well as the receipts of unrequited transfers from abroad minus the sum of imports of physical goods
and (factor and non-factor) services as well as the payments of unrequited transfers abroad. But the X in the
national accounts excludes the receipts of unrequited transfers from abroad just as the M too excludes the
payments of unrequited transfers abroad. Thus, the X – M = CA balance minus the receipts of unrequited
transfers from abroad plus the payments of unrequited transfers abroad.

1
2. Derivation of IS Relationship
Y = C + I + G + (X – M) …… (1)

C = α0 + α1Yd ……. (2)

where Yd = Y – T and where
T = t0 + t1Y …… (3)
implying Yd = Y – t0 – t1Y so that:
C = α0 + α1(Y - t0 – t1Y) = α0 + α1Y - α1t0 – α1t1Y
I = i0 – i1r … (4)
G = g0 ….. (5)
X = x0 + x1R + x2Yw …. (6)
(where Yw = income in the rest of the world and R = index of real exchange rate defined as domestic currency
per unit of foreign currency, in real terms).
M = m0 + m1Y – m2R ….. (7)

Equations (2) to (7) are referred to as the structural equations.

The reduced-form equation for Y is given by:

Y = α0 + α1Y - α1t0 – α1t1Y + i0 – i1r + g0 + (x0 + x1R + x2Yw - m0 - m1Y + m2R) OR
(1 - α1 + α1t1+m1 )Y = α0 - α1t0 + i0 – i1r + g0 + (x0 + x1R + x2Yw - m0 + m2R) OR
Y = [α0 - α1t0 + i0 – i1r + g0 + (x0 + x1R + x2Yw - m0 + m2R)]/[ (1 - α1 + α1t1+m1 )] ….. (8)
Let H = 1 - α1 + α1t1+m1 so that the SIMPLE (or IS) multiplier = 1/H …… (8a)
Then, 𝝏𝒀/𝝏𝜶0, 𝝏𝒀/𝝏𝒕0, 𝝏𝒀/𝝏𝒊0, 𝝏𝒀/𝝏𝒈0, 𝝏𝒀/𝝏𝒙0 , ∂Y/∂( x1R + x2Yw)= 1/H ≥ 0; and 𝝏𝒀/𝝏𝒕0, 𝝏𝒀/𝝏𝒎0 = -1/H ≤ 0 …. (9)
Also, let autonomous expenditures be denoted by A = α0 - α1t0 + i0 – i1r + g0 + (x0 + x1R + x2Yw - m0 + m2R) … (9a)

To derive the IS relationship, make r the subject of the formula thus:

r = -(1 – α1 + α1t1 + m1)Y + [α0 – α1t0 + i0 + g0 + (x0 + x1R + x2Yw –m0 + m2R)] = -HY + A (10)
i1 i1 i1 i1
𝝏𝒓/𝝏𝒀 ≤ 0 Why? Because an increase in r → a fall in I so that to preserve the equality between I and S (or the
commodity market equilibrium), S has to fall and this can be brought about through a fall in Y (since S is a
positive function of Y).
Factors that shift the IS curve to the right and to the left are as respectively identified in equation (9) above.

3. Derivation of the LM Relationship

Money Demand (or Liquidity Preference) Function: L = Md/P = l0 + l1Y – l2r …. (11)

Money supply: Ms = ms0 … (12)

Money market equilibrium requires that Md = Ms so that Md/P = m0/P OR
= l0 + l1Y – l2r = m0/P OR Y = (1/l1)(ms0/P – l0 + l2r) …… (13)
The SIMPLE (or LM) multiplier = ∂Y/(∂mso/P) = 1/l1 …. (13a)
∂Y/∂mso ≥ 0 and 𝝏𝒀/𝝏𝑷0, 𝝏𝒀/𝝏𝒍0 ≤ 0 … (14)

Making r the subject of the formula yields: r = l0/l2 + (l1/l2) Y – (1/l2) (ms0/P) …… (15)
𝝏𝒓/𝝏𝒀 ≥ 0 Why? Because an increase in r → a fall in speculative demand for money (l2r) so that, to preserve the
equality between the fixed ms0 and Md, the transactions demand for money (l1Y) has to rise to offset the fall in
speculative demand and this can only happen if Y too rises, implying both r and Y have to rise or fall together
for the money market equilibrium to be preserved.

Factors that shift the LM curve to the right and to the left are as respectively identified in equation (14) above.

2
 4. DERIVATION OF THE AGGREGATE DEMAND EQUILIBRIUM COMBINING IS AND LM RELATIONSHIPS
Equating the IS relation in equation 10 and LM relation in equation 15 to get rid of r gives:
r = -(1 – α1 + α1t1 + m1)Y + [α0 – α1t0 + i0 + g0 + (x0 + x1R + x2Yw –m0 + m2R)] = l0 + l1Y - 1 ms0
i1 i1 l2 l2 l2 P
l1 + (1 – α1 + α1t1 + m1)] [α0 – α1t0 + i0 + g0 + (x0 + x1R + x2Yw –m0 + m2R)] -l0 + 1 ms0
l2 i1 i1 l2 l2 P OR
After multiplying both the numerator and denominator by l2i1 and simplifying, we have:
[i1l1 + l2(1 – α1 + α1t1 + m1)]Y = l2[α0 – α1t0 + i0 + g0 + (x0 + x1R + x2Yw –m0 + m2R)] – i1l0 + i1ms0
P
w s
Y =Y l2[α0 – α1t0 + i0 + g0 + (x0 + x1R+ x2Y –m0 + m2R)] – i1l0 + (i1m 0)/P ……………..(16)
[i1l1 + l2(1 – α1 + α1t1 + m1)] [i1l1 + l2(1 – α1 + α1t1 + m1)]
Substituting into equation (16), for simplicity and compactness, our definitions of H (reciprocal of the simple
multiplier) and A (autonomous expenditure items) in equations (8a) and (9a) respectively, we have:
OR: Y = l2A/( i1l1 + l2H) + [- i1l0 + (i1ms0)/P ]/ ( i1l1 + l2H) …………………………. (16a)

Fiscal Policy Multiplier (∂Y/∂g0 = -∂Y/∂t0) = l2/[i1l1 + l2(1 – α1 + α1t1 + m1)] =

1/[i1l1/l2 +(1 – α1 + α1t1 + m1)] = 1/(i1l1/l2 + H) …………………………………………………….(17)
Required: Evaluate and comment on the value of the fiscal multiplier for each of the 5 scenarios or different
combinations of i1 and l2 values [viz: (i) 0< i1 < ∞ combined with 0< l2 < ∞; (ii) 0< i1 < ∞ combined with l2 → ∞;
(iii) 0< i1 < ∞ combined with l2 = 0; (iv) i1 = 0 combined with 0< l2 < ∞; and (v) i1 = 0 combined with l2 → ∞].

Monetary Policy Multiplier [∂Y/∂(ms0/P) = -∂Y/∂l0] = i1/[i1l1 + l2(1 – α1 + α1t1 + m1)] =

1/(l1 + l2H/i1) = (∂Y/∂g0)(i1/l2) ……………………………………………… (18)
Required: Evaluate and comment on the value of the money multiplier for each of the 5 scenarios or different
combinations of i1 and l2 values [viz: (i) 0< l2 < ∞ combined with 0< i1 < ∞; (ii) 0< l2 < ∞ combined with i1 → ∞;
(iii) 0< l2 < ∞ combined with i1 = 0; (iv) l2 = 0 combined with 0< i1 < ∞; (v) l2 = 0 combined with i1 → ∞].

5. DERIVATION OF AGGREGATE DEMAND RELATIONSHIP

∂Y/∂P =[- i1ms0/P2]/ [i1l1 + l2(1 – α1 + α1t1 + m1)] = [- i1ms0/P2]/ [i1l1 + l2H] =-ms0/ [p2(l1 + l2H/i1)] ≤ 0 …..(19)
Alternatively, we can re-arrange equation (16) or (16a) to make P the subject of the formula. Based on Equation
(16a), we will have:
P = ms0/[Y(l1 + l2H/i1) + l0 – (l2/i1)A] ………….. (19a)
From equation (19a), the inverse relationship between P and Y is evident as Y appears only in the denominator,
with other expressions there being either constant parameters or exogenous items.

From equation (19), if l2 → ∞ or i1 = 0, p2(l1 + l2H/i1) → ∞ so that ∂Y/∂P → 0 and ∂P/∂Y → ∞, implying a vertical
aggregate demand curve, meaning there is no relationship between Y and P. The same conclusion can be
deduced from equation (19a). But why? Because the change in money supply implied by a change in price level
will not affect aggregate demand (and, hence, Y) if either l2 → ∞ or i1 = 0, since these are the two situations
when monetary expansion or contraction is totally ineffective in changing Y. Barring this extreme situation, the
aggregate demand curve is a sort of hyperbola (looking like a conventional indifference curve or Average Fixed
Cost, AFC, curve in microeconomics) in the sense that it asymptotically approaches (without actually touching)
each of the axes. Although the curve can get flatter, it never becomes a horizontal straight line.

Note that, through shifting of the IS curve, changes in each component of A will cause a shift in the aggregate
demand curve, with positive changes (viz: ∆α0 ; -∆t0; ∆i0; ∆g0; ∆x0; ∆R, ∆Yw, and –∆m0 ) shifting the curve to the
right and negative changes (viz: -∆α0 ; ∆t0; -∆i0; -∆g0; -∆x0; -∆R, -∆Yw, and ∆m0 ) shifting it to the left, along the
same direction as they shift the IS curve. Similarly, by shifting the LM curve, an increase in nominal money
supply (viz: ∆ms0) or a fall in autonomous component of money demand (-∆l0) will shift the aggregate demand
curve to the right while a decrease in nominal money supply (viz: -∆ms0) or an increase in autonomous
component of money demand (∆l0) will shift the aggregate demand curve to the left.
3
 OPEN ECONOMY MACROECONOMICS
1. THE BALANCE OF PAYMENTS (BOP) STRUCTURE AND FORMAT
The BOP of a country (i. e., the reporting country) is a statistical record of all economic and financial
transactions between the residents of that country (i. e., those resident or intending to be resident for not less
than a year in that country) and the residents of the rest of the world.

The BOP records are kept on the basis of the bookkeeping principle of double entry whereby every credit entry
has a corresponding debit entry. Each transaction giving rise to a receipt of foreign exchange (e. g., exports and
capital inflows) is a credit item while the actual receipt of foreign exchange (e. g., accretion to the foreign
exchange holdings) constitutes the corresponding debit entry. In the same vein, each transaction giving rise to a
payment of foreign exchange (e. g., imports and capital outflows) is a debit item while the actual payment of
foreign exchange (e. g., outflow or depletion of foreign exchange) constitutes the corresponding credit entry.

While there is no unique or rigid format for presenting the statistics and considerable variations exist among
countries, the IMF has recommended a particular format or standard which are generally adopted by many
countries. In all cases, the BOP highlights two distinct classes of transactions and, hence, two main accounts,
viz: income flows that are recorded in the current account and flows of (or changes in) assets and liabilities that
are recorded in the capital account. These are reviewed in Paragraphs A to D below.

A. The Current A/C segment has sub-accounts for merchandise trade (the balance of which is called the balance
of Trade), trade in non-factor services (like transportation, travels, insurance, banking, royalties & license fees,
consultancy fees, etc) ; factor incomes (viz: investment incomes like interest and dividends as well as wage
incomes earned by non-residents or temporary workers outside the countries of their residence); and
unrequited transfers - whether official (mainly in the form of bilateral and multilateral foreign grants) or private
(mostly, in the form of private remittances from workers resident abroad to their countries of origin). The
balance in the services, incomes and unrequited transfers, when added to the balance of trade, constitutes the
current account balance – which is surplus if positive (i. e., if credit entries exceed the debit entries) and deficit
if it is the other way round.

B (i) The Capital A/C segment, on the other hand, has sub-accounts for long-term capital flows (viz: Capital
items like acquisition and disposal of non-financial assets as well as financial items like FDI; portfolio capital in
the form of non-FDI equity flows and long-term private borrowing and repayments; public or official borrowing
and repayment from the international capital markets as well as from bilateral and multilateral sources; and
long-term trade credits, among others). All inflows are credit (or positive) entries while all outflows are debit
(or negative) entries, with surplus being the difference if positive and deficit being the difference if negative.

B (ii) The Capital A/C also has sub-accounts for short-term capital flows (like short-term trade credits and short-
term investments in foreign money markets, among others). All inflows are credit (or positive) entries while all
outflows are debit (or negative) entries, with surplus being the difference if positive and deficit being the
difference if negative.

C. Due to the manner that the statistics are compiled in practice, there is bound to be incomplete information
and errors and omissions do occur, these sometimes being referred to as Statistical Discrepancy – which is
often presented immediately below the afore-mentioned Capital A/C items and just before the last segment of
Capital A/C called Financing or Change in Foreign Reserves.

D. Financing or Change in Foreign Reserves is the last sub-account of the Capital A/C segment. It is here that any
unusual mode of financing BOP deficit (or representing BOP surplus) is recorded. More importantly, it is here
that changes in foreign reserves are recorded – with a depletion of foreign reserves to finance BOP deficit being
a credit entry (i. e., with a positive sign) and an accretion to foreign reserves to represent the BOP surplus being
a debit entry (i. e., with a negative sign).
4
2. ALTERNATIVE CONCEPTS OF BOP SURPLUS AND DEFICIT
By design, the sum of credit entries must equal the sum of debit entries in all the accounts combined, so that,
on the whole, the BOP must balance – neither a surplus nor a deficit!

Thus, when we talk of BOP position being in surplus or deficit, we refer to only a segment that is of interest. In
this context, a distinction is often made between those sub-accounts (starting from the balance of trade
account downward) where autonomous transactions are recorded, which are also referred to as above-the-line
transactions, and those sub-accounts (starting from the Change in Foreign Reserves account upwards) where
accommodating transactions are recorded, which are also referred to as below-the-line transactions.
Autonomous or above-the-line transactions are those that are undertaken by private residents and those
government units that are not concerned with whether the BOP position is desirable or not so that the
transactions are undertaken with entirely different motive from inducing a particular or desired BOP position.
On the other hand, the accommodating or below-the-line transactions are those undertaken by those
government agencies whose responsibility is to bring about a desired BOP position (particularly the Central
Bank) with the primary motive of accomplishing the desired BOP position, e. g. conscious accumulation of
foreign reserves to represent the BOP surplus or depletion of foreign reserves to finance the BOP deficit; official
borrowing from abroad to finance the BOP deficit, and so on.

There is no consensus as to where to draw the line above which the sub-accounts are autonomous and below
which they are accommodating because this varies from country to country and from period to period. But, in
virtually all cases, the current account is regarded as being wholly autonomous while the Change in Foreign
Reserves account is regarded as being wholly accommodating.

If it is only the current A/C that is regarded as being autonomous, then a BOP surplus exists if the current A/C is
in surplus while a BOP deficit exists if the current A/C is in deficit. Since, by design, the Capital A/C (broadly
defined to include Change in Reserves A/C balance) must be equal and opposite to the current A/C balance, a
current A/C surplus means that the reporting country must be transferring resources or funds equal to the
surplus abroad (i. e., running a Capital A/C deficit) while a current A/C deficit means the reporting country must
be living on funds received from abroad equal to the deficit. If the current A/C balance is zero, then Capital A/C
balance too must be zero.

Sometimes, particularly during the 1948-1973 fixed exchange rate era, long-term capital account items too
were being regarded as being autonomous so that only short-term capital account and those below it were
regarded as being accommodating. The balance in the long-term capital account plus the current account
balance constitute what is referred to as the Basic Balance. By this, the rest of the Capital A/C (viz: short-term
capital flows A/C and changes in foreign reserves A/C – plus, of course, statistical discrepancy) must be equal
and opposite to the Basic Balance.

Also, it is possible and plausible to regard both long-term and short-term capital flows as being autonomous so
that only the Financing account (particularly, Change in Foreign Reserves A/C) is treated as being
accommodating. The balances in the long-term and short-term capital A/Cs, when added to the current A/C
balance, is called Official Settlement balance (i. e., after also including the Statistical Discrepancy). Sometimes,
the Official Settlement balance is loosely referred to as the Overall BOP position. By design, the Official
Settlement balance must be equal and opposite to the balance in the Financing account (particularly, Change in
Foreign Reserves A/C), which is the only one now constituting the accommodating or below-the-line account.

The BOP for a hypothetical country is shown below, as an illustration.

5
3. EXCHANGE RATES
3.1 DEFINITION OF EXCHANGE RATE
An exchange rate is the number of units of a currency per unit of another currency. There are two ways of
expressing or defining the exchange rate of a currency. The first is the direct method, whereby it is defined as
the number of foreign currency per unit of domestic currency, i. e. price of domestic currency in terms of
foreign currency, implying that 1 unit of domestic currency will be in the denominator – e. g. US$ per N or
US$/N1; £ per N or £/N1; € per N or €/N1; ¥ per N or ¥/N1; etc. When defined in this direct manner, the higher
the rate over time, the greater the value of domestic currency in terms of foreign currency – implying that
domestic currency is appreciating or waxing stronger.

The second method of defining exchange rate is called the indirect method, whereby it is defined as the
reciprocal of the direct method, viz: the number of domestic currency per unit of foreign currency or the price
of foreign currency in terms of domestic currency, implying that 1 unit of foreign currency will be in the
denominator – e. g. N per US$ or N/US$1; N per £ or N/£1; N per € or N/€1; N per ¥ or N/¥1; etc. When defined
in this indirect manner, the higher the rate over time, the lower the value of domestic currency in terms of
foreign currency – meaning that domestic currency is depreciating or losing value.

There is a common fallacy among laymen that if the units of the currency of Country 1 that must exchange for 1
unit of currency of Country 2 is large, it means the economy of Country 2 is stronger! This is wrong. Hundreds of
¥ are needed to get just 1 unit of £ or even 1 Ghanaian Cedi and yet Japanese economy is stronger than that of
UK or Ghana. That about 1.5 US$ can be obtained with just £1 does not mean that UK economy is stronger than
the US economy. The currency with highest value in the world is probably that of Kuwaiti dinar (KD), with KD1 =
about US$3½ and yet Kuwait’s economy is not the strongest in the world. What is important for comparison
and for policy purpose is the movement of exchange rate over time and not the exchange rate at a point in
time. This movement over time is often expressed in index form, whereby a period is set as the base or
reference point with value set at 100%.

Direct and Indirect Quotes of Hypothetical Bilateral Naira and US Dollar Exchange Rates on Jan. 1, 2010 - 2014

Price of US$ in terms of N Price of N in terms of US$

(i. e. US$/N1) or Direct Method (i. e. N/US$1) or Indirect Method
Index Form (Jan. 1 Index Form (Jan. 1
Market Quote 2012 = 100) Market Quote 2012 = 100)

Jan. 1, 2010 0.00909 136.3 110 73.3

Jan. 1, 2011 0.00833 124.9 120 80.0
Jan. 1, 2012 0.00667 100.0 150 100.0
Jan. 1, 2013 0.00556 83.4 180 120.0
Jan. 1, 2014 0.00500 75.0 200 133.3

3.2 EXCHANGE RATE TYPOLOGY – NOMINAL, REAL, BILATERAL AND EFFECTIVE RATES

EXCHANGE RATE TYPES

Nominal Real

Bilateral Multilateral or Effective 6 Bilateral Multilateral or Effective

Bilateral exchange rate is the exchange rate between currencies of only two countries, viz: between the
domestic currency and that of another country. Effective or multilateral exchange rate, on the other hand, is
the exchange rate between the currency of a country and a number of currencies of the rest of the world, viz:
between the domestic currency and those of a number of countries. Effective exchange rate is based on the
weighted average bilateral exchange rates with these other countries, with the weights being the relative
magnitudes of the volumes of trade (exports + imports) with the countries concerned.

Whether bilateral or effective, the exchange rate can be nominal or real. While the nominal exchange rate does
not take cognizance of the differential in domestic and foreign price level movements, the real exchange rate
adjusts for this differential, as further explained below.

Bilateral nominal exchange rate: This can be in monetary terms (or market quotes) like US$/N1 or N/US$1, as
shown in the above Table or can be in index form, as also shown in the same Table. Movement in this rate over
time does not tell much as to whether the competitiveness of the domestic currency is improving or worsening.

Nominal effective (or multilateral) exchange rate: This cannot be in monetary terms like US$/N1 or N/US$1. It
must be in index form. To construct the nominal effective exchange rate vis-à-vis a number of (say, k) trading
partner countries over a period (say, p periods) , we start with bilateral exchange rate Si (I = 1, 2, … k) with each
of the k trading partners. We also compute the relative importance of each trading partner in each period t ( t =
1, 2, … p) thus: wit = Tit/Tt (where Tt is the total volume of trade between the country and its trading partners in
period t and Tit is the country’s trade volume with country I in the same period t) such that ∑6378 𝑤 3 = 1 ).
Finally, for each period t, we get the weighted average as ∑𝒌𝒊 𝒘iSi as the S or nominal effective exchange rate for
the period. For illustration, please refer to the working done in the class. In practice, the construction can be
further refined but the explanation here demonstrates the principle involved. Despite its relatively wide
geographical coverage, nominal effective exchange rate does not tell much about the competitiveness of the
economy because it is not in real terms.

Bilateral real exchange rate: This is the bilateral nominal exchange rate (in index form) that has been adjusted
for the movement in price differential between the country and the other country (or its trading partner). Let S
be the bilateral nominal exchange rate index, P; the domestic price level; and Pf, the foreign price level (i. e.,
price level in the trading partner country (with the same base period when S = P = Pf = 100), then the bilateral
real exchange rate (R) = S(Pf/Pd) if indirect quote is used in defining S (as units of domestic currency per 1 unit
of foreign currency) so that an upward movement in R denotes depreciation of domestic currency in real terms.
Otherwise, if the direct quote is used in defining S (as the number of units of foreign currency per 1 unit of
domestic currency), then, R = S(Pd/Pf) so that an upward movement in R denotes appreciation of domestic
currency in real terms. The bilateral real exchange rate is an indicator of the competitiveness of the economy
vis-à-vis only the single trading partner that is taken into account, but not in relation to other trading partners.

Multilateral or effective real exchange rate: This is the multilateral nominal exchange rate that has been
adjusted for the movement in price differential between the country and its trading partners. Starting from the
nominal effective exchange rate S, the corresponding real effective exchange rate (denoted by R) is constructed
in principle by first constructing the effective foreign price (Pf) as the weighted average price level (with a
common base period) of the trading partner countries, using the relative share of each trading partner in the
total trade (i. e. wit = Tit/Tt) as in the case of the nominal effective exchange rate discussed above, with Pfi
replacing Si thus: ∑𝒌𝒊 𝒘iPfi = Pf. Thereafter, the effective exchange rate is constructed as R = S(Pf/Pd) if indirect
quote is used in defining S so that an upward movement in R denotes depreciation of domestic currency in real
terms. Otherwise, if the direct quote is used in defining S, then, R = S(Pd/Pf) so that an upward movement in R
denotes appreciation of domestic currency in real terms. The effective real exchange rate is an indicator of the
competitiveness of the economy vis-à-vis the collectivity of the trading partners taken into account in
constructing it. In practice, some modifications are often made to what has just been described in the actual
construction of R, but the principle still remains the same. (Please refer to the Example worked in the Class).
7
 3.3 EXCHANGE RATE SYSTEMS: FIXED; FREELY FLOATING; AND MANAGED FLOATING SYSTEMS
3.3.1 Fixed Exchange Rate System
S (N/$1) S (N/$1)
D$ 1
S$ 0
D$ 0
D$ 0 S$ 1
S$ 0 X
C
S0 Y
A
h B
S0
S Z
D$ 1
AndS$0 S$ 0 D$ 0
D$ 0
S$ 1
Q$ Q$
Q$0 Q$1 Q$0
Q$1

Figure 1 - Fixed (or Pegged) Exchange Rate System: The Case of BOP Deficit Figure 2- Fixed Exchange Rate System: The Case of BOP Surplus

A country could peg the exchange rate of its currency to a commodity like gold (as it used to be the case before 1947) or to an anchor currency
like the US dollar (as it was the case for all IMF member countries before 1973 and as it is still the case for some countries presently – CFA Zone
West African countries pegged their common currency, CFA, to Euro).

Assuming Nigeria pegged its Naira to US$ at the exchange rate of number of Naira per US$ of S0.

As shown in Figure 1, suppose there is an increase in demand for US$ that shifts the $ demand curve from D$0D$0 to the right, viz: D$1D$1
(Factors that could cause such a shift in demand are discussed later). Had it been that the exchange rate is not pegged, the equilibrium would
have been at point C, corresponding to a depreciation (i. e., higher value) of S. But as the country is committed to S0 exchange rate, there will
be an excess demand for US$ amounting to AB or Q$1 minus Q$0 US$ (i. e., balance of payments deficit), which the central bank will have to
finance by reducing its previously accumulated foreign reserves (i. e, running an overall balance of payments deficit) in order to get the US$ to
sell. But, in the meantime, the authorities would be looking for ways of making the deficit to be short-lived through a combination of the
following measures:

(i) Expenditure switching policies like commercial policies (import tariffs, export subsidies, propaganda to dissuade people from patronizing
imported goods, reduction in domestic price level so as to reduce the real value of Naira (although this is difficult as prices are sticky
downwards), etc. Nominal exchange rate, an important expenditure switching policy measure, cannot be tampered with, by definition.

(ii) Expenditure reducing policy of contractionary monetary and fiscal policy – so as to reduce income and, hence, import demand.

(iii) Financing policy – attraction of foreign capital inflows and reduction of outflows by raising interest rate, canvassing for FDI and others and
by raising official loans (whether bilateral, multilateral or commercial).

But, if, despite all such measures, the BOP deficit still continues, the country would be said to have a BOP fundamental disequilibrium and will
then devalue its currency.

As shown in Figure 2, now suppose there is an increase in supply for US$ that shifts the $ supply curve from S$0S$0 to the right, viz: S$1S$1
(Factors that could cause such a shift in supply are discussed later). Had it been that the exchange rate is not pegged, the equilibrium would
have been at point C, corresponding to a depreciation (i. e., lower value) of S. But as the country is committed to S0 exchange rate, there will be
an excess supply of US$ amounting to XY or Q$1 minus Q$0 US$ (i. e., balance of payments surplus), which the central bank will have to use by
increasing its foreign reserves (i. e, running an overall balance of payments surplus) in order to get the US$ to buy. But, in the meantime, the
authorities, if they so choose, would be looking for ways of making the surplus to be short-lived through a combination of the measures that
constitute a reversal of those measures enunciated earlier in the case of BOP deficit: viz: expenditure switching policies away from exports to
imports; expenditure increasing policies; and financial policies of lowering interest rate, external loan repayment and external lending, etc. But,
as BOP surplus does not present much problem (even though too much of a good thing is bad), there is no urgency for the country to embark
on such measures, e. g. China, with its Yuan or Renminbi pegged to US$ (with the Yuan generally believed to be grossly undervalued at the
pegged rate) for some decades, has been accumulating BOP surplus up to US$ trillion and has not taken measures to reduce the surplus.
8
 3.3.2 Floating Exchange Rate System

S (N/$1) S (N/$1)
D$ 1
S$ 0
D$ 0
S$ 1
D$ 0
S$ 0 X
B
S1 S0

S1 Y
S0
S
A D$ 1
S$ 0 S$ 0 D$ 0
D$ 0 S$ 1
Q$ Q$
Q$ Q$1
0 Q$0 Q$1
Figure 3- Floating (or Flexible) Exchange Rate System: Figure 4- Floating (or Flexible) Exchange Rate System:
The Case of Depreciation of Domestic Currency The Case of Depreciation of Domestic Currency
A country can allow the value of its currency to float freely in accordance with the demand and supply factors of the
market system, although rarely have countries done so without some interventions one way or another.

Assuming Nigeria allows the value of its Naira to float freely vis-à-vis foreign currencies (represented by the US$). In
Figures 3 & 4, the exchange rate (Naira per US$1) is represented on the vertical axis and the quantum of US$ on the
horizontal axis, with the initial exchange rate being S0 in both diagrams.

As shown in Figure 3, suppose there is an increase in demand for US$ (due to any of the factors to be discussed later) that
shifts the $ demand curve from D$0D$0 to the right, viz: D$1D$1. As a result, the equilibrium moves from point A to point B,
corresponding to a higher value of S (i. e., S1, which is higher than the initial S0) and, hence, a lower value of Naira. Thus,
there is nothing like the BOP deficit to finance and, in fact, the country does not have to hold foreign reserves for
defending the value of the currency – depreciation in the value of the currency does all the trick!

As shown in Figure 4, also suppose there is an increase in supply of US$ (due to any of the factors to be discussed later)
that shifts the $ supply curve from S$0S$0 to the right, viz: S$1S$1. As a result, the equilibrium moves from point X to point Y,
corresponding to a lower value of S (i. e., S1, which is lower than the initial S0) and, hence, a higher value of Naira. Thus,
there is nothing like the BOP surplus to accumulate and, in fact, the country does not have to accumulate any foreign
reserves as defending the value of the currency is inapplicable.

3.3.3 Managed or Dirty Float System

There is no perfectly floating exchange rate system in real life. Authorities do intervene from time to time by
buying and selling foreign reserves in order to influence the nominal exchange rate of their currencies so as to
make them be in line with what they consider appropriate. But, unlike under the pegged system, there is no
commitment to a particular pre-announced exchange rate that each authority is bound to adhere to.

3.3.4 Concepts of Devaluation, Revaluation, Depreciation and Appreciation

Devaluation (a reduction in the value of a currency) and revaluation (an increase in the value of a currency) is
used under a fixed exchange rate system and it is normally a discrete thing that is due to official action.
Depreciation (a reduction in the value of a currency) and appreciation (an increase in the value of a currency) is
used under a floating exchange rate system and it is normally a continuous thing that is due to the operation of
market forces.
9
3.4 MODELS OF NOMINAL EXCHANGE RATE DETERMINATION: DEMAND & SUPPLY APPROACH AND THE
PURCHASING POWER PARITY (PPP) MODEL

3.4.1 Demand and Supply Model of Exchange Rate Determination

One traditional model of nominal exchange rate determination is based on the conventional demand and supply
tools, now applied to the foreign exchange. While this model has a number of weaknesses and has since been
replaced by many models, particularly variants of asset-market models (including monetary approach), that have
been recently put forward, its simplicity still endears it as a useful and introductory one for understanding many
forces at work in the determination of exchange rate. According to this model, demand for foreign exchange is a
derived demand (i. e. not for its own intrinsic value but for making payments for things like import demands) and
supply of foreign exchange too is derived from receipts from exports and other sources.

Supply of Foreign Exchange: As shown in the Table below, the higher the exchange rate (units of domestic currency
per 1 unit of foreign currency, e. g. N/US$1), the lower the value of the domestic currency (Naira) and the higher the
price (in domestic currency) of export (at an unchanging price in foreign currency, as shown in Col. 1 of the Table
where the world price still remains at $2 per Kg) confronting domestic producers or exporters (See Col. 3 of the
Table). Due to the positive relationship between the price (in domestic currency) and the quantity supplied, the total
export receipt of foreign exchange therefore increases (in the Table, from US$800 million to US$1,600 million) as the
domestic currency depreciates (in the Table, from N120 per US1 to N200 per US$1). On a graph with exchange rate
on the vertical axis and foreign exchange on the horizontal axis (not shown, for brevity), this will depict a positively
sloped supply curve for foreign exchange.

Within this framework, factors that could cause an increase in foreign exchange supply, and thereby shift the supply
curve to the right, include the following:

- A fall in domestic price level or a rise in foreign price level, each of which leads to a depreciation of domestic
currency in real terms - viz: R = S(Pf/Pd) will rise, thereby improving the trade (export) competitiveness of the
country.
- A rise in foreign income Yw and/or an improvement of foreign taste and preferences for the domestic export
items which would boost demand for domestic export.
- Adverse supply shocks (e. g., wars or political upheavals, bad weather, etc) in those countries that compete
with the country in international markets – e. g. geopolitical shocks in the mid-east that affect their supply of
crude oil to the US market, paving way for Nigerian crude to capture the market there.
- Increased attraction of tourists to the country, coming to spend their foreign exchange in the country.
- Increased inflow of private unrequited transfers (particularly, foreign remittances) and official unrequited
transfers (whether bilateral or multilateral).
- A rise in domestic interest rate or a fall in foreign interest rate that will increase capital inflow from abroad.
- Increased borrowing from abroad by the private sector or by the government (from multilateral, bilateral,
and commercial sources).
Hypothetical Naira/US Dollar Exchange Rate and the Resulting Supply Schedule for US$

Col. 1 Col. 2 Col. 3 Col. 4 Col. 5

Price in Exchange Quantity (in million Kg) Amount (in US$ million)
US$ Rate Price in N per Kg supplied Received by Nigerian Exporters (i.
per Kg (N/US$1) facing Nigerian exporters by Nigerian Cocoa producers e., amount of US$ supplied)

2 120 240 400 800

2 150 300 500 1,000
2 180 360 650 1,300
2 200 400 800 1,600

10
Demand for Foreign Exchange: As shown in the Table below, the higher the exchange rate (units of domestic
currency per 1 unit of foreign currency, e. g. N/US$1), the lower the value of the domestic currency (Naira) and
the higher the price (in domestic currency) of import (at an unchanging price in foreign currency, as shown in
Col. 1 of the Table where the world price still remains at $10 per telephone handset) confronting domestic
buyers or importers (See Col. 3 of the Table). Due to the inverse relationship between the price (in domestic
currency) and the quantity demanded, the total import payments of foreign exchange therefore decreases (in
the Table, from US$1,200 million to US$7500 million) as the domestic currency depreciates (in the Table, from
N120 per US1 to N200 per US$1). On a graph with exchange rate on the vertical axis and foreign exchange on
the horizontal axis (not shown, for brevity), this will depict a negatively sloped demand curve for foreign
exchange.

Within this framework, factors that could cause an increase in foreign exchange demand, and thereby shift the
demand curve to the right, include the following:

- A rise in domestic price level or a fall in foreign price level, each of which leads to an appreciation of
domestic currency in real terms - viz: R = S(Pf/Pd) will fall - thereby worsening the trade (import)
competitiveness of the country.
- A rise in domestic income, thereby increasing import demand.
- A domestic shift in taste and preferences for foreign commodities, away from the domestically
produced ones.
- Decreased availability of substitutes for imports, compelling buyers to patronize imports more.
- Increased outflow of private unrequited transfers and official unrequited transfers.
- A reduction in domestic interest rate and/or increase in foreign interest rate, thereby increasing capital
outflows.
- Increased lending abroad and repayments of maturing foreign debts by the private sector or by the
government .

Hypothetical Naira/US Dollar Exchange Rate and the Resulting Demand Schedule for US$

Col. 1 Col. 2 Col. 3 Col. 4 Col. 5

Price in
US$
per Exchange Price in N per phone Quantity (in million phones) Amount (in US$ million)
Android Rate facing Nigerian demanded paid by Nigerian Importers (i. e.,
Phone (N/US$1) importers by Nigerian importers amount of US$ demanded)

10 120 1200 120 1200

10 150 1500 100 1000
10 180 1800 85 850
10 200 2000 75 750

Combining the supply schedule and the demand schedule in the above two Tables (not shown for brevity)
shows that the equilibrium exchange rate is N150/US$1, with the quantity of foreign exchange traded being
US$1,000 million.

11
3.4.2 Purchasing Power Parity (PPP) Model of Exchange Rate Determination
There are two versions of PPP – the Absolute PPP and the Relative PPP. The absolute PPP is a restatement of
the Law of One Price, which states that, barring transport costs and other barriers to trade, the price of a
commodity, when expressed in a single currency, should be the same everywhere – whether in the country or
abroad. For example, if the price of a loaf of bread (denoted by Pd) is N500 in Nigeria and an identical loaf of
bread sells for US$2.5 (denoted by Pf) in the US, then the implied exchange rate S (N/US$1) must be equal to
Pd/Pf, i. e. 500/2.5 = 200. If the exchange rate were to differ from N200 to US$1, say, N150/US$1, Naira would
be overvalued and it would pay arbitrageurs to buy $ in Nigeria for just N150 and use it to import bread from
the US and sell in Nigeria. For every N375 used in buying US$2.5 at the exchange rate of N150/US$1 (since 2.5 x
150 = 375), the arbitrageur would buy 1 loaf of bread in the US and re-sell it in Nigeria for N500, making a profit
of N125 per loaf of bread. This process would continue, with the increasing demand for US$ putting pressure on
Naira value to fall and/or US$ value to rise (i. e., leading to a rise in S) until the S rises from N150/US$1
eventually to the N200/US$1 that the Law of One price predicts. The reverse process would take place if Naira
is undervalued below what the Law of One Price predicts, e. g. N250/US$1.

Moving from the Law of One Price to the absolute PPP, the absolute PPP applies to a bundle of commodities
and not necessarily one commodity item (loaf of bread in the above example). It states that, barring
transportation costs and other barriers to trade, a basket of commodities should command the same price at
home and abroad if the price is expressed in a common currency. Letting the domestic price of the basket of
commodities be Pd in domestic currency and foreign price of an identical basket be Pf in foreign currency (US$),
then according to absolute PPP, the domestic price, when restated in US$, which would be Pd/S (where S=
N/US$1) and this has to be equal to the foreign price Pf (which is already expressed in US$). That is, absolute
PPP predicts that Pd/S = Pf. Rearranging this to make S the subject of the formula, we have S = Pd/Pf. In other
words, it is the Pd and Pf that determine the S. If, starting from a position of equality, Pd rises while Pf remains
the same, then S has to rise (i. e., domestic currency must depreciate) and, if Pf rises when the Pd remains
unchanged, then, S has to fall (i. e. domestic currency must appreciate). Multiplying both sides of the equality
by Pf/Pd, we have S(Pf/Pd) = 1, where S(Pf/Pd) is our definition of R, i. e. real exchange rate. Thus, PPP is implying
that R = 1 or 100%. If R > 1, domestic currency is undervalued in real terms and the ensuing increase in
competitiveness will lead to increase in exports and fall in imports that would both serve to reduce R back to 1.
The reverse would hold if R < 1 (a situation of overvaluation of domestic currency).

Moving from the absolute PPP to the relative PPP, the relative PPP applies to change in S, Pd and Pf. Simply put,
relative PPP states that the rate of depreciation of a currency (i.e., ∆S/S) should equal the differential in
domestic and foreign inflation rates (i. e., ∆Pd/Pd minus ∆Pf/Pf). While the absolute PPP relies on very strong
assumptions concerning absence of transportation costs and other barriers to trade, the relative version does
not necessarily rely on such assumptions in as much as those costs and barriers do not change over time. If the
absolute PPP holds, the relative PPP too must hold but that the relative PPP holds does not necessarily mean
that the absolute PPP must hold.

r
12
3.5 POLICY DILEMMA: INTERNAL AND EXTERNAL BALANCES
3.5.1 Derivation of the Balance of Payments (BP) Curve
Our discussion so far has highlighted the fact that the overall balance of payments must balance, i. e. the sum
of the current account (CA) balance and capital (K) account balance must equal zero, which is another way of
stating that the capital account balance is equal and opposite to the CA balance. Thus:

BP = CA + K = 0 ….. (20)
Combining our earlier export function in equation (6) and import function in equation 7, we have the following
CA function:

CA = X- M = F(Y, R, Yw) = (x0-m0) + (x1 + m2)R – m1Y …….. (21)

Also, capital account balance (K) is often posited to depend positively on the domestic interest rate r and
negatively on foreign interest rate rw thus:
K = k0 + k1(r – rw) …………………. (22)
Substituting (21) and (22) into (20) gives:
(x0-m0) + (x1 + m2)R – m1Y + k0 + k1(r – rw) = 0 …….. (23)
Making r the subject of the formula gives:
r = [(m0 – x0 – k0) +m1Y – (x1 +m2)R – x2Yw + k1rw]/k1 …….. (24)
∂r/∂Y = m1/k1 ≥ 0 ……… (25)
Equation (25) indicates that the higher the income Y the higher also would be the interest rate for the BOP (or
the external sector) to be in equilibrium (or to balance). This means that the BP line should have a positive
slope (see Figure 5 below), just like the LM curve. The economic explanation of this is that, starting from an
initial position of overall BOP balance, the effect of an increase in Y, by increasing imports and thereby
worsening the CA position, must be neutralized or counterbalanced by the opposite effect of an increase in
domestic interest rate that, by attracting capital inflows, will improve the capital account balance that would
offset the worsening current account balance. Also, we have:
∂r/∂R, ∂r/∂Yw, ∂r/∂x0, ∂r/∂k0, ≥ 0 and ∂r/∂rw, ∂r/∂m0 ≤ 0 ….. (26)
This shows that increases in R (i. e., depreciation of domestic currency in real terms), the rest of the world
income Yw, autonomous export x0, and autonomous capital inflows k0 will shift the BP curve to the right (See
Figure 6) while an increase in the rest of the world interest rate rw and autonomous imports m0 will shift the BP
curve to the left.

The more sensitive capital flows are to interest rate, the flatter the BP line becomes. There is an extreme case
of perfect capital inflow, which happens when r = rw (See Figure 6).

Points that are not on the BP line represents disequilibrium positions whereby the overall BOP differs from
zero. To the left of a BP line is BOP surplus as, for a given interest rate, income is not high enough to reduce the
CA balance to what it should have been for the overall BOP to be zero. It can also be said that, for a given
income level, interest rate is too high that the resulting capital account balance is too much to neutralize the
current account balance and thereby produce zero overall BOP position. Similarly, to the right of the BP line is a
BOP deficit.

13
 r BP0
r BP0
BP1
BP1
BP
BOP Surplus
BP2

BOP Deficit

Y Y
Figure 5: To the left of the BP Figure 6: Depreciation of domestic
line is surplus while the right currency; autonomous increase in
of the line represents a deficit. exports, autonomous reduction in
imports; and autonomous capital
inflows shift the BP line to the right
from BP0 to BP1.
Y
Figure 7: The more sensitive capital
flows are to interest rate changes,
the flatter the BP line becomes. In
the extreme case of perfect capital
mobility, the BP line becomes a
horizontal line, BP2.

3.5.2 Concepts of External and Internal Balances

External balance occurs when the economy is on the BP curve, i. e. when the BOP is in equilibrium, with the
BOP balance being zero.

On the other hand, internal balance happens when the economy is just at full employment, producing full
employment output – not less and not more than full employment output. Beyond the full employment output
signifies inflation (as the economy is being overheated) and below full employment output connotes a
recession. Graphically, an economy is having internal balance if the intersection of the IS curve and LM curve is
at the point corresponding to full employment output Yf (point A in figure 9). But the economy depicted in this
Figure 9 is not having external balance – it is having a deficit in the BOP because point A is below the BP line.

If the intersection of IS and LM curve is on the BP curve (as in Figure 8, point A), the economy is having external
balance. But, as Illustrated in that same Figure 8, this does not mean that the economy is having internal
balance as point A corresponds to income level Y* that is below the full employment income Yf, implying that
the economy is in recession.

3.5.3 Policy Instruments for Simultaneous Achievement of External and Internal Balances
Generally, in the context of macroeconomic policy, the idea has been put forward by Jan Tinbergen that policy
makers need, at least, as many policy instruments as the number of goals to be attained. Here, the number of
goals is two, viz: internal balance and external balance. There is also the assignment problem to address,
whereby each goal will be assigned policy instruments on the basis of comparative advantage of each
instrument in achieving each goal.

So, there is the need for not less than two policy instruments. Depending on the exchange rate system
(whether fixed or flexible), these two policy instruments would be selected from monetary policy, fiscal policy
and exchange rate policy. Also, assignment problem will be considered in pairing each instrument with each
goal. How we accomplish this is discussed below each diagram later. To simplify our analysis, it is assumed that
domestic price Pd and foreign price Pf are fixed so that, among others, a given nominal exchange rate variation
translates to the same amount of real exchange rate variation. Also, we assume that foreign exchange inflows
and outflows are not sterilized, so that they translate fully into increase and decrease in domestic money.
14
 IS
r BP
A LM
r*
Y Y
Y*
Yf
Figure 8: Because point A is on both the LM and IS curves, it
represents domestic equilibrium in both the money and
commodity markets. Also, because it is on the BP line, there is
equilibrium in the external sector. But, as the equilibrium income
Y* is below the full employment output Yf, there is internal
imbalance (unemployment or recession).
3.5.4 Use of Fiscal and Monetary Policies in Achieving Internal and External Balances under Fixed Exchange Rate
BP0
r IS0
LM0
A r2
a
r0
LM1
r0
r1 B
Y Y
Y0 f Y0
Y = Y1
Figure 10 - Demonstration of Ineffectiveness of Monetary Policy
in Influencing Output under a Fixed Exchange Rate Regime:
Monetary expansion initially shifts the LM to the right from LM0
to LM1, moving the economy from point A to point B where the
LM1 intersects the unchanging IS0, tending to raise output from
Y0 to the full employment output Yf (= Y1). But, as point B is
below the BP line, it represents a point of balance of payments
deficit – the reasons being the lower interest rate r1 (which is
below r0) that reduces net capital inflow and higher output Y1
(vis-à-vis Y0) that worsens the current account balance. Thus, the
monetary authority has to finance the deficit by selling foreign
exchange and thereby reducing money supply (as the foreign
exchange outflow is assumed not to be sterilized). The reduction
in money supply will continue to shift the LM1 back to the left
15
and the process will stop only if the LM1 curve shifts back to the
original LM0, forcing the output back to the original Y0.
IS BP
r LM
A
r*
Y* = Yf
Figure 9: Because point A is on the LM and IS curves,
it represents domestic equilibrium and because the
equilibrium income Y* equals the full employment
income Yf, it is also a point of internal balance. But,
as the point is below the BP line, there is imbalance
(viz: deficit) in the balance of payments.
IS1 BP0
r IS0
C
LM1
A LM0
B
Yf = Y2 Y1
Figure 11 - Demonstration of Effectiveness of Fiscal Policy in
Influencing Output under a Fixed Exchange Rate Regime:
Fiscal expansion shifts the IS to the right from IS0 to IS1,
which intersects the original LM (i. e., LM0) at point B,
raising output from Y0 to Y1, which is higher than the full
employment output level Yf. But, as point B is below the BP
line, it is a situation of balance of payments deficit –
because, although interest rate is higher than the original r0
(thereby inducting more net capital inflow), the adverse
effect of the much higher output level on current account
balance is higher, thereby resulting in an overall deficit. As
the central bank is financing the deficit by selling foreign
exchange and thereby reducing the money supply (because
non-sterilisation is assumed), the LM curve shifts leftward
from LM0 to LM1, which now intersects the IS1 and the BP0
lines at the common point C, corresponding to a higher
interest rate r2 and full employment output level Y2 (= Yf).
3.5.5 Use of Fiscal and Monetary Policies in Achieving Internal and Ext. Balances under Floating Exchange Rate

BP0
IS1
BP1 IS1
IS0 IS2
IS0 BP0
r r
LM0
A BP1

r0 LM1 r2 LM0
C
r2 r0
C
A

Y Y
Y0 Y1 Yf = Y2
Figure 12 – Demonstration of Effectiveness of Monetary
Policy in Influencing Output Level under a Floating
Exchange Rate System: Monetary expansion shifts the LM
from LM0 to LM1, which intersects the original IS curve (i.
e., IS0) at a point (for brevity, not indicated on the diagram)
which corresponds to a lower interest rate (thereby
reducing net capital inflow) and a higher output level Y1
(thereby worsening the current account balance) so that,
on the whole, it is to the right of the original BP (i. e., BP0)
line, implying it is a balance of payments deficit situation.
This deficit will lead to a depreciation of domestic currency
which, in turn, will increase exports and reduce imports –
thereby shifting the IS curve from IS0 rightwards to IS1 and
the BP line from BP0 rightwards to BP1, both of which
intersect the LM1 curve at a common point C –
corresponding to full employment output Yf (= Y2) and a
lower interest rate r2.
Y0 Y1 f
Y = Y2
Figure 13– Demonstration of Effectiveness of Fiscal
Policy in Influencing Output Level under a Floating
Exchange Rate System: Fiscal expansion shifts the IS
curve rightwards from IS0 to IS1, which intersects the
unchanging LM curve (i. e., LM0) at a point (for brevity,
not indicated on the diagram) which corresponds to a
slightly higher interest rate (thereby increasing net
capital inflow somewhat) and a higher output level Y1
(thereby worsening the current account balance) so
that, on the whole, the worsening of the current
account outweighs the improvement in capital account
situation and the point is therefore to the right of the
original BP (i. e., right of the BP0) line, implying it is a
balance of payments deficit situation. This deficit will
lead to a depreciation of domestic currency which, in
turn, will increase exports and reduce imports – thereby
shifting the IS curve further still from IS1 rightwards to
IS2 and the BP line from BP0 rightwards to BP1, both of
which intersect the LM1 curve at a common point C –
corresponding to full employment output Yf (= Y2) and a
higher interest rate r2.

16
 3.5.6 Use of Fiscal and Monetary Policies in Achieving Internal and Ext. Balances under Fixed Exchange Rate
with Perfect Capital Mobility
r LM0
IS0
LM1
A C
r = rw
BP
Y
Y0 f
Y = Y1
Figure 14 - Demonstration of Ineffectiveness of
Monetary Policy in Influencing Output under a Fixed
Exchange Rate Regime with Perfect Capital Mobility:
Monetary expansion initially shifts the LM to the right
from LM0 to LM1, moving the economy from point A
to point B where the LM1 intersects the unchanging
IS0, tending to raise output from Y0 to the full
employment output Yf (= Y1). But, as point B is below
the BP line (at which the domestic interest rate r
equals the world interest rate rw), it represents a point
of balance of payments deficit – the reason being
that, apart from the higher output remaining at r = rw.
level that will worsen the current account position,
any tendency for r to fall below rw will cause an
infinite amount of capital outflow, necessitating the
central bank to massively run down its foreign reserve
holding in financing the resulting deficit and, in doing
so, correspondingly reduce the money supply (as
there is assumed to be no sterilization). The ensuing
reduction in money supply will continue to shift the
LM curve leftward and the process will continue until
it shifts back to the original LM0, thereby bringing the
economy back to the original situation, with output
level returning to Y0 and interest rate back to the
original r = rw.
17
IS1
r IS0 LM0
B
LM1
A
r = rw BP
Y
Y0 Y1 Yf = Y2
Figure 15- Demonstration of Effectiveness of
Fiscal Policy in Influencing Output under a Fixed
Exchange Rate Regime with Perfect Capital
Mobility: Fiscal expansion shifts the IS to the right
from IS0 to IS1, which intersects the original LM (i.
e., LM0) at point B, raising output from Y0 to Y1. As
point B is above the BP line, it is a situation of
huge balance of payments surplus. This is
because, although output level Y1 is higher than
Y0 so that the current account position is worse,
domestic interest rate r exceeds the world
interest rate rw, leading to virtually unlimited
capital inflows and an overall balance of
payments surplus. This huge surplus will, in turn,
lead to foreign reserves accumulation and, hence,
increase in money supply (since there is no
sterilization). It is this increase in money supply
that leads to a rightward shift of LM curve from
LM0 to LM1, which intersects the IS1 curve and BP
line at point C, which corresponds to a higher
output level Y2 (= Yf).
 3.5.6 Use of Fiscal and Monetary Policies in Achieving Internal and Ext. Balances under Flexible Exchange Rate
with Perfect Capital Mobility

IS1 IS1
LM0 r IS0 LM0
r B
IS0
LM1
C A
A
r = rw BP r = rw BP

Y Y
Y0 Y1 Yf = Y2 Y0 Y1

Figure 16 Figure 12 – Demonstration of Figure 17- Demonstration of Ineffectiveness of Fiscal Policy

Effectiveness of Monetary Policy in Influencing
Output Level under a Floating Exchange Rate
System with Perfect Capital Mobility: Monetary
expansion shifts the LM from LM0 to LM1, which
intersects the original IS curve (i. e., IS0) at point B,
which corresponds to a higher output level Y1
(thereby worsening the current account balance)
and a lower interest rate that is now below the
world interest rate rw so that so that there would
be a massive capital outflows and, hence, a huge
balance of payments deficit and a consequential
depreciation of domestic currency. The
depreciating domestic currency would, in turn,
increase exports and reduce imports, serving to
shift the IS curve to the right from IS0 to IS1 – which
intersects the LM1 curve and the BP line at point C,
corresponding to the higher and full employment
output Yf (= Y2).
in Influencing Output under a Floating Exchange Rate
Regime with Perfect Capital Mobility: Government
expenditure expansion shifts the IS curve to the right from
IS0 to IS1, which intersects the LM curve (i. e., LM0) at point
B, raising output from Y0 to Y1. As point B is above the BP
line, it is a situation of huge balance of payments surplus.
This is because, although output level Y1 is higher than Y0
so that the current account position is worse, domestic
interest rate r exceeds the world interest rate rw, leading
to virtually unlimited capital inflows and an overall
balance of payments surplus. This huge surplus will, in
turn, lead to an appreciation of domestic currency which
will reduce exports and increase imports, thereby shifting
the IS curve back or leftward from the interim IS1, with the
process continuing until the IS gets back to the original IS0,
leaving the output unchanged at Y0. Thus, the increase in
government spending will fully crowd out net exports
(exports minus imports), instead of crowding out private
investment as we have when interest elasticity of money
demand is zero. This result of ineffectiveness of
government spending equally applies to increase in any
other exogenous spending, whether exports, autonomous
investment, autonomous consumption, etc.

18
6. DERIVATION OF AGGREGATE SUPPLY RELATIONSHIP
6.1 Wage Setting Relationship
Aggregate supply relationship is based on interaction between wage setting relationship (which is equivalent to
labour supply relation in microeconomics) and price setting relationship (which is equivalent to labour demand
relation in microeconomics). It is the interactions between the two relationships that yields the aggregate
supply function whereby price level is expressed as a function of aggregate output. We first describe wage
setting relationship here. Next, we describe the price setting relationship before we finally discuss the
interaction between the two relationships.

An equation for wage determination can be stated thus:

W = PeF(u, z) = Pe(1-βu + z) ……. (27)
where W = nominal wage rate; Pe = expected price level; u = percentage unemployment (proportion of labour
force L that is unemployed), β = coefficient indicating the strength of unemployment rate in W determination;
and z = a combination of several other factors (that are not of much interest here) which can determine W.

Role of Pe: The higher the expected price level, the higher the W that wage setters (whether firms or a
combination of firms and workers through collective bargaining process) would set. This is because workers
care about what the wages could buy in real terms and employers too feel at ease to grant higher wages,
knowing they would be able to sell their goods at the anticipated higher prices. Thus, Pe has a one-for-one
positive effect on W.
Role of u: The higher the unemployment rate, the lower the W. This is because, during high unemployment
period, workers’ bargaining strength is weak and employers would be able to call a bluff of any demand for
higher pay or any resistant to wage cut, as there are many unemployed one waiting to replace the existing
workers. This is why the coefficient of u, i. e. β, has a negative sign.
Role of z: This is a catch all variable for several other factors that can affect W, but which are not of much
interest in the present discussion.

6.2 Re-statement of Wage Setting Relationship in Terms of Output, instead of Unemployment Rate
The above wage setting relationship in equation (27) is in terms of unemployment rate u. We now want to
express W, not directly in terms of u but directly in terms of aggregate output Y. This is done by substituting the
relationship between u and Y in equation (27) to get rid of u there. To do this, we start with a specification of an
aggregate production function thus:
Y = αN …… (28)
where Y = aggregate output; N = number or quantity of workers engaged; and α = coefficient that indicate
productivity of workers or units of output produced by a unit of labour (= Y/N).
This production function assumes only labour as the factor of production. This is okay for the present purpose
as inclusion of other factors of production would complicate the analysis.

At this stage, the relationship between the unemployment rate u and Y should be clarified. First, u is the ratio
of unemployed people (denoted by U) to the total labour force (whether employed or unemeployed). That is,
the total labour force (denoted by L) is the sum of those in employment (N) and those that are unemployed
(denoted by U), viz: L = N + U or U = L – N. Utilising this relationship, we have:

𝑼 𝑳=𝑵 𝑵 𝒀
u= = =1- =1- ……. (29)
𝑳 𝑳 𝑳 𝜶𝑳

𝒀
Substituting u = 1 - in equation (29) into equation (27) to get rid of u, we have:
𝜶𝑳
𝒀 𝛃𝒀
W = PeF(u, z) = Pe[1 - β(1 - ) + z] = Pe(1 - β + + z) ……. (30)
𝜶𝑳 𝜶𝑳

19
The positive relationship between W and Y is evident from equation (30). The economic explanation of this
relationship is that, an increase in output being produced, by increase employment N, will reduce
unemployment rate u and thereby strengthen the bargaining power of workers, leading to increase in W.

6.3 Price Setting Relationship

The prices firms set are link to their production costs. Given the production function in equation (28), each unit
of labour produces α units of output (since α is the average product of labour) so that the labour cost of each
𝑾
unit of output would be 𝜶 . There would also be a markup over labour cost of, say, θ per unit of output to take
care of cost of other factors of production employed by the firms, e. g. cost of capital, raw materials, and an
allowance for the firms’ normal profit (and, if competition is not perfect, an allowance for monopoly profit also,
depending on the market power wielded by the firms). So, with this markup on labour cost, the price set by the
firms can be described by an equation thus:
(𝟏C 𝜽)𝑾
P= ………. (31)
𝜶

6.4 Combination of Wage Setting Relationship and Price Setting Relationship

Final Aggregate Supply Relationship: Substituting the wage setting relationship in equation (30) into price
setting relationship in equation (31) in order to get rid of W in equation (31) gives:
𝛃𝒀 𝛃𝒀
(𝟏C 𝜽)𝐏𝐞(𝟏 − 𝛃 C + 𝐳) 𝑷𝒆(𝟏C 𝜽)(𝟏 − 𝛃 C 𝜶𝑳 + 𝐳)
P= =
𝜶𝑳
….. (32)
𝜶 𝜶
Equation (32) is the final aggregate supply relationship. It expresses the price level P as a positive function of
aggregate output Y as ∂P/∂Y = Pe(1 + θ)β/αL ≥ 0.

Some Salient Properties of Aggregate Supply Relationship: The following properties of the aggregate supply
function should be noted:

First, an increase in Y leads ultimately to an increase in P through the following stages:

Increase in Y increase in employment N decrease in unemployment U and, hence, in
unemployment rate u increase in W (due to enhanced bargaining power) increase in prices due to
increase in wage cost of production increase in price level P.

Second, an increase in expected price level Pe increases actual price level P on a one-for-one basis through the
following stages:
Increase in Pe increase in W that wage setters (whether firms only or jointly by both firms and unions)
set increase in prices due to increase in wage cost of production increase in price level P.

Third, an increase in markup (1 + θ) on wages W leads to an increase in P through the following stages:
Increase in (1 + θ) increase in prices due to increase in markup cost of production increase in
price level P. An increase in workers’ productivity α reduces P through a symmetrical channel.

Aggregate supply graphs illustrating the above properties are as shown in Figure 18 and Figure 19 below.

P
AS0 Figure 18: Shifting of AS curve: Factors that can cause AS
curve to shift from AS0 rightward to AS1 are those factors
AS1 that increase aggregate supply at a given price level and
they include a fall in expected price level Pe; a fall in
markup on wages (1 + θ); and an increase in workers’
productivity, α. Conversely, a rise in Pe, a rise in (1 + θ);
and a fall in α will shift AS from AS1 to AS0.
Y
20
 Further Salient Properties of Aggregate Supply Relationship - Natural Rate of Unemployment and
Corresponding Natural Output Level: There is what is called the natural rate of unemployment (to be denoted
henceforth by un) and it refers to what is conventionally called frictional unemployment. The natural level of
unemployment (Un) is the number of workers that are out of jobs due to one friction or the other in the
economy, e. g. they have just being laid off and are in transit, about to get other jobs, or that they need to be-
retrained to fit into other jobs, etc. It is the level of unemployment at which the inflow into the pool of
unemployed balance the outflows. The natural rate of unemployment (un) , therefore, is the natural level of
unemployment as a ratio of the total workforce L, i. e. un = Un/L. Corresponding to this un is also the natural
level of output Yn, which is the output level produced by those employed, viz: total labour force L minus natural
level of unemployment Un or L – Un. The higher the Un (and, hence, un), the lower therefore is Yn.

The un (and, hence, Yn) can also be characterized or defined as the rate of unemployment (and, hence, output
level) that occurs when P = Pe. Accordingly, the Yn has the definitional property that an AS curve passes through
it when P = Pe. In other words, Y = Yn only when P = Pe. When Y is higher than the Yn (say, at Y = Y* in Figure 19),
P too would be higher than the Pe. Conversely, when Y is lower than Yn, P would be lower than Pe. This
conclusion can be inferred from Figure 19, where a line projected vertically from any point to the right of Yn
(say, Y*) will intersect AS0 at a point where the corresponding P (on the vertical axis) would be above the Pe,
with the converse holding true for a line projected vertically from any point to the left of Yn.

While P and Pe can differ in the short run, the tendency is for them to be equalized in the long-run as people
revise their expectations. If P > Pe (as would be the case if the economy produces at Y* in Figure 19), the
tendency is for people to revise Pe upwards, thereby shift the AS to the right from AS0 to AS1 in the diagram.
This will continue until P = Pe. As Pe is being continually revised upward (until it equals P), the resulting ever-
shifting AS curve (to the left) passes through the Y = Yn point (at which, by definition, the new values of P equal
the ever-increasing Pe). Conversely, if initially P < Pe, people would revise their Pe downwards, thereby
continually shifting the AS rightward until P = Pe. The locus of points from the Y = Yn on horizontal axis upward
therefore define a long-run AS (denoted on the diagram by LAS).

P
LAS

AS1 Figure 19: Passing of AS curve through Yn when P = Pe:

All short-run AS curves pass through the vertical line
B AS0 projected from Y = Yn, on which P always equal Pe. This
P = Pe1
vertical line, labelled LAS, constitutes the long-run AS
curve.

P = Pe
A
Y
Yn Y*

21
 7. COMBINATION OF AGGREGATE DEMAND AND AGGREGATE SUPPLY RELATIONSHIPS
7.1 Equilibrium in the Short-run
Bringing together our aggregate demand equation (19a) and the above aggregate supply equation (32) and
solving the two equations should, in principle, yield the general equilibrium output Y and price level P, with
simultaneous equilibrium in the money market (because it would satisfy the LM relationship); commodity
market (because it would satisfy the IS relationship); and labour market (because it would satisfy the labour
market relationship in equation 32 above). We can also bring together the relationships graphically, with the
aggregate demand curve and aggregate supply curves being shown on the same graph, as in Figure 20 and
Figure 21 below.

P P

AS’
AS

A
Pe
P
P
Pe
B C D
AD

AD’
Y Y
Yn Y* Y** Yn

Figure 20: Occurrence of Short-run General
Equilibrium at an Output Level Y that is above the
Natural Output level Yn. As the equilibrium output
Y* is above the natural rate output Yn, P too is
above Pe. This can only happen in the short-run.
Figure 21: Occurrence of Short-run General
Equilibrium at an Output Level Y that is below the
Natural Output level Yn. As the equilibrium output
Y** is below the natural rate output Yn, P too is
below Pe. This can only happen in the short-run.

7.2 Equilibrium in the Long-run

The process of moving from short-run equilibrium to the long-run equilibrium is as shown in Figures 22 and 23
below, with the narrations underneath them describing the process in words. Thereafter, we adopt the analysis
to the situation of analyzing the effectiveness of monetary and fiscal policy both in the short-run and in the
long-run.

22
 P LAS P LAS
AS1
AS’0
AS0
AS’1
A
Pe
P
P
Pe
B C D
AD

AD’
Y Y
Yn Y* Y** Yn

Figure 22: Occurrence of Short-run General
Equilibrium at an Output Level Y that is above the
Natural Output level Yn. As the equilibrium output
Y* is higher than the natural rate output Yn, P too is
above Pe. This can only happen in the short-run. As
time passes, wage setters would revise their Pe
upwards and increase wages W accordingly,
thereby increasing wage cost of production. This
would compel them to raise prices and, hence, the
price level – thereby shifting the AS curve to the left
(from AS0 to AS1) and, with it , the point of its
intersection with the AD curve (as indicated by the
arrows). The process will continue until Y* shifts
leftward enough to be same with the Yn. The
economy would move along the AD curve until Y*
falls to Yn.
Figure 23: Occurrence of Short-run General
Equilibrium at an Output Level Y that is below the
Natural Output level Yn. As the equilibrium output
Y** is lower than the natural rate output Yn, P too is
below Pe. This can only happen in the short-run. As
time passes, wage setters would revise their Pe
downwards and decrease wages W accordingly,
thereby reducing wage cost of production. This
would make them to reduce prices and, hence, the
price level – thereby shifting the AS curve to the
right (from AS’0 to AS’1) and, with it , the point of its
intersection with the AD curve (as indicated by the
arrows). The process will continue until Y** shifts
rightward enough to be same with the Yn. The
economy would move along the AD curve until Y**
falls to Yn.

7.3 Effects of Monetary Policy

In Figure 24 below, we show the short-run effect of monetary policy, which is able to influence output level in
the short-term. But, in the long-run, there is what is called monetary neutrality, which means monetary policy if
ineffective in influencing interest rate and real variables like output and unemployment – it would only lead to
a proportionate change in price level. The question then is: Is monetary policy useless? The answer is no, as it
produces short-run gain in terms of change in output level and unemployment rate. As J. M. Keynes once said,
in the long-run, we are all dead!

23
 r
LM0
IS0 An expansionary monetary policy would
A LM1 initially shift the LM curve to the right,
r0 from LM0 to LM1. This will have the short-
run effect of shifting the AD curve to the
B right, from AD0 to AD1, thereby expanding
r1 the output level from the initial natural
output Yn to Y1. As Y1 is higher than the
natural output level Yn, it follows that P
would be higher than Pe. This would
Y make wage setters to revise the Pe
Yn Y1 upward, thereby continually shifting the
AS0 line to the left (not shown, for
brevity) as described previously and the
process would stop only when the output
r AD1 level shrinks back along the AD1 line back
E AS0 to Yn. Meanwhile, the ever-increasing P
(as a result of upward revision of Pe)
would reduce the real value of (M/P),
P1
D tightening the money market
AD0
continuously and shifting the LM curve
P0 leftwards – a process that will not stop
until LM1 shifts back to the original
C
position, which is LM0. In the end, there
would be only an increase in money
supply and price level (the proportionate
Y
increase of which would equal the
Yn Y1
proportionate increase in money stock).
But there would be no effect on the
Figure 24: Short-run Effects of Monetary Policy and Long- output level (that would still remain at
run Neutrality of Monetary Policy the Yn) or interest rate (that would still
remain at r0). It is this phenomenon that
is referred to as long-run neutrality of
money – i. e., monetary inability to
influence interest rate and real variables
like unemployment and output level..

24
7.3 Effects of Fiscal Policy
In Figure 25 below, we show the short-run effect of expansionary fiscal policy, which is able to increase output
level in the short-term. But, in the long-run, there is what is complete crowding out, which means expansionary
fiscal policy is ineffective in influencing the level of real variables like output and unemployment – it would, by
increasing interest rate, only lead to a one-for-one reduction in private investment, a phenomenon called
crowding out of private investment. The question then is: Is fiscal policy useless? The answer is no, as it
produces short-run gain in terms of change in output level and unemployment rate. As J. M. Keynes once said,
in the long-run, we are all dead!

An expansionary fiscal policy would initially

shift the IS curve to the right, from IS0 to IS1,
r LM1
IS1 thereby shifting the AD too to the right,
C from AD0 to AD1, and expanding output
r2 level from the initial natural output Yn to
IS0 LM0
Y1. As Y1 is higher than the natural output
r1 B level Yn, it follows that P would be higher
than Pe. This would make wage setters to
r0 revise the Pe upward, thereby continually
shifting the AS0 line to the left (not shown,
A for brevity) as described previously and the
process would stop only when the output
level shrinks back along the AD1 line back to
Yn. Meanwhile, the ever-increasing P (as a
result of upward revision of Pe) would
Y reduce the real value of (M/P), tightening
Yn Y1 the money market continuously and shifting
the LM curve leftwards from LM0 to LM1 – a
process that will not stop until LM1 shifts
just enough to intersect the IS1 at point C,
r AD1 which corresponds to the natural output Yn.
E AS0 In the end, there would be an increase in
price level P and the consequential
P1 reduction in real money stock (M/P), an
D increase in interest rate, and a higher
AD0
interest rate-induced reduction in private
P0 investment that would equal the original
increase in government spending. Given the
C
identity Y = C + I + G + (X – M), it follows
that the rise in G would be exactly offset by
a fall in I – a phenomenon that is called
Y
complete crowding out of private
Yn Y1
investment by government spending. As a
reminder, for a different reason, we also
Figure 25: Short-run Effects of Fiscal Policy and Long- came across crowing out when the IS curve
run Crowding Out of Private Spending by Expansionary is horizontal (perfect interest elasticity of
Fiscal Policy investment spending) or LM curve is vertical
(zero interest elasticity of money demand).
25
 7.4 A re-visit of Short-run and Long-run Aggregate Supply Curve
In the short-run, aggregate supply curve is often described as a horizontal line (See Figure 26 below). This
means that firms are ready to produce as much as demanded at the prevailing price level and they do not need
to be induced by an increase in price level to increase output. This would happen if there is mass
unemployment and idle capacity, as was the case during the 1930s Great Depression, which provided the real
life background for J. M. Keynes to posit that the aggregate supply curve is horizontal and that is why this is
called Keynesian Aggregate Supply Curve. Nowadays, we do not need mass unemployment to arrive at the
same idea as short-run price and wage stickiness would also lead to the same conclusion.

In the long-run, aggregate supply curve is a vertical line, meaning that supply by firms are not responsive at all
to price changes – they would supply the same output level, irrespective of the prevailing price level (See Figure
27 below). This would be the case if all factors of production are already fully employed, meaning that, even if
prices increase, firms have no further factor inputs to utilize to produce more and take an advantage of price
increase. This was the idea of Classical Economists, who contend that there used to be full employment in the
economy. Hence, a vertical supply curve has since been referred to as the Classical Supply Curve. Nowadays, we
do not need to resort to an assumption of full employment to arrive at a vertical aggregate supply curve. As we
have just analysed, all that is required is for the expected price level to equal the actual price level, thereby
producing the natural output level, at which the supply curve becomes vertical.
P P
AD1 AD1 AS
AD0
P1
P0 AS AD0

P0

Y Y
Y0 Y1 Y0

Figure 26: Keynesian Aggregate Supply
Curve: Changes in Aggregate Demand
(e. g. through monetary or fiscal policy)
Produce Maximum Effect on Output,
with no effect on price level.
Figure 27: Classical Aggregate Supply
Curve: Changes in Aggregate Demand (e.
g. through monetary or fiscal policy)
Produce No Effect on Output, but merely
increases the price level.

7.4 Differences Between Aggregate Demand and Supply and Microeconomic Demand and Supply
In conclusion, it should be noted that the aggregate demand curve, while having broadly the same shape and
slope as the demand for a commodity that we are familiar with in microeconomics, are different in a number of
ways. The microeconomic demand has its foundation in utility maximization while aggregate demand has its
foundation in equilibrium conditions in the money market (Md and Ms, giving rise to LM curve) and commodity
market (IS relationship). Also, while we deal with price level in aggregate demand analysis, we deal with
relative price in microeconomics.

Similarly, the microeconomic supply analysis has its foundation in output maximization while aggregate supply
analysis has its own foundation in the labour market conditions. More important, while price elasticity of
demand for a commodity increases with passage of time (i. e. supply curve becomes more horizontal in the
long- than in the short-run), the reverse is the case with aggregate supply curve where long-run aggregate
supply curve becomes more vertical as time passes.

26