Investments (I) – everything that a firm spends to produce future goods and services

Circular Income Flow

We got 2 fundamental economic agents:

 Households – in an oversimplified view, households are the people, and people work at
firms (labor), rent their properties to the firms (land), invest in the firms (capital) and
own firms (enterprise);
 Firms/Businesses – firms are entities that produce and provide goods and services.
How do these 2 agents interact?

 Households provide factors of production to the firms (Land, Labor, Capital and
Enterprise);
 Firms use the factors of production provided by the households to produce goods and
services;
 In return of the factors of production that households provide them, the firms give the
households factor incomes (Wages, Rent, Interest Rates and Profits);
 Households spend the income that firms give them in goods and services provided by
the firms.
Basicamente, as pessoas trabalham nas empresas, arrendam-lhes propriedade, investem nas
empresas e algumas pessoas até são donas das empresas. Agora que as empresas têm
trabalhadores, um sítio onde operar, dinheiro e alguém que as coordene, elas podem cumprir a
sua função, que é produzir e dar (vender) bens e serviços às pessoas. Mas as pessoas não dão
tudo aquilo às empresas de graça, elas têm de receber algo em troca e, portanto, as empresas
recompensam o trabalho com salários, a propriedade com renda, o investimento com juros e
dividendos e os donos das empresas recebem os lucros destas. Com este dinheiro que agora as
pessoas têm elas vão gastá-los nos bens e serviços que as empresas oferecem (vendem).

Circular income flow pt.2

However, the economy is not closed and there aren’t only 2 agents and only 2 possibilities of
what to do with money. Let’s now see a more realistic view of our economy.
Now we are introducing 2 new agents to this economy:

 Government
 Outside economies
Changes in factor incomes – Not all of people’s income is spent on goods and services in this
economy, other things can happen that income:

 Savings – people can save a part of their income;

 Taxation – people’s income can be taxed by the government;
 Imports – people can spend their income on goods and services made abroad, in other
economies.
Changes in consumer expenditure – Households are not the only ones expending on goods
and services produced by the firms, there are many other ways where expenditure can take
place:

 Investment – firms can spend on goods and services;

 Government Spending – the government can spend on goods and services;
 Exports – foreigns, people from abroad, can spend on the goods and services produced
on our economy.

Principles of National Accounts

Calculating the GDP
Gross Domestic Product (GDP) – the market value of all final goods and services produced
within a country in a given period of time.
Expenditure approach – calculates total country’s expenditure on goods and services in a year.
It is calculated in the following way: Y=C+I+G+(X-M)

 Y - GDP
 Consumption (C) – goods and services bought by the households;
 Investments (I) – everything that a firm spends to produce future goods and services;
 Government Spending (G) - everything that the government spends on goods and
services and wages to public servants;
  Exports (X) – what the country sells to foreign countries;
 Imports (M) – what a country buys from foreign countries.

Fundamental Identity of Macroeconomics

If we include taxation to the expenditure approach, we get: Y=C+I+G+X-M+T-T 
Disposable income

Y–T–C–I+T–G=X–M

Savings (S)
This means that the money you make (income) minus the money government takes away from
your income (taxes) is the money you have to spend (disposable income). The money you have
to spend (disposable income) minus the money you spend consuming (consumption) is the
money you save (savings).
T – G (Public Savings / Fiscal Balance)  How much money the Government makes throw
taxation (taxes) minus the money the Government spends (government spending)
X – M (Current Account)  How much money a country receives by selling to abroad
(Exports) minus how much money a country spends by buying from abroad (Imports)
Fundamental Identity of Macroeconomics: (S – I) + (T – G) = (X – M)

Production approach – calculates de sum of the value created by each sector. It is calculated

the following way: Y= ∑ GVA =Production – Intermediate consumption

sector

 GVA – Gross Value Added

 ∑ GVA – the sum of the value added by each sector

sector
 Intermediate consumption – everything that is bought to produce (doesn’t include
wages)
Example:
  The farmed adds 10€ of gross value because he sold the cotton for 10€ and he didn’t
spend anything on intermediate consumption. So, this sector’s GVA = 10€
 The thread maker adds 10€ of gross value because he sold the thread for 20€ and spent
10€ on intermediate consumption. So, this sector’s GVA = 10€
 The fabric maker adds 10€ of gross value because he sold the fabric for 30€ and spent
20€ on intermediate consumption. So, this sector’s GVA = 10€
 The clothes producer adds 20€ of gross value because he sold the shirt for 50€ and
spent 30€ on intermediate consumption. So, this sector’s GVA = 20€

Now we just have to sum the Gross value added by each sector to find out the GDP GDP =

∑ GVA = 10€+10€+10€+20€ = 50€

sector

Income approach – calculates who and how much is being paid.

Y = National Income = wages + rents + interest payments + profits

Real Variables VS. Nominal Variables

Real Variables – they only consider quantities and don’t really care about the prices;
Nominal Variables – they also consider prices;
So, if we are calculating something using real variables, we only use quantities and not prices
and, on the other hand, if we are using nominal variables to calculate something, we use both of
them, quantities and prices.
Which one is more important when calculating GDP? Both are important but the real variables
are more useful, cause what real matters when we calculate the GDP is the productivity and not
the prices.

 Nominal GDP t = Pt * Yt (calculating the current GDP)

 Nominal GDP t = Pt-1 * Yt (calculating the current GDP but with last year’s prices)
 Nominal GDP t-1 = Pt-1 * Yt-1 (calculating last year's GDP)
Prices (P)
Quantities (Y)
Current year (t)
Last year (t-1)
Example:
Let’s imagine that Portugal only produces apples.
In 2022:

 Portugal’s GDP = 2000€  Nominal GDP t-1

 Apples’ price = 1€/kg  Pt-1

In 2023:

 Portugal’s GDP = 3000€  Nominal GDP t

 Apples’ price = 1.36€/kg  Pt

Growth rate of GDP:

3000 €
Growth rate of GDP = - 1 = 0.5  it means that the GDP has a growth rate of 50%.
2000 €
Real growth rate of GDP:
Nominal GDP t-1 = Pt-1 * Yt-1  Yt-1 = Nominal GDP t-1 / Pt-1  Yt-1 = 2000€/1€ = 2000
 it means that in 2022 Portugal produced 2000 apples
Nominal GDP t = Pt * Yt  Yt = Nominal GDP t / Pt  Yt = 3000€ / 1.36€ = 2206  it
means that in 2023 Portugal produced 2206 apples
2206
Real growth rate of GDP = – 1 = 0,1  it means that the GDP has a real growth rate of
2000
10%
As we can see, there is a difference between the growth rate of GDP and between the real
growth rate of GDP. Like I said before, the nominal variables take into account the prices, while
the real variables don’t. GDP’s growth rate is a nominal variable and the GDP’s real growth rate
is a real variable. Because the growth rate of GDP uses prices, changes in prices will affect the
calculation of it. So, the GDP’s growth rate (50%) is much higher than the GDP’s real growth
rate (10%) because most of it’s increase is due to the fact that apples’ price increased. The
GDP’s real growth rate, by not considering prices, shows the real increase in productivity, that is
what actually matters. And this is why real variables are more useful when calculating GDP.

Simple Keynesian Model

Desired Demand (AD) = C + I + G + X – M
In equilibrium, Y = AD  The production (GDP) is the same as the desired demand, which
means that, in a perfect situation, everything that you make, you will spend.
-
Consumption Function: C = C + c*Y
-it’s what you have to spend independently of your will to spend.
Autonomous Consumption (C):
Marginal Propensity to Consume (c): how much of your income you want to spend on
consumption. 0<c<1

Example: if my Marginal Propensity to Consume is 0.5, I will spend half of my income and
save the other half.
Now let’s put the 3 formulas we saw above together and find out something new:
AD = C + I +G + X – M
Y = AD  Y (eq) = C + I + G + X – M 
-
C = C + c*Y -
 Y (eq) = C + c*Y + I + G + X – M 
 Y – c*Y = C-+ I + G + X – M 
 Y (1-c) = C-+ I + G + X – M 
1 -
 Y (eq) = * (C + I + G + X – M)
1−c

Keynesian Multiplier

 So, c is how much of my income I want to spend consuming;

 c is never 1, so every 1€ that comes in Y is not =+1
 This means that I will never spend everything I make with my income, I will always
save something;
 So, the savings take out the strength of the growth;
 The GDP does not explode, the “ball goes slower and slower” because the
marginal propensity to consume (c) is always less than 1, so 1€ of income is not
equal to 1€ of consumption;
 If the c (marginal propensity to consume) was = 1, the ball would just keep
rolling and rolling. The GDP and the economy would explode.
If the Government Spending (G) increases, then the output/income (Y) will increase even more
1
because Δ Y = ∗Δ G
(1−c)
Let’s imagine this:

 Government was spending 1000€ (G=1000€) and now is spending 1200€ (G’=1200€),
then Δ G =200€
 The marginal propensity to consume is 0.4 (c=0.4)
 1 1 1
 ΔY = ∗Δ G ↔ Δ Y = ∗200 € = ∗200 € =1.67∗200 € =334 €
(1−c) 1−0.4 0.6
 Like I said , theincrease∈the output ( 334 € ) is bigger than the increase in
Government Spending (200€)

1
This happens because unless c=1 or c=0 (which never happens), will always be higher
1−c
than 1

1. The Government increases its spending, which means that there is more demand 
desired expenditure increases
2. Now that there is more demand, the Firms will produce and sell more  income /output
increases
3. The firms and the people will now have more money to spend, which means they buy
something else, so the demand for something will increase  desired expenditure
increases
And this is a continuous cycle until the economy reaches the new equilibrium (second purple
dot)
Example:
The Marginal Propensity to Consume is 0.5 (c=0.5).
The Government was spending 1000€ (G=1000€), but they felt like the economy was a little
down so decided to inject some money in the economy. They did it by constructing schools. The
Government chose a few civil construction firms to build the schools and in total paid them
2000€ for it. The desired expenditure increased because there is more demand to build schools.
So, now the Government spending is 3000€ (G’=3000€) and the difference between what they
were spending back then and what they are spending now is 2000€ ( Δ G=2000 € ).

Because Government wants the civil construction firms to build more schools and is paying
them for that, the firms will have to produce more, increasing the output. Now the firms have
more money and because the c=0.5 they will save half of the money the government paid them
(1000€) and will use the other half (1000€) to buy concrete. Now the desired expenditure
increases again because there is more demand for concrete and as there is more demand for
concrete, the concrete companies will have to produce more, increasing the output.
The c=0.5 so the concrete firms will save 500€ and spend 500€ buying sand, increasing the
demand for sand and the desired expenditure.
And this goes on and on and on until the market reaches the new equilibrium.

Output and interest rates

Money is an asset with 3 functions:

 Unit of account – you can express prices in these units (1€, 2€, 3€, …)
 Store of value – it is able to store value that can be transferred into the future so, if I
keep this in my pocket, the asset will keep being valuable and I can buy tomorrow with
the money I have today.
 Widely accepted for payments – you can settle your payments with this asset because
everyone accepts it as a form of payment.
Gold, for example, only has the 2 first functions.
Interest Rates are the price of money, how much you have to pay to obtain money. For example,
if I want 1€, I have to pay 1€ + interest rate.

Demand for money

There is a demand for money, people want it. But why do they want it?

 Transaction motives – to finance transactions (buy and sell)

 Speculative motives – to compose people’s portfolio (it’s good to have money because
it is liquid and you can immediately use it, instead of having to trade it  but we should
not only have money, because it’s more susceptible to inflation)
 Cautionary Motives – to use in case of emergency.

D
M
Real money demand: =α∗Y −β∗i
P
D
 M – Money demand
 P – Prices
 Y – income
 i – interest rates
  α ∧β – parameters
Interest rate – the opportunity cost of having money (the higher the interest rates, the less the
demand for money is  if they are high, the alternative is better, so it’s better not to have
money; the banks have a high opportunity cost for holding the money, it’s better to lend it).

Variables that affect the money demand:

 Income – More income means more demand

 Interest rates – Lower interest rates mean more money demand and higher interest rates
mean less money demand.

Real Money Supply

Real Money Supply:

M-S
=α∗Y −β∗i
P
The money supply is a variable policy. The central banks decide how much money there is.
They determine the quantity of money that exists in the market.

Bonds
When you buy a bond, you are basically lending money to someone, and they will pay you back
in the future. You can buy:

 A company bond – you’ll be lending money to a company.

 A government bond – you’ll be lending money to the government.

Let’s imagine that in 2021 you bought a 1000€ government bond and that at the time the
interest rates were at 10%. This means you will be lending 1000€ to the government within a
period of 2 years. The government will give you 10% of those 1000€ (100€) every year within
that period of time (200€ in total) because those were the interest rates at the time you bought
it. In the end of those 2 years the government will give you your 1000€ back and you’ll have
1200€.

Now let’s imagine that in 2022, while you still had your bond, the interest rates increased and
became 15%. This means that everyone that buys a Government Bond at the time will have a
15% interest rate in it. Your bond only has 10% interest, which means it will pay you back less
than the bonds bought in 2022. Now if you want to sell your bond in 2022, it will be less
valuable and you will not be able to sell for its original price (1000€), because with that money
someone can buy a better bond with 15% interest rates and if you really want to sell it, you’ll
have to do it at a lower price (less than 1000€). So, when the interests rates increase the price of
bons decrease.
Let’s imagine that in 2022, while you still had your bond, the interest rates decreased and
became 5%. This means that everyone that buys a Government Bond at the time will have a 5%
interest rate in it. Your bond has 10% interest, which means it will pay you back more than the
bonds bought in 2022. Now if you want to sell your bond in 2022, it will be more valuable, and
you will be able to sell for a bigger price because with that the original 1000€ someone can only
buy a worst bond with 5% interest rates, and you can sell it at a higher price (more than 1000€).
So, when the interest rates decrease, the price of bonds increases.

Money Market
There’s an equilibrium when Real Money Supply = Real Money Demand
-M =α∗Y −β∗i↔ β∗i=α∗Y − M ↔ i=-α∗Y − M
S S S -
P P β P∗β

Money Supply

Money Demand

Money Quantity

This curve is constant and rigid

because the Central Bank defines
the quantity of money available.
The Central bank decreased the money supply and because of this, at the current interest rates,
there is an excess demand for money.
The fact that exists and excess demand for money means that people want more money than the
money that there is available and, to get the money they want, people will sell their bonds. With
everyone selling their bonds, their price will decrease, which will result in an increase in interest
rates. Higher interest rates will cause a decrease in money demand, putting the money market
back in equilibrium.

Quantitative Theory of Money

MxV=PxY

 M – Money
 V – Velocity of Circulation  how many times 1 unit of money is used for transaction
 P – Prices
 Y – Income
 P x Y  proxy for the transaction in the economy

M∗V
M∗V =P∗Y ↔ P=
Y
In the long run, if the velocity of circulation (V) and the income (Y) are constant and stable,
there is a direct correlation between Money (M) and Prices (P), so they will evolve
simultaneously, which means that “Inflation is always a monetary phenomenon”.
M Y
If the velocity depends on the interest rates  =
P v (i)
ISLM Model
Once covered the Keynesian Model and the Money Market, now we are putting both of them
together in one single model, the IS-LM Model. The IS-LM Model represents the equilibrium
between the goods and services market (Keynesian model) and the money market.

IS
This part of the IS-LM Model covers the goods and services market.
Let’s first understand the IS curve.

 I – Investment
 S – Savings

1
As we have seen in the Keynesian Model: Y = ∗(C + I +G+ X−M )
1−c
Now we’ll learn a new thing: Investment is a negative function of the interest rates. The desired
investment depends on the interest rates.

Desired Investment Function: I =I (barra)−h∗i

I – Investment
I (barra) – Autonomous Investment
h – parameter
i – interest rates
Rearranging the 2 functions:
1
Y= ∗(C + I ( barra )−h∗i+G+ X −M )
1−c
So, this means that the higher the interest rates are, the lower Investment will be. This happens
because interest rates are the price of money and:

 If I want to invest but I don’t have money and interest rates are high  I have to borrow
money, but it’s expensive to borrow money because interest rates are high so, I won’t
invest as much because it’s not worth it.
 If I want to invest, I have money and interest rates are high  I can invest my money or
I can lend it to someone else, but because the interest rates are high maybe it will be
more worth it and profitable to lend it than to invest, which means I won’t invest as
much.
Basically:

 If interest rates increase, then the investment decreases

 If interest rates decrease, then the investment increases

1
Y= ∗(C + I +G+ X−M ), which means that:
1−c
 Higher investment (I)  Higher output (Y)
  Lower Investment (I)  Lower output (Y)
Before seeing the IS-LM model, let’s see what this changes in the Keynesian model.

The interest rates decreased, so the investment went up and the output also increased.
1
∆Y = ∗∆ I
1−c
So, as we can see, we can relate the interest rates with the output:

 Higher interest rates (i)  Lower Investment (I)  Lower output (Y)
 Lower interest rates (i)  Higher Investment (I)  Higher output (Y)
And this is where the IS-LM model will start being useful.
Let’s introduce the IS curve that shows what we just saw:

High interest rates (i)

Low interest rates (i)

Low output (Y) High output (Y)

LM
This part of the model covers the money market.

 L – Liquidity
 M – Money
S
M
LM = =α∗Y −β∗i
P
If there is a lot of economic activity (the output (Y) is high), people want to have money in their
hands (want to have more liquidity) so they can make transactions. So, when the output is
higher, there is more demand for money. Since there is more money demand, people are willing
to pay more to get money and the ones that have money want to be paid more to loan that
money. As we remember the price of money is interest rates, which means that when the output
is higher, people want more money (+ money demand), so they are willing to pay higher interest
rates to get that money.
So, basically:

 Higher output (Y)  Higher interest rates (i)

 Lower output (Y)  Lower interest rates (i)

High interest rates (i)

Low interest rates (i)

Low output (Y) High output (Y)

IS-LM
Now, putting the two curves together, we get the IS-LM Model

The equilibrium between the two markets is at the interception and this is where the complex
economy will stabilize. IS = LM  equilibrium
Now let’s see the impact that some changes can make in this model.

Expansionary Fiscal Policy

Expansionary Fiscal Policy increases the Government Spending
An expansionary fiscal policy will make the IS curve expand:
Now the equilibrium is no longer the same:

 Interest rates (i) are higher.

 Output (Y) is higher.
This happens because:

 When Government Spending increases, the output increases (G↑  Y↑)

 When the output increases, the money demand increases and consequently the interest
rates increase (Y↑  M D ↑  i↑)
 The increase in interest rates triggers a decrease in investment (i↑  I)
Crowding Out Effect
Eventually, this decrease in investment might cause a decrease in output.
So, in the short term this will be beneficial since the Y increases, but in the long term it’s a
negative effect because the Y might decrease.

Expansionary Monetary Policy

Expansionary monetary policy increases the money supply.

An expansionary monetary policy will make the LM curve expand:

Now the equilibrium is no longer the same:

 Interest rates (i) are lower.

 Output (Y) is higher.

This happens because:

S
M
 When money supply increases, the interest rates decrease (   i)
P
 The reduction in the interest rates leads to a increase in investment and consequently to
an increase in output (i  I  Y)

Eventually this might backfire because more output means higher money demand that leads to
an increase in interest rates and, when there are higher interest rates, the output decreases.
However, this policy usually has a beneficial impact on the economy.

Monetary Policy ends up being better than Fiscal Policy because there is no crowding effect.

Mix of both policies

This mix of the Expansionary Fiscal Policy with the Expansionary Monetary Policy will increase
the government spending and increase the money supply
If both policies are put together, we reach a new equilibrium where for the same interest rates
we have more output. This might be dangerous because the output grows too much too fast
which might lead to higher inflation.

Balance of Payments
Balance of Payments tracks global economic relations.

To understand the balance of when need to have in consideration mainly 3 things:

 Current Account
 Capital Account
 Financial Account

Current Account
The current account includes:

 Net Exports  How much money enters the country selling things to abroad minus
how much money leaves the country buying things from abroad (NX = X – M)
 Income  how much income people from our country make aboard minus how much
income people from outside make in our country (includes transfers between
countries)

Capital Account
It’s not very important and it’s not really needed to know what it includes.

The capital account includes:

 Capital transfers between residents and people from abroad.

 Other irrelevant things

The current and capital account usually work together

Financial Account
The financial account is focused on the change in assets.

The financial account includes:

 Portfolio Investment  The assets that people/companies/governments from abroad

have in the country minus the assets that people/companies/government from the
country have abroad.
 Foreign Direct Investment
 Changes in reserves of currency or gold
We still have to consider, outside from these 3 accounts, the errors and omissions, because all
these accounts are estimates, which means that errors may occur. The error is usually lower or
equal to 1% of the GDP.

Now that we have seen all the parts of the balance of payments, it’s the look at the actual
balance of payments.

Balance of Payments: Current Account + Capital Account + Financial Account + Errors and
omissions = 0

Considering that the errors are irrelevant, if:

 Deficit in the current and capital accounts  Surplus in Financial Account

 Deficit in Financial Account  Surplus in current and capital accounts

Real Exchange Rate

First, we need to understand the difference between:

 Nominal Exchange Rate – the price of one currency in terms of another (1 dollar = 0.91
euros)
 Real Exchange Rate – the price of one country’s goods against those of another country
F
e∗P
Real Exchange Rate (R) = D
P
 e – Nominal Exchange Rate
F
 P – Foreign Prices
P – Domestic Prices
D


If:

 e increases – depreciation
 e decreases – appreciation
 R increases – real depreciation
 R decreases – real appreciation

The higher the R, the more competitive we are because our products are cheaper than foreign
(we export more and import less – NX increases)  real depreciation

Capital Flows
expected
eT +1 −e T Expected rate of change of the
F
International Interest Rate Parity: i=i + exchange rate
eT

 i – domestic interest rate

F
 i – foreign interest rate
expected
 e T +1 – expected nominal exchange rate tomorrow
 e T – nominal exchange rate today

If:

 e increases  € is worth less

  e decreases  € is worth more

Financial Markets will always attempt to make both sides equal, so:
expected
 if e T +1 increases  i <i F (…)  excess supply of €  people want to sell their euros
 depreciation of euros
expected
 if e T +1 decreases  i>i F (…)  lack of €  people want to buy more euros 
appreciation of euros

If:
F
 i>i  Capital Inflow
F
 i<i  Capital Outflow
Capital Flows (Domestic Interest Rates – Foreign Interest Rates)  CF (i−i F )

Mundell-Fleming Model
 BP  Balance of Payments
 NX  Net exports (X-M)
 CF  Capital flows  CF(i−i F )
 NX + CF = 0

BP = NX (Y; Y F; R) + CF (i−i F ¿ = 0

Current Account Financial Account

 In the beginning BP = 0 (red dot)

 Output (Y) increases
 Net exports (NX) decreased because Y has a negative effect in it BP < 0 (blue dot)
  It was fixed by an increase in interest rates (i) that lead to an increase in capital flow
(CF) and BP is back to BP = 0 (purple dot)

What changes the slope of BP curve?

 If good capital mobility  soft/lower slope (it means there is a perfect capital mobility
and the markets are stable)
 If poor capital mobility  steep/higher slope (it means there is an imperfect capital
mobility and the markets are unstable)
 No capital mobility  vertical slope (BP*)

If a country goes bankrupt (CF=0), you are forced to live with what you have: BP = NX + 0 = 0 
means that NX need to be = 0 so exports = imports
F
e∗P
Now we must remember the real exchange rate: (R) = D
P

Exchange Rates (e) regimes:

 Flexible – exchange rates can change.

 Fixed – the Central Bank is committed to keep them fixed.

Fiscal Policy with Flexible Exchange rates

In the intersection between the IS, the LM and the BP curves (red dot) domestic interest rates
are equal to foreign interest rates (i=i F )

 Government Spending increased (G↑)

  The IS curve expanded (IS(G)) (seta 1)
 Domestic interest rates are now bigger than foreign interest rates and there is a capital
inflow (blue dot) (i>i F )
 This will lead to an appreciation of € (everyone wants it)
 Since there is an appreciation of the €, nominal exchange rates will decrease (e↓)
 That will make the real exchange rates decrease (R↓) and consequently Net exports
will decrease (NX↓)
 This change in Net exports will lead to a contraction of the IS Curve, going back to its
original point (seta 2)

This means that increasing Government Spending (G↑) will allow a temporarily increase in
interest rates and in output, but eventually the circumstances will force the economy back to
the starting point.

Fiscal Policy with Fixed exchange rates

 Government Spending increased (G↑)

 The IS curve expanded (IS(G))
 Now the interest rates are higher than foreign interest rates (i>i F )
 This will lead to an excessive demand of €.
 However, because exchange rates are fixed, the central bank will increase the money
supply (MS↑)
 This will make the LM curve expand.
With fixed exchange rates, Fiscal policies are more efficient because for the same interest rates
(i), there is a higher output (Y↑)

Monetary Policy with flexible exchange rates

 An expansionary monetary policy will increase the money supply (MS↑)

 This will shift the LM curve to the right, reaching a new equilibrium point (green dot)
 The new equilibrium is bellow the BP line, so we have a capital outflow and the
domestic interest rates are lower than the foreign interest rates (BP < 0) (i<i F )
 This will lead to a depreciation of the € and nominal exchanges will increase (e↑)
 The increase in nominal exchange rates will allow foreigners to buy more products in
our country with the same money, which will increase the Net Exports (NX↑)
  This will increase the output (Y↑) and shift the IS curve to the right (IS’)
 We will reach a new equilibrium (yellow dot)

At this new equilibrium, the interest rates will be the same and the output increases, which
mean that with flexible exchange rates a monetary policy works well.

Monetary Policy with fixed exchange rates

 An expansionary monetary policy will increase the money supply (MS↑)

 This will shift the LM curve to the right, reaching a new equilibrium point (green dot)
 The new equilibrium point in below the BP curve, which means there is a capital
outflow and the domestic interest rates are lower than the foreign ones (BP < 0) (
F
i<i )
 The exchange rates (e) are fixed, so there is no depreciation and the central bank has
to revert its own policy and decrease the money supply (MS↓)
 This will make the LM curve go back to the original place.
Banks and Money Creation
Without banks, there would be too little investment in society and the output would be
smaller. Banks end up creating money (giving money to someone to use, without destroying
the deposits)  credit originates deposits that lead to further credit (leakages in this process
are reserves and circulation)

Money (M) = deposits + what is in circulation

Balance sheets of a Banks:

Assets (ativo) Liabilities (passivo)

 Reserves (the banks keep some money  Deposits
aside for safety)  Capital/equity (is not really a liability) 
 Credit Capital = Assets – Liabilities
 Portfolio
If the capital < 0, the bank is insolvent (more liabilities than assets)

Banks Contribute to GDP by providing credit and allowing savings.

The whole system works based on trust, Banks trust they’ll be paid back for the credit they
provided, and People trust Banks to keep their savings safe. So, there are laws in place to help
the Banking System be more reliable:

 Mandatory Reserves: % of deposits the Bank is obligated to keep

 Minimal Capital Ratios: Assets should be above liabilities in a certain %
 Deposit insurance (fundo de garantia dos depósitos) - commitment of a number that
they always pay you back; If a bank closes it ensures up to 100000€ per account.
 Prudential Supervision: there are supervisory authorities that check if the banks are
complying with the mandatory reserves and minimum capital requirements 
Regulators keep watch on Bank’s business.
 Lender of last resort: – if everything else fails, this is the ultimate layer of safety;
someone with the ability to come to the bank with all the money necessary to save it
 someone with unlimited resources able to fix an issue. It can be the central bank,
the government, etc…

Resolution Mechanism
What do we do when a bank goes bankrupt (can’t repay the deposits immediately)? (Ex: BES)

We use the resolution mechanism, that is an procedure established by Europe if a bank goes
really wrong (BES was the first bank to use this mechanism). The resolution mechanism
consists of splitting the bank in 2 (the good bank and the bad bank) and then support the good
bank and hope it goes well and let the bad bank die.

Good bank Bad Bank (will be extinguished and doesn’t

contain deposits because they were sent to
the good bank)
Deposits Bad assets
Good assets Other liabilities
Fresh Capital injected  public money
coming from a resolution fund
Now the bad bank only has bad assets.

What are good and bad assets?

 Good assets – Loans that you can’t collect anymore and bonds that the bank bought in
other firms.
 Good assets – good credit that will recover; fresh capital.

Central Bank
Assets Liabilities
 Foreign Reserves  Deposits from Banks
 Bonds  Bank notes

Differences between the central bank and normal banks:

 Assets – Central Bank doesn’t give credit because it does not take any loans.
 Liabilities – Central Bank issues money

The Central Banks have an expansionary monetary policy by decreasing interest rates and they
do this through an increase in money supply. But how?

 CB buy bonds from Banks (open market operations) and the banks get that money 
CB are injecting money in the economy.
 We the money they get, Banks can do 2 things with it:
o Increase the reserves (deposits in the CB); or
o Drop the reserves and increase credit (this is what the CB wants them to do);
 When they increase the credit  more people get loans  part of the money from the
loan will be saved (+ Bank’s deposits) and the other part goes to consumption  the
money spent on consumption goes to the producer that spend a part of it and saves
the other part (+Bank’s deposits)  with more deposits banks can increase their
reserves and give more credit and this goes on and on (it’s a cycle)

However, this doesn’t keep going forever because there are some leakages

From the Money that goes to deposit, only a part goes to the reserve and a part of the money
from credit won’t go to deposit but to consumption.