MASTER OF FINANCE – FALL 2022

MACRO- AND MONETARY

ECONOMICS
PART 1 – NEOCLASSICAL MACROECONOMICS

SESSION 1 – INTRODUCTION AND THE NEOCLASSICAL MODEL: LABOUR SUPPLY

Macroeconomics is fundamental in order to understand finance because in general, macroeconomics provides an

answer to the question: which factors determine the real interest rate, inflation and the nominal interest rate? and
the interest rate is the most important price in finance. More specifically, a distinction needs to be operated
between the nominal interest rate (I ), which is given by real interest rate (r) + inflation (Π), and the real interest
rate (r), which does not take into any account the effect of inflation.
The answer provided by the application of macroeconomic theory to the above-cited fundamental question,
nonetheless, depends on the methodological approach underlying the macroeconomic model employed. According
to neoclassical macroeconomics, indeed, the real interest rate is determined by real factors, such as changes in
productivity of capital (machinery, equipment,…) and the time preferences of agents. Consequently, according to
this macroeconomic theory, changes in the real interest rate are not monetary of nature and do not depend on
currencies or exchange rates at all. According to neoclassical macroeconomics, the real interest rate is the price
that clears the capital market, namely investment (capital demand) and savings (capital supply). Inflation, instead,
is determined (always in the perspective of neoclassical macroeconomic theory) directly in the money market by
money supply versus money demand. This item is therefore described as purely monetary and represents nothing
else if not a simple change in the price level of goods. The nominal interest rate, consequently, is just the result of
(the sum) of the real interest rate and the inflation rate and is, therefore, not determined by the market itself.
According to Keynesian macroeconomics, instead, the nominal interest rate is directly determined by money
supply and money demand (meaning it can be highly influenced by the monetary policies undertaken by the
central bank). In its turn, inflation is determined by aggregate demand and aggregate supply and the real interest
rate is just the result of the nominal interest rate minus the inflation rate.
Macroeconomics, as the Keynesian model suggest, is closely linked to monetary economics and monetary policy.
Also in this case, however, a distinction needs to be made between conventional monetary policy and
unconventional monetary policy. Conventional monetary policies see as main action performed by central
institution the change of the short-term nominal interest rate. In simpler words, the central bank sets the price it
charges when providing central bank money to the state. A more recently experimented unconventional monetary
policy, instead, was put into action in a moment when nominal interest rates were reaching a zero or lower bound.
In this case, central banks did not act on changing the nominal interest rate but rather on changing the assets they
possess. Basically, the central banks started purchasing assets (mainly State bonds) in order to expand its balance
sheet, thereby influencing general financing conditions (they are impacting the demand for assets directly →
quantitative easing)

Macroeconomics and the explanation of business cycles As much as macroeconomics provides us with all the
elements to answer the questions posed above, the subject does not directly aim at explaining which factors
singularly determine interest rates and inflation, but it rather aims at explaining the business cycle. There are
some specific aspects which drive business cycles:
• quantities: output (goods produced = growth), employment, consumption/saving and investment;
• (relative) prices: real wages and real interest rates
• the price level (inflation)
Quantities and prices specifically are the outcomes of decisions by many agents on many markets. Of these
markets, macroeconomics places importance on three of them: labour market, capital market and money market.
And, more specifically, when considering output and aggregate supply and demand, neoclassical economics
considers it to be de product of labour and capital market, whereas Keynesian macroeconomics considers it the
product of the capital and the money market.
The models adopted in order to explain business cycles are usually described as “unrealistic”, and indeed, they are
so by definition. Therefrom it follows, that realism should not be seen as a criterion for assessing the quality of a
model. The latter should, in facts, be determined by its ability to generate/replicate movements in the variables of
interest consistent with what we currently observe → main question should be: do models match the stylized facts
of the business cycle?

→ co-movements (in correlation with GDP): - consumption, investment, hours worked and employment are
strongly correlated with output and also among each other (they always move in the same direction)
- productivity needs to be procyclical (meaning it goes in the same direction as GDP)
- real wage is only weakly correlated to GDP
- real interest rate and price level are basically a-cyclical (they are not affected at all by movements in GDP)
→ volatility (relative to GDP): - consumption is smoother and investment is substantially more volatile than output
(meaning that given a movement in GDP, consumption will react with a smaller magnitude to the rise in GDP with
respect to investment which will increase [decrease] more substantially);
- hours worked are basically as volatile as output, while employment, productivity and the real wage are less
volatile than output;
- the real interest rate and the price level are substantially less volatile than output.

The Neoclassical Model: methodological approach Neoclassical macroeconomics is micro-founded. This means
that the model is based on basic microeconomic principles such as optimization and competitive equilibrium.
Basically, neoclassical macroeconomics tries to explain macroeconomic events and models taking as a reference
the decisions made by a single individual maximizing his own utility under a specific constraint (which could be
represented by a budget constraint, in the case of a household, or by a constraint placed by limited factors of
production in the case of a firm). Decisions by individuals maximizing their utility (households) and profits
(businesses) explain level and changes of macroeconomic aggregates (output, consumption, saving, investment or
inflation for the economy as a whole). This is strong in contrast to the standard IS/LM model usually presented,
since the latter is based on behavioural functions of aggregates such as the consumption function, the investment
function,…. These reduced form equations are subject to the Lucas critique.

Equations of the standard reduced-form Keynesian model are presented in the following
manner:
(1) 𝐶𝑡 = 𝛽1.0 + 𝛽1.1 𝑌𝑡 + 𝑢1.𝑡 (𝛽1.0 represents independent consumption, 𝛽1.1 is marginal
propensity to consume and indicates by how much consumption rises given a rise in
income)
(2) 𝐼𝑡 = 𝛽2.0 + 𝛽2.1 𝑌𝑡 + 𝛽2.2 𝑌𝑡−1 + 𝑢2.𝑡
(3) 𝑌𝑡 = 𝐶𝑡 + 𝐺𝑡 + 𝐼𝑡
The βs in the equations above can be estimated based on data collected from the past and, for
this specific reason, Lucas stated that coefficients from these reduced form equations are
policy variant. This means that the estimated relationships of the past basically fail to capture
the effects of policy actions as agent behaviour changes when policies change. This is because
agents are forward-looking and adapt to a new policy stance. For instance, when government
increases spending (∆𝐺), it is not automatically true that this will raise C by 𝛽1.1 , since the
change in G might also lead to a different reaction of C to a change in Y/G than the one statically
represented by 𝛽1.1 . For example, agents might expect that due to a rise in government
expenditures there will be tax hikes in the future. They prepare for these hikes by increasing
savings and reducing consumption. Therefore, it might happen that consumption might fall
rather than rise when the government increases spending.
Starting from this observation, Lucas argued that models have to be built on parameters which
are invariant to policy interventions: parameters should not change when policy changes.
Parameters like utility and production functions which express preferences of agents and
technological possibilities to produce goods and services are believed to be policy invariant
as they guide economic decision-making by households and firms when pursuing the goals of
utility and profit maximization. Thus, macroeconomics needs to be micro-founded and the
respective models have to be built on preferences (utility function) and technology
(production function). This view was boosted in the 70s by the emergence of a concrete proof
stating that Keynesian models offered neither a cohesive theoretical explanation for the
stagflation observed during this period nor a defensible policy advice. As a matter of fact, the
observation that coefficients are policy variant makes of the model a pretty useless mean to
rely on when deciding whether to engage in a new policy. As rational agents and firms take
the future into account when maximizing utility and profits, models need to be intertemporal
and try and describe what the agent will do both in the current and future period. Key
parameters are:
• marginal rate of substitution of leisure for consumption, marginal product of labour
(willingness of a single household to trade leisure for consumption)
• the marginal rate of substitution of current for future consumption (reflects also savings:
how much does the individual save today in order to consume more in the future?)
• the marginal product of capital and the marginal rate of substitution of current for future
leisure
The representative agent device In the model, macroeconomic outcomes are explained as the result of
decisions taken by a single representative household/ consumer. There is, then, only one single representative
household/consumer, which is constantly assumed to:
• maximize her utility and determine the supply of labour and the level of savings (consumption);
• owns the single representative firm which maximizes profits and determines the demand for labour
and the demand for capital (investment). Thus, the firm is a “veil” in acting in accordance with the
interest of the representative household/consumer;
• maximizes utility and profits given the constraints set by time and by the macroeconomic production
function with three factor inputs: labour, capital and technological process;
The economic environment described by the representative agent is usually referred to as a Robinson Crusoe
economy (an economy where actions are taken by insulated individuals).
From a financial point of view, the representative agent model implies that we cannot actually analyse financial
transactions as these transactions require at least two people. Moreover, financial transactions only occur
when the two sides transacting with each other have different and opposing views and expectations about the
future (Example: when someone sells shares they do so because they expect the prices to fall. But a sale is only
possible if there is a buyer who obviously has the exact opposite expectations about future share prices. Clearly,
the representative individual cannot represent both at the same time). As a result, the neoclassical model has
no capital market reallocating resources among individuals. However, in a closed economy financial
transactions usually are not prone to the creation of wealth: any financial asset also represents, indeed, a
financial liability. Thus, the sum of financial net- worth in a closed economy is zero by definition. This can be
interpreted as suggesting that financial transactions and the build-up of financial assets and liabilities (debt)
can be ignored as they do not show up on a macro-level. Neoclassical economics follows this solution.
Despite being the only agent active in a closed economy, the model actually accounts for “lending” and
“borrowing” by the representative individual: concretely, the individual lends to and borrows from the
representative firm and this represents the “capital market” in the neoclassical model.
• the representative individual lends to the representative firm it owns by foregoing consumption of
goods produced. This allows the firm to employ these goods as investment goods;
• accordingly, saving is identical to “lending” to the firm which is equal to the firm borrowing and
investing. The firm basically pays for this lending by providing higher dividends in the form of
consumption goods and a higher capital stock to the representative individual in the future;
The model, then, indirectly analyses under which conditions the representative agent is willing to save and
lend and under which conditions the firm is willing to invest and borrow. The capital market of the neoclassical
model is a market for “loanable funds” between households and firms. In such a case, however, the capital
market described does not involve money at all, but it rather involves goods: all financial transactions happen
in terms of goods and not in terms of money. This can be illustrated by the analysis of banks and the banking
system in a representative agent model. Banks are barter institutions which intermediate real saving from
households to firms: banks collect deposits of real savings from households and lend them to firms.

Exogenous shocks and market clearing Given that there is only one individual transacting with themselves, no
coordination failures can arise. It is therefore more than reasonable to assume that the utility and profit
maximizing behaviours of the representative agent under the given constraints always leads to market clearing,
meaning an equilibrium between demand and supply. This implies that macroeconomic developments, like
business cycles, are substantially driven by shocks of preferences of the representative agent and of production
technologies, concretely, total factor productivity only. These shocks, however, can actually not be explained
by the model themselves, but they actually need to happen in the external world. It is the shock which changes
the way the firm produces or the way the agent decides to allocate their consumption over time. Usually,
however, shocks to preferences are ignored as a possible source of business cycle fluctuation and this is why
the model is also referred to as “the real business cycle model”. The representative agent responds optimally
to these shocks and – by doing so- generates the business cycle we observe, which holds both in the short and
in the long run.

The Neutrality of Money Essentially, the model depicts a barter economy, since the analysis of the labour and
capital market is done without money being part of the analysis and the model at all. Accordingly, the
representative household does not receive a nominal wage from the firm (in terms of monetary compensation
for their job), but directly exchanges labour time against consumption goods which represent a real wage. In
the same way, households and firms meet on the capital market to exchange goods today against claims on
goods in the future at the real interest rate. Only when we introduce a money market, money becomes part of
the analysis: however, money only determines the price level which allows us to express the real wage and real
interest rate as a nominal wage and a nominal interest rate. For the rest, money has no bearing on the
functioning of the goods and labour markets because it does not influence relative prices (for instance, the real
wage and the real interest rate). The latter are, indeed, independent from monetary conditions.

Hierarchy of Markets The neoclassical model is characterized

by the following hierarchy of markets. The level of output, as
well as, the real wage and the real interest rate are determined
in the labour and capital market, whereas the price level is
determined in the money market. Developments in the money
market have no implications for the labour and goods market
(changes in the price level only change nominal but not real
variables).

The Neoclassical Model: Labour Supply In order to better understand how the representative individual makes
choices in a multiperiod economy, one first needs to understand what drives decisions in a single period.
Basically, the representative household demands consumption goods and offers labour to the firm producing
consumption goods. The representative firm demands labour in order to produce goods and offers goods in
exchange for labour to the representative household. Household and firm approach the labour market with the
goal of maximizing utility (household) and profits (firm). The household maximizes utility facing a time
constraint, whereas the firm maximizes profits under the technical constrains given by the macroeconomic
production function.

→ the household has the following utility function: 𝑼(𝑪, 𝒍), with U being utility, C the quantity of consumption
and l the quantity of labour. A consumption bundle describes a particular combination of consumption and
leisure (𝑪𝟏 , 𝒍𝟏 );
→ the individual’s utility function represents how the consumer ranks different consumption bundles (with
leisure being the alternative to consumption in terms of goods tradable).
- (𝑪𝟏 , 𝒍𝟏 ) is, generally speaking, strictly preferred by the consumer to (𝑪𝟐 , 𝒍𝟐 ) if 𝑼(𝑪𝟏 , 𝒍𝟏 ) > 𝑼(𝑪𝟐 , 𝒍𝟐 )
- (𝑪𝟐 , 𝒍𝟐 ) is, generally speaking, strictly preferred by the consumer to (𝑪𝟏 , 𝒍𝟏 ) if 𝑼(𝑪𝟏 , 𝒍𝟏 ) < 𝑼(𝑪𝟐 , 𝒍𝟐 )
- the consumer is indifferent between the two consumption bundles if 𝑼(𝑪𝟏 , 𝒍𝟏 ) = 𝑼(𝑪𝟐 , 𝒍𝟐 )
In addition to this, preferences and consequently the utility functions have some specific properties:
1. more is always preferred to less but the marginal utility of each homogeneous unity decreases as
the number of units of that specific good increases. The marginal utility of consumption (𝑴𝑼𝒄 )
measures the rate of change in utility associated with a small change in the amount of C consumed
(the utility from the second to the third pizza increases less than it did getting the second pizza
after the first);
2. more diversity is preferred to less: this derives from the law of declining marginal utility as the
more the consumer opts for leisure and her consumption falls, they are willing to forego less and
less of consumption for a given increment in leisure as the marginal utility of leisure falls and the
marginal utility or consumption increases (in general, we do not like extreme positions, since
when finding yourself in those situations you would be willing to easily forego a little bit of
consumption to get leisure or vice versa);
3. consumption and leisure are normal goods (a good is normal if the quantity of the good purchased
increases when income increases)
→ an indifference curve connects consumption bundles among which the
consumer is indifferent (reaches the same level of utility). An indifference
curve has two fundamental properties: it slopes downward in order to reflect
the fact that more is always preferred to less and it is convex (bowed-in
towards the origin) thereby expressing that diversity is preferred.
The slope of the indifference curve is represented by the marginal rate of
substitution of leisure for consumption ( 𝑴𝑹𝑺𝒍,𝑪 ). This represents the rate at
which the consumer is willing to substitute leisure for consumption goods:

∆𝑪 𝑴𝑼𝒍
𝑴𝑹𝑺𝒍,𝑪 = = −
∆𝒍 𝑴𝑼𝑪

Stating that an indifference curve is convex is identical to stating that the marginal rate of substitution is
diminishing. This is because, as the quantity of leisure increases and the quantity of consumption declines, the
amount of consumption the consumer is willing to give up in exchange for one additional unit of leisure
declines. The consumer requires this extra compensation due to the preference for diversity.
The Representative Consumer’s Budget Constraint We analyse the representative consumer under two
fundamental assumptions, the first one of those being that the representative consumer behaves competitively.
Competitive behaviour means that the consumer is a price-taker and market prices are taken as being given
(meaning that the actions of consumers actually have no effect on prices).

→ the household needs to obey the following time constraint: 𝒍 + 𝑵𝑺 = 𝒉, where l indicates leisure, whereas
𝑵𝑺 and 𝒉 represent the labour supply (time spent working) and the hours of time fully available (which can be
allocated).

Labour time is sold by the consumer in the labour market at a price w , which represent the consumer’s real
wage and is always expressed in terms of consumption goods. Therefore, w is the real wage, or the wage rate
of the consumer in units of purchasing power (the consumption goods play the role of the numeraire in this
model, meaning everything is expressed in terms of consumption goods). If the consumer works 𝑁 𝑆 hours, her
real wage income is 𝑤𝑁 𝑆 .
Nonetheless, consumers usually have a secondary source of income, which can be described as general profits
(𝝅). They are distributed as dividends from the representative firm and owned by the representative
consumer, they are a source of non-wage income.
The model also foresees the existence of a government and the consumer has to pay taxes to the government
in the form of consumption goods. We assume that the real quantity of taxes is a lump-sum amount (T).
Consequently, the tax does not depend in any way on the actions of the economic agent who is being taxed.
That is a pure abstraction, since no taxes are actually lump-sum. Nonetheless, lump-sum taxation has the
advantage of keeping the model simple, as changes in lump-sum taxes have no impact on relative prices (i.e.
the real wage and the real interest rate). Conversely, if we took into account any other kind of tax, then we
would need to consider the fact that their presence fundamentally distorts the behaviour of the average
consumer.

→ the budget constraint of the consumer can be written as: 𝑪 = 𝒘𝑵𝑺 + 𝝅 − 𝑻 – where 𝑁 𝑆 = ℎ − 𝑙 and thus
results in: 𝑪 = 𝒘(𝒉 − 𝒍) + 𝝅 − 𝑻. Here, the right – hand side of the equation represents the real disposable
income, whereas the left-hand side is the expenditure on consumption goods. Adding 𝑤𝑙 to both sides can
result in: 𝐶 + 𝑤𝑙 = 𝑤ℎ + 𝜋 − 𝑇, where:
- right-hand side: implicit quantity of real disposable income: the consumer has h units of time which they
could use to earn the wage w, since each additional unit of labour given is valued with the market real
wage w. 𝜋 − 𝑇 is the real dividend income minus taxes (net real dividend income);
- left-hand side: implicit expenditure on the two goods: C is what is spent on consumption goods, whereas
wl is what is implicitly spent on leisure (the opportunity cost of leisuring instead of working);

To graph the consumer’s budget constraint, we can

rewrite the equation in a slope-intercept form, with C as
the dependent variable:

𝑪 = −𝒘𝒍 + 𝒘𝒉 + 𝝅 − 𝑻

• −𝒘 is the slope of the budget constraint;

• 𝒘𝒉 + 𝝅 − 𝑻 is the vertical intercept (when you
basically decide to work only and not take up any bit of
leisure)
• 𝒉 + (𝝅 − 𝑻)/𝒘 is the horizontal intercept (when you
decide not to work and to enjoy leisure only.

This budget constraint shows only the case where 𝑻 > 𝝅, meaning that the dividend income the consumer
receives has no influence in determining the amount of consumption or leisure the representative consumer
decides to take up. From this fact also another important conclusion follows: we observe, indeed, that even if the
consumer decides not to work, they would nonetheless not be able to enjoy a full time of leisure. As a matter of
fact, they would need to consumer (work) a little amount in order to be able to pay the taxes the government
imposes (which are higher than the dividend income you receive).
Nonetheless, for the following model we will actually be driven by the assumption that 𝑻 < 𝝅 and therefore the
consumer has an exploitable income which can be used in order to pay taxes, meanwhile enjoy a full time of
leisure.

The Consumer Optimization Problem Given this budget constraint,

the consumer needs to decide which combination of leisure and
consumption will be optimal for them. Generally speaking, the optimal
consumption bundle is given by the point representing a consumption
leisure pair that is on the highest possible indifference curve and is on
the consumer’s budget constraint.

→ optimization is characterized by the given marginal rate of

substitution of leisure for consumption, which is equal to the real
wage: 𝑴𝑹𝑺𝒍,𝑪 = 𝒘. The latter indicates that the relative price of
leisure in terms of consumption goods is given directly by the wage (if
you decide to leisure one hour more, your opportunity cost is equal to
the wage which you are foregoing by not working that additional
hour). MRS of leisure for consumption equals the relative price of
leisure in terms of consumption goods.

Given our assumption that the representative consumer behaves

optimally, we can now predict the consumer’s response to changes in
the budget constraint. Specifically, we want to look at changes in the
consumer’s non-wage income, which can be due in either increases in
the dividends received by the representative consumer or by decreases
in taxes. This creates a rather pure income effect on the consumer’s
preferences and choices.
→ consumption and leisure are normal goods. Hence, higher non-wage
disposable income should increase the demand for consumption as
well as the demand for leisure.

If changes in non-wage income could cause changes in the representative consumer’s preferences which could be
explained by describing a pure income effect, conversely if the consumer registers a change in real wage income,
its subsequent behaviour is explained by the crossing of two effects: the income and substitution effect. As a matter
of fact, as much as an increase in real wage implies and increase in total
income of the consumer (thus potentially leading to the thought that the
consumer would want more of both consumption and leisure), such a
change also causes an increase in the “cost of leisure” – meaning that the
marginal rate of substitution increases. Therefore, as much as the
consumer has “more to spend” on both goods, it will also suffer from the
increase in the “price of leisure” (which is also an increase in the
opportunity cost of working)
The substitution effect can be graphically derived by following these steps:
1. hold utility constant and find a bundle which reflects the new relative
price but on the previously chosen utility curve;
2. project this bundle on the new budget constraint where we can
appreciate both: a) the substitution effect = change in demand due only to
the change in relative price (movement along 𝐼1 from F to O); b) the
income effect = the remaining change in demand due to the rise in income
(parallel shift in the budget constraint curve and finding of a new tangent
indifference cure (movements from 𝐼1 to 𝐼2 and from O to H).
Whether the substitution effect will be stronger/ weaker/ equal to the income, it is a question which could be
answered only empirically and could change the consumer’s behaviour result.
The Labour Supply Curve In general, we assume that the substitution
effect is stronger than the income effect and derive the labour supply
curve by answering the following question: how much labour does the
representative consumer wish to supply given any real wage? Imagine
presenting the representative consumer with different real wage rates
and asking which quantity of leisure/labour the consumer would choose
to demand or supply at each wage rate.

→ 𝒍(𝒘) is a function that tells us how much leisure the consumer wishes
to consumer, given the real wage 𝒘. Then, the labour supply curve is
given by: 𝑵𝑺 (𝒘) = 𝒉 − 𝒍(𝒘). From there we can observe that labour
supply increases with an increase in real wage (consumer consumes less
leisure, meaning it works more as the wage increases and the
opportunity cost of working rises) and that the labour supply curve is
upward-sloping (thus, it is utility maximizing to provide more labour
once wage is increased). Labour supply curve shifts when disposable
non-wage income changes: labour supply curve shifts to the left as a
result of a positive income effect on leisure for the consumer.

The Labour Demand Curve Consumers and firms exchange labour for consumption goods:
- the representative household supplies labour and demands consumption goods
- the representative firm demands labour and supplies consumption goods
The demand for labour of the representative firm is determined by the available technology of producing goods,
meaning the by the production function and profit maximization.

→ the production function describes the technological possibilities for converting factor inputs into outputs: 𝒀 =
𝒛𝑭(𝑲, 𝑵𝒅 ) with z being total factor productivity, Y being output of consumption goods, K quantity of capital input
in the production process and 𝑁 𝑑 the quantity of labour input measured as total hours worked by employees on
the firm.
The macroeconomic production function has three fundamental properties:
1. constant returns to scale meaning that if all factors of production are changed
by factor x, then also output changes by the same factor x → 𝒛𝑭(𝒙𝑲, 𝒙𝑵𝒅 ) =
𝒙𝒛𝑭(𝑲, 𝑵𝒅 ). The alternative to constant returns to scale in production are
increasing returns to scale and decreasing returns to scale. Nonetheless,
assuming those would imply that there are some firms (respectively large and
small) which are more efficient and best performing than other firms. With
constant returns to scale, instead, a small firm is just as efficient as a large firm.
consequently, a very large firm simply replicates how a very small firm produces
but many times over. The assumption of constant returns to scale makes it
convenient to suppose that there is only one firm in the economy.
2. Marginal products of labour and capital are both positive: this means that output
increases when either capital input or the labour input increases → 𝑴𝑷𝑵 >
𝑴𝑷𝑵 > 𝟎 (recall: marginal product is the additional output that can be produced
with one additional unit of that factor input, holding constant the quantities of
other factor inputs.
→ If we assume a fixed quantity of capital at some arbitrary value K*, while
labour input varies, we can derive the marginal product of labour which is given
by the slope of the production function at a point N*. At this point, indeed, the
slope represents the additional output produced from an additional unit of
labour input when the quantity of labour is N* and the quantity of capital is K*;
3. the marginal product of labour decreases as the quantity of labour increases (the
law of declining marginal returns)
4. the marginal product of capital decreases as the quantity of capital increases
5. the marginal product of labour increases as the quantity of capital increases: an
increase in the quantity of capital, indeed, shifts the marginal product of labour
schedule to the right.
→ the effect of a change in total factor productivity: more factor can actually be produced
given capital and labour inputs, when z increases. This shifts the production function
upwards. Consequently, the marginal product of labour increases when z increases: for any
given quantity of labour input, 𝑵𝒅 , the slope of the production function is steeper when
𝒛 = 𝒛 𝟐 than the slope given 𝒛 = 𝒛𝟏 . The marginal product of labour schedule, then shifts
automatically to the right from 𝑴𝑷𝟏𝑵 𝐭𝐨𝑴𝑷𝟐𝑵 when z increases. Thus, an increase in z has a
similar effect on the marginal product of labour schedule as an increase in the capital stock.

BOX: THE PRODUCTION FUNCTION

In Neoclassical economics, changes in total factor productivity are exogenous, meaning that the model cannot
explain these changes and, above all, households and firms need to adjust to these changes. Neoclassical economics
is more specifically built on the assumption that TFP changes are exogenous to economic activity and can,
therefore, be regarded as supply shocks, which shifts the production function.
These exogenous changes in TFP are the main drivers of the business cycle by triggering adjustments in labour
and goods markets. This is one of the reasons why neoclassical macroeconomics is also referred to as real business
cycle theory – since what moves business cycles is something which is not monetary at all. Causes of changes in
TFP can be technological innovation, whether conditions, government regulations and an abrupt increase (fall) in
the relative price of energy (often interpreted as to have an impact in determining increases or decreases in z ).
Moreover, the Neoclassical model builds on the pro-cyclicality of TFP meaning that:
• positive TFP shocks and the associated responses by agents account for the upswing;
• negative TFP shocks and the associated responses by agents account for the downturn in the economic
activity.
With an a-cyclical or even countercyclical TFP pattern, the model would not be able at all to generate movements
in key variables matching the data.
Employment and hours worked do not necessarily capture the effective utilization of labour, meaning how
intensively firms make use of the amount of labour/hours worked. In recessions, for instance, firms typically
reduce the use of employed labour and they engage in the so-called process of labour-hoarding due to adjustments
costs associated with hiring, firing and training and given that firm regard the recession as a temporary
phenomenon. Thus, utilization of labour can, in fact, be procyclical.
This, of course, has implications for the interpretation of measured TFP developments over time: the fall in
measured TFP during a recession might just reflect a rise in labour hoarding. When the recovery sets the measured
rise in TFP just reflects the fall in labour hoarding. Thus, measured TFP changes might not be exogenous, indeed,
but endogenous to the business cycle.

→ for the moment, we treat K (capital), as being a fixed input to production,

thereby causing 𝑵𝒅 to be the only variable factor of production: the firm,
consequently, has flexibility in hiring and laying off workers. The assumption
which we are making derives from the fact that we are currently still studying a
one-period model (thereby assuming that the economy will not develop after one
single period), which implies that it would make no sense for the representative
firm to invest and to change K.
The representative firm behaves competitively: it takes the real wage as given
(representing it the price at which labour trades for leisure) and pursues its profit
maximization goal given by the function: 𝒀 − 𝒘𝑵𝒅 , with:
• 𝒀 being the total revenue the firm receives from selling its output (in
units of the consumption goods);
• 𝒘𝑵𝒅 being the total real cost of labour input or total real variable costs;
We substitute for 𝑌 using the production function 𝑌 = 𝑧𝐹(𝐾, 𝑁 𝑑 ) and the firm’s problem becomes to choose the
quantity of labour demanded such as to maximize their own profits 𝝅:

𝝅 = 𝒛𝑭(𝑲, 𝑵𝒅 ) − 𝒘𝑵𝒅

where K is fixed and 𝜋 represents the real profits of the firm.

To maximize the profits, then, the firm must choose 𝑁 𝑑 = 𝑁 ∗ and the slope of the total revenue function (Y) is
equal to the slope of the total variable cost function (represented by 𝑤𝑁 𝑑 ). Being the slope of the total revenue
function also the slope of the production function, or the marginal product of
labour, and being the slope of the total variable cost function the real wage w, the
firm maximizes profits by setting 𝑴𝑷𝑵 = 𝒘 (this implies that if wages rise, a
higher marginal product of labour will be achieved since more people will be
willing to supply labour and forego leisure. Nonetheless, the higher marginal
product of labour can be achieved only by reducing the number of people
employed if the technological tools possessed by the firm remain constant).

A is the profit maximizing point because it is the point where the

difference between total revenues and total variable cost is the
greatest (the revenue function is, indeed, simply represented by the
production function)

SESSION 2 –THE NEOCLASSICAL MODEL: LABOUR DEMAND AND THE CAPITAL MARKET

The Neoclassical Model: Labour Demand We can now derive the labour demand curve,
representing how much labour the representative firm demands given any real wage .
This is given by the function 𝑵𝒅 (𝒘) and tells us how much labour the representative firm
wants to employ given their profit maximization constraint. Basically, the firm will
increase the number of people employed until 𝑀𝑃𝑁 = 𝑤 and will instead decrease the
number of people employed the higher the wage – as signalled by the downward sloping
curve (when marginal product of labour is falling, then more labour is demanded, making
the real wage w fall to a lower amount – when the real wage increases, then the firm
demands less labour so as to sustain the an increase in the marginal product of labour).
The labour demand curve shifts when the TFP changes. As a matter of fact, TFP shocks
imply that 𝑀𝑃𝑁 is moving (either rising or falling depending on the nature of the shock
affecting TFP):
• negative supply shocks cause the marginal productivity of labour to drop for
each unit of labour, meaning that the labour demand curve shifts leftward
(negative TFP shock → 𝑴𝑷𝑵 ↓)
• positive supply shocks cause the marginal productivity of labour to rise for
each quantity of labour, meaning a that the labour demand curve shifts right
given the firm’s profit maximization behaviour (negative TFP shock → 𝑴𝑷𝑵 ↑)

we reach a new equilibrium point in response

to a change in TFP:

- given the positive shock, the

representative firm is almost forced to
increase the real wage
- the representative household will
become aware of the increase and
consequently be willing to supply more
labour and forego leisure (assuming
that the substitution effect dominates
the income effect)
The Neoclassical Model: The Capital Market In principle, households demand goods for consumption, whereas
firms also demand goods and, namely, for investment. In the neoclassical model investment is financed by the
representative household in the form that the household foregoes consumption of produced goods in the current
period. Thus, the household supplies capital in the form of produced goods to the representative firm in exchange
for claims on consumption goods in the future period. This is known as capital supply, which is also more
commonly referred to as savings.
The representative firm issues debt to the representative household in order to make use of the capital supplied
(the goods produced by the firm itself are employed as investment goods which increase the given capital stock).
The representative firm, then, makes use of these goods when serving its debt to the household in the future period
(the representative consumer saves now to consume more in the future; the representative firm in order to
produce these additional goods in the future makes use of the capital supplied in the form of goods by the
representative consumer in the current period → the amount saved by the representative consumer is the amount
invested by the representative firm).
Therefrom it follows that firm and household meet on the capital market to exchange current consumption goods
into debt in the current period and claims on future goods. Accordingly, we now move to an intertemporal model
where we should analyse the utility maximizing saving decision by the household and the corresponding profit
maximizing investment decision by the firm. The intertemporal model involves the current and future period and
is, consequently, a two-period model.
The capital market we describe in the neoclassical model is very different from the financial market we are able to
observe in the real world:
1. financial markets in the real world are not part of a barter economy, but they involve money. For being
active on financial markets, households must provide money and not goods in order to buy financial
claims;
2. the neoclassical capital market has no banks with the ability to create money by lending to firms and
households. Banks only serve as intermediaries of goods between households and the firm. moreover,
saving by households in the form of goods is a strict precondition for banks’ ability to lend funds to firms
for investment purposes;
3. the neoclassical capital market is a market focusing on flows (variables which we measure in the
dimension of a time period). Consequently, the interest rate is determined by how much the
representative household aims at expanding its holdings of financial claims on the representative firm
and by how much the representative firm aims at expanding its financial liabilities to the representative
household. The real world capital market is a market mainly recording transactions and involving the
exchange of stocks (re-allocation of existing assets among households,..). funding of newly created liability
is a rare activity and a key function of financial markets is seen as ensuring an efficient allocation of assets
across households;
4. the neoclassical capital market has households as lenders and firms as borrowers only. Nonetheless, in
the real world, households are major borrowers on capital markets and many firms hold financial assets
reflecting their saving behaviour.
Despite the huge differences, the model is seen as useful:
1. many economists are guided by the money neutrality postulate. However, if money is neutral, ignoring
the role of money in capital markets and the role of banks as money creating institutions is not a major
shortcoming when analysing macroeconomic developments;
2. in a closed macroeconomy, moreover, net financial assets are zero because any financial claim held by an
agent also represents a financial liability by another agent. Thus, the argument can be made that in
macroeconomics we can forego studying financial transactions among individuals with the goal of
reallocating the holding of existing financial assets. This holds specifically for transactions within sectors
and within the household and the corporate sector.

Capital Supply : the household’s saving decision We assume that :

• the representative consumer has an income both in the current ( 𝒚) and future period ( 𝒚′). Moreover, the
household pays lump – sum taxes ( 𝒕) both in the current and future period ( 𝒕′);
• 𝒚 − 𝒕 and 𝒚′ − 𝒕′ represent the endowment of goods, captured by the endowment point E, which the
household allocates (it represents the household’s disposable income) in a utility maximizing way into
consumption in the current and future period. This allocation automatically implies a utility maximizing
saving decision.
• the capital market is perfect and, therefore, the representative household can save (=lend) and borrow
at the same real rate of interest
• borrowing and lending are constrained by the lifetime budget constraint. Consequently, we rule out
“overborrowing” by households and firms (debt crises are typically not captured by the model).
The household’s budget constraint in the current period is given by: 𝒚 − 𝒕 = 𝒄 + 𝒔, with c = current period
consumption and s = savings in the current period. Saving (s ) implies that the household does not consume all
goods the firm produces in the current period, but it rather offer these goods to the firm for expanding its own
capital stock (saving for the household means investing for the firm). If 𝒔 > 𝟎, this implies that the household is a
supplier (lender) on the capital market. By contrast, if 𝒔 < 𝟎, the household is a borrower on the capital market
and asks the firm to reduce the given capital stock in order to allow for a higher level of consumption than
income in the current period.

BOX: SAVING AND SAVINGS

Saving is a flow variable and indicates the difference between income and expenditures in a given period.
Savings is a stock variable and is the amount of money and other financial assets held at a given point in time.
Other ways to indicate savings refer to the net financial wealth or the net worth of the single household.

→ in the neoclassical model, savings takes place in the form of real goods only: the representative consumer
decides not to consume part of the goods that he/she produced. Savings, instead, will be equal to the capital stock.

The household’s future disposable income is given by : 𝒚′ − 𝒕′ and, in addition, the household receives the interest
and the principal on his/her savings, totalling an amount of 𝒔(𝟏 + 𝒓). If the household had negative savings, the
amount would indicate the payment of the interest and principal on the loan from the firm. Since the future period
is the final period, the household basically finishes the future period with no asset and all the future net income as
well as interest and principal on saving are consumed (if the household was a borrower s < 0, then it would repay
interest and principal on the bond and basically consume all the remaining disposable income). Accordingly, the
household’s future budget constraint will be represented as follows: 𝒚′ − 𝒕′ + 𝒔( 𝟏 + 𝒓) = 𝒄′.
We transform the two budget constraints into a single lifetime budget constraint by adding up the current budget
constraint and the present value of the future budget constraint. The equation indicating the future budget
constraint implies that:

𝑐 ′ + 𝑦 ′ + 𝑡′ 𝑐 ′ + 𝑦 ′ + 𝑡′
𝑠= →𝑐+ =𝑦−𝑡
1+𝑟 1+𝑟

By rearranging, we get:

𝒄′ 𝒚′ 𝒕′
𝒄+ =𝒚+ −𝒕−
𝟏+𝒓 𝟏+𝒓 𝟏+𝒓

In words: the present value of lifetime consumption equals the present value of lifetime income minus the present
value of lifetime taxes. This indicates that over your lifetime you are basically going to consume everything you
have at your disposal.
The lifetime budget constraint is expressed in terms of units of current consumption goods as future income and
𝟏
future taxes are discounted. Consequently, can be interpreted as the relative price of future consumption goods
𝟏+𝒓
in terms of current consumption goods. A single household can give up 1 unit of current consumption and obtain
1+r units of future consumption goods by saving for one period. The higher the real interest rate, the cheaper are
future goods (the more expensive are current goods) relative to current goods (→ the representative household
will therefore consume less in the current period and supply more labour in order to consume more in the future
– saving in current period also increases).
The present value of the lifetime disposable income represents lifetime
𝒚′ 𝒕′
wealth (we ): 𝒚 + −𝒕− and represents the quantity of
𝟏+𝒓 𝟏+𝒓
resources that the household has available to spend on consumption in
present-value terms, over the two periods. Therefrom it follows that:
𝒄′
𝒄+ = 𝒘𝒆.
𝟏+𝒓

The household’s lifetime budget constrain can be expressed in the form

of a linear equation: 𝒄′ = −(𝟏 + 𝒓)𝒄 + 𝒘𝒆(𝟏 + 𝒓). The equation helps
depicting the relationship between current and future consumption and
signals that for each unit of current consumption we need to give up
(1+r ) units of future consumption. The endowment point E represents
the point of the lifetime budget constraint where 𝒚 − 𝒕 = 𝒄 and 𝒚′ −
𝒕′ = 𝒄′ . At this point the consumer exactly consumes the amount that they
earn both in the current and future period. However, the perfect capital
market allows the household to opt for combinations of 𝒄 and 𝒄′ which differ
from E: savings is, indeed, positive to the left of E because it witnesses that
the household is actually consuming less than the amount the earn in the
current period. Conversely, if the representative household consumes to the
right of E, it means that they are consuming actually more than what they
earn:
• any point BE implies that s > 0, so that the household is a lender
because 𝒄 < 𝒚 − 𝒕;
• a consumption bundle along AE implies that the household is a
borrower and, hence, s < 0;
The household chooses s ( the level of current and future consumption c and
c’ ) to maximize lifetime utility while satisfying the lifetime budged constraint.
We study intertemporal utility maximization by assuming that more is preferred to less, a higher degree of
diversity is preferred to less and c and c’ are normal goods. Indifference curves depict intertemporal utility levels
where the household is indifferent between consumption bundles c and c’ and the marginal rate of substitution
of consumption in the current period for consumption in the future period,
𝑴𝑹𝑺𝑪,𝑪′ is minus the slope of an indifference curve (as always, the marginal
rate .of substitution is diminishing: the more the representative consumer
consumes in the current period, the less willing they will be to forego future
consumption). The desire for diversity is depicted by the convex shape of the
indifference curves and implies a desire for consumption smoothing: the
household generally dislikes extreme intertemporal consumption patters
(those with a lot of current consumption and very little future consumption of
vice versa).
The household’s optimal consumption bundle is determined by where an
indifference curve is tangent to the budget constraint. At point A, the MRS of
current consumption (equal to minus the slope of the indifference curve) is
equal to the relative price of current consumption in terms of future
consumption (1+r), which is minus the slope of the household’s lifetime
budget constraint 𝑀𝑅𝑆𝐶,𝐶′ = 1 + 𝑟.
→ why isn’t the consumer consuming at point E? Because the utility curve is flatter at this point and would
therefore be ready to give up a lot of current consumption to have only an additional amount of future
consumption.
At point A, the quantity of saving is 𝑠 = 𝑦 − 𝑡 − 𝑐 ∗ or the distance BD. Thus, the household regards it as lifetime
utility maximizing given r and his preferences to forego current consumption in the amount of BD. Accordingly,
the household lends these goods to the firm which makes use of them to increase the capital stock in the future
period. This allows the firm to produce more goods in the future period. Accordingly, the household’s future
consumption can exceed the level of future income → 𝒄′ > 𝒚′ − 𝒕′

→ the effect of changes in current-period income: when current income rises

from 𝑦1 to 𝑦2 , the optimal consumption bundle shifts from 𝐸1 to 𝐸2 (given an
unchanged level of future income). The slope of the budget constraint remains
unchanged as the real interest rate is the same. The household increases
current consumption from 𝑐1 to 𝑐2 . A rise in current income implies a rise in
current consumption.
However, also saving rises because of the household’s desire to smooth
consumption over time. This implies that the representative household does
not consumer all the increase in the present period, but they actually save
some of the increase for the future period → consequently, marginal utility of
consumption of goods (𝑦2 − 𝑐2 ) − (𝑦1 −𝑐1 ) = D − F is lower than the marginal
utility of goods 𝑐2′ − 𝑐2′ = B − F.
An increase in future income has a similar effect as the increase in current
income. The main difference is that an increase in future income leads to
smoothing backwards: the household will actually save less in the current period so that current consumption can
increase. Conversely, an increase in current income leads to smoothing forward as described above.
SAVING IN THE CURRENT PERIOD

If the households respond to a rise in income by consumption

smoothing, we should observe that aggregate consumption is
smooth relative to aggregate income as the representative
individual adjusts to income shocks by mainly changing savings. The
empirical evidence is also in line with this proposition, since
aggregate consumption has been proven to be less variable than
GDP. Nonetheless, there is an excess variability of aggregate
consumption relative to aggregate income: consumption is, indeed,
smoother than income but not as smooth as theory predicts.
Explanation for the higher variability in consumption than predicted
by the model are the following:
• the capital market is not perfect: lending and borrowing rates are not identical, but borrowing rates are
typically much higher than deposit rates. Moreover some households are credit constrained, meaning they
are unable to respond to negative income shocks by borrowing in order to smooth consumption. thus,
when confronted with an income shock, consumption falls or rises (depending on the nature of the
income) to a larger extent than predicted by the model (there is much less consumption smoothing than
predicted);
• fallacy of composition argument: when few households aim at consumption smoothing, the interest rate
remains constant. However, in a recession all households want to reduce their saving in order to smooth
consumption over time while in a boom all households want to increase their savings in order to smooth
consumption. However, if all households change their consumption/saving in order to smooth
consumption over time, the interest rate is unlikely to remain constant. If saving falls strongly in a
recession, r should rise which triggers an additional fall in consumption (and vice versa in a boom). Thus,
consumption is more volatile than predicted by the model at a given interest rate.

The income effect leads to a positive relationship between C and Y (at a

given r ) as depicted in a simple consumption function. However, the
marginal propensity to consume is not constant but declines with rising
current income as- given a fixed future income- the representative agent
responds to a rise in current income with a lower rise in consumption
than a lower level of current income (the more current income you have,
the more you will be prone to save out of consumption smoothing
reasons). By implication, there is also a positive relationship between S
and Y (at a given r ) as depicted in a simple saving function. In the case
of savings, the marginal propensity to save rises with rising current
income. This reflects consumption smoothing behaviour as with higher
current income – given a future current income – the representative
agent responds to a rise in current income with a stronger rise in saving
than at a lower level of current income.

→ changes in real interest rates: a change in real interest rate effectively

changes the relative price of future consumption goods in terms of
current consumption goods. The slope of the budget constraint – going
through E- becomes steeper (because the endowment point is the one
which is not affected by r → it is, indeed, the point where consumption
in the current period is equal to current income and the same holds for
future consumption, there is no lending or borrowing situation) : this
triggers a substitution and an income effect. Nonetheless, the direction
of the income effect depends on whether the representative household
is a lender or a borrower. For a saver, the income effect is positive
because their saving will be worth more in the future period, allowing
them to consume more in terms of consumption goods. Conversely, for a
borrower, the income effect will be negative, forcing the representative
consumer to pay an additional amount on the amount they are
borrowing.

Example Substitution Effect due to a change in interest rate 1. you hold utility constant and make the budget
constraint steeper according to increase in interest rate;
2. holding utility constant, we identify the new optimal consumption bundle given the
higher interest rate and, thus, the steeper budget constraint
3. the substitution effect causes a change in saving behaviour along the same utility
curve → the substitution effect is positive, as saving rises and current consumption
falls, since the latter has become more expensive relative to future consumption.

Income effect 1. rise in interest rate has a positive effect on income for a lender. This
is represented by a parallel shift of the budget constraint F-G until it runs trough the
endowment point E;
2. the income effect is represented by the move from D to B (saving falls from Y1-D to
Y1-A) and current consumption rises.

In the example, th eincome exactly outweights the substitution effect. Thus neither
saving nor current consumption change.

If the substitution effect is larger than the income effect, instead, when r rises, the
representative household tends to save more and consume less in the current period, thereby
providing these goods in the form of capital to the representative firm. Consequently, we
depicts an upward sloping saving function. Given that the consumption good is a malleable
good, saving increases the capital stock in the form of machinery and equipment.
Remaining under the assumption that the substitution effect is larger than the income effect,
then, an increase in real interest rate triggers a fall in the demand for current consumption
goods for each level of current income. Conversely, when there is an increase in lifetime
wealth (meaning a fall in real interest rate), there will be an increase in the demand for
current consumption goods because of the desire for consumption smoothing.

Investment demand The representative firm has a demand for investment as it produces output not only in the
current but also in the future period. It does so based on the production function 𝒀′ = 𝒛′𝑭(𝑲′, 𝑵𝒅′ ), which
represents the amount of future output the representative firm is able to produce given future total factor
productivity, as well as, future capital stock and future labour input. Investment implies that the future capital
stock, K’, rises and is determined by the intertemporal profit maximization of the firm. As a consequence, K’ is an
endogenous variable as opposed to K, which is exogenous. The future capital stock is, indeed, the sum of the given
capital stock K, which depreciates in the current period at a rate d, and investment in the current period → 𝑲′ =
(𝟏 − 𝒅)𝑲 + 𝑰. The depreciation rate d is given while investment is determined by the profit maximizing behaviour
of the representative firm. Investment implies that the profits the firm can distribute to the household in the
current period falls (𝝅) because it makes use of some goods produced for expanding the capital stock in the future:
𝝅 = 𝒀 − 𝒘𝑵 − 𝑰, whereas future profits for the firm are given by 𝝅′ = 𝒀′ − 𝒘′ 𝑵′ + (𝟏 + 𝒅)𝑲′.
Note: future profits include the capital stock available at the end of the period (𝟏 + 𝒅)𝑲′. This reflects that the firm
is a veil only: at the end of the future period, indeed, it transfers the capital stock to the representative household
allowing the household to derive utility from “consuming” the capital stock (by demanding goods in the future
period). From the perspective of financial markets as we observe them in the real world, this treatment of the
capital stock makes sense as it seems to capture that in the real world any household can sell shares/equity of
firms against money and can make use of the money to raise consumption. The problem is that in the model we
study there is neither money no other individuals to which the household can sell her shares or equity to. Thus,
the model clearly assumes that the capital stock is instantly and costlessly malleable.

→ the firm chooses a level of investment which maximizes the present value of profits to be distributed to the
𝝅′
household in the form of dividend income: 𝑽 = 𝝅 + . Like for labour demand, investment (capital demand) is
𝟏+𝒓
expanded until the marginal cost of investment MC(I) is equal to the marginal benefit of investment. The marginal
cost of investment is 1: an additional unit of current investment I reduces current profits 𝝅 by one single unit,
which reduces the present value of profits V by one unit.
The marginal benefit from investing MB(I), consists of two components:
• Y’ increases as for each unit of I, the future capital stock K’ increases. This allows the firm to raise future
output by 𝑴𝑷′𝑲 ;
• each unit of I implies that additional 1-d units of capital can be liquidated at the end of the future period
(this represents exactly what the firm can pay the household in the future period in exchange for the claim
the household has on the firm).
Consequently, one unit of additional investment in the current period implies an additional 𝑴𝑷′𝑲 + 𝟏 − 𝒅 units of
future profits 𝝅′. To compare the marginal benefits with marginal cost, future profits have to be discounted. Thus,
𝑴𝑷′ 𝑲 +𝟏−𝒅
𝑴𝑩(𝑰) = → the firm invests until MB(I) = MC(I) and consequently, the must impose: 𝑴𝑩(𝑰) =
𝟏+𝒓
𝑴𝑷′𝑲 +𝟏−𝒅
= 𝟏.
𝟏+𝒓
We can rewrite the optimal investment rule as follows: 𝑴𝑷′𝑲 − 𝒅 = 𝒓 (marginal product of capital must equal the
interest rate). The optimal investment rule indicates that changes in r lead to adjustments in the future capital
stock K’ the firm aims at producing with:
• if r rises, it is profit maximizing to choose a smaller K’ , so as to increase
𝑴𝑷′𝑲 ;
• if r falls, it is profit maximizing to choose a larger K’, so s to reduce
𝑴𝑷′𝑲
Since K’ is unavoidably liked to I, there is a negative relationship between I and
r , given K. therefrom it follows, that an investment curve is downward sloping
in and r – I space (as a matter of fact, an increase in r causes the firm to opt for
a lower future capital in order to increase the marginal product of labour:
consequently, the increase in interest rate kind of forces you to keep a lower
capital stock in order to achieve a condition of profit maximization).
The optimal investment schedule shifts due to any factor that changes the future
marginal product of labour:
• the optimal investment schedule shifts to the right if future total factor productivity z’ increases (an
increase in total factor productivity in the future period affects investment and not labour demand as it
was for an increase in the current period;
• the optimal investment schedule shifts to the left if the current capital stock K is higher

The Capital Market The capital market equilibrates, then, capital supply in
the form of saving and capital demand (in the form of investment required by
the firm). As we suggested, investment by the firms corresponds to savings
on behalf of the representative household: S implies that the representative
household foregoes current output in order to give it to the firm, which
demands current output for investment. I depends on r only, whereas S
depends on both r and Y, due to the principles of consumption smoothing.
At point I*, S*-r* the representative household exchanges goods into claims
on the representative firm for providing the household with (1+r )S goods in
the future period. Vice versa, the representative firm issues a financial
liability which involves the payment of (1+r )S goods in the future period.

Combining Labour and Capital Market via the rate of interest In the one period model, labour supply increases
when the real wage increases (always assuming substitution effect is larger than income effect) and real income
falls (due to a pure income effect). In the intertemporal model, instead, labour supply in the current period is also
influenced by the real interest rate, since movements in the latter can make saving in the current period more or
less profitable (intertemporal substitution of leisure effect).
𝒘( 𝟏+𝒓)
Relative price of current leisure in terms of future leisure is given by: 𝑴𝑹𝑺′𝒍′ ,𝒍 = . Thus, for the
𝒘′
representative household – as a net lender- the opportunity costs of leisure have two components: the current real
wage and the interest rate of saving as it provides additional income
and hence consumption in the future period. Thus, a rise in the
interest rate triggers a substitution effect; the consumer will opt for
more work and less leisure in the current period (given a constant
real wage w ), if the real interest rate rises. However, for a household
that is a net lender, a rise in the interest rate also increases income in
the future period. This triggers a negative income effect on labour
supply, since the rise in intertemporal income induces the consumer
to opt for more leisure (the demand for leisure increases).

➢ ASSUMPTION: the substitution effect is larger than the

income effect

As a result, a rise in the rate of interest shifts the labour supply curve
to the right and the positioning of the labour supply curve in the N-w
space also depends on the real interest rate. In the same way, an increase in lifetime wealth (which is given by a
decrease in the real interest rate) shifts the labour supply cure to the left from 𝑁 𝑆 (𝑟1) to 𝑁 𝑆 (𝑟2), since the
representative household will intuitively want more leisure today.

SESSION 3 –THE NEOCLASSICAL MODEL: A REAL INTERTEMPORAL MODEL WITH INVESTMENT

The Output Supply Curve When the real interest rate rises, labour supply increases due to the intertemporal
substitution of leisure. Consequently, at a wage level 𝒘𝟏 , a situation of excess labour supply is witnessed given the
increase in the real interest rate, which triggers a necessary fall in the real wage to the point 𝒘𝟐 . As a consequence,
labour demand rises (movement along the labour demand curve to adapt to the new wage) and employment rises
from 𝑁 1 to 𝑁 2 . With employment rising, more output can be produced at the given production function. As a
consequence, also aggregate supply curve signals the increase in a Y-r space.

An increase in government spending, instead, increases the present value of taxes. As a consequence, the lifetime
wealth of the consumer falls. The supply of labour at this point rises (and leisure demand falls) due to a negative
income effect: the labour supply curve shifts to the right. This creates once again a situation of excess supply given
the previously established real wage 𝒘𝟏 ; this brings about a fall in the real wage 𝒘𝟏 → 𝒘𝟐 in order to restore the
labour market to its equilibrium and establish a higher employment 𝑁 2 . With more employment also more output
can be produced and, consequently, the output supply curve shifts to the right, granting a new and higher level of
output 𝑌 2 . An increase in government spending, then, also increases output supply, given a constant interest rate.
An increase in current TFP (z) shifts the labour demand curve 𝑁 𝑑 to the right as it creates a disequilibrium
betweeen 𝑴𝑷𝑵 and 𝒘𝟏 . As a conseqeunce, at 𝒘𝟏 , there is excess demand for labour. As a result, the real wage rises
to 𝒘𝟐 and labour supply increases (movement along the given labour supply curve). Employment rises from 𝑵𝟏 to
𝑵𝟐 and hence output, also benefitting from the increase in total factor productivity z (outward shift of the
production function). As a consequence, the output supply curve shifts to the right (𝒀𝟏 → 𝒀𝟐 ). Also in this case, at
the same level of the interest rate, more output is supplied.

The Output Demand Curve Components of output demand include the demand for
goods of both the private and public sector:
• private sector demand: 𝑪 = 𝑪𝒅 (𝒀, 𝒓), 𝑰 = 𝑰𝒅 (𝒓)
• public sector demand: 𝑮 = 𝑮𝒆𝒙
Of those components, C depends on income (due to consumption smoothing
reasons), but also on r ; differently, the other components of demand, I and G , do
not depend on income. For this reason, they are just added on the consumption
function: 𝒀𝒅 = 𝑪𝒅 (𝒓) + 𝑰𝒅 (𝒓) + 𝑮.
The output demand curve is concave in the 𝒀𝒅 − 𝒀 space and the slope is
represented by the marginal propensity to consume (MPC). The positioning of the
curve depends on r , since a rise in r negatively impacts C and I for any given level
of Y, as well as, on exogenous government spending.

Output demand by the representative household and firm, as well as, by the
government has to be identical to income, which is the amount of goods the
representative firm produces by employing labour and capital. This is because
the representative household will never produce more than the goods it
demands as both pure consumption goods and investment goods (together with
the representative firm which is owned by the representative household itself).
As a matter of fact, production of goods involves time at work, which is utility
maximizing to spend for leisure. The equilibrium situation is depicted by a 45°
degree line in the 𝒀𝒅 − 𝒀 space. On this line, demand for current goods 𝑪𝒅 ( 𝒓) +
𝑰𝒅 (𝒓) + 𝑮 is equal to income. For each level of r, there is only one level of
demand where the equilibrium condition holds (bundle 𝒓𝟏 , 𝒀𝟏 ). If the interest
rate rises to a level of 𝒓𝟐 , the demand for goods falls for each level of output Y, as
consumption and investment are both negatively impacted by the rise in r. As a
consequence, demand falls, which implies that at 𝒀𝟏 income is larger than the
output demanded. Hence, income has to fall to 𝒀𝟐 in order to restore the
equilibrium. Combining for each level of r, the equilibrium level of demand and
income leads to the output demand curve which is downward sloping in a Y – r
space.
The Complete Real Intertemporal Model We start from a situation of perfect equilibrium both in the labour and
the capital market:

→ an increase in current TFP: an increase in current total factor productivity causes the marginal product of labour
to rise( 𝑧 ↑ → 𝑀𝑃𝑁 ↑). At this point, 𝑀𝑃𝑁 results in being greater than the equilibrium wage 𝑀𝑃𝑁 > 𝑤 ∗ and this
causes the labour demand function to rise (shifts rightward), now demanding more labour given the previous
equilibrium wage. Once the labour demand shifts, nonetheless, we find ourselves in a situation of excess labour
demand, where 𝑁𝑑 > 𝑁𝑆 . This situation forces the firm to higher the wages in order to attract more labour, and
therefore the equilibrium wage increases from 𝑤1 to 𝑤2 . The increase in wage causes a shift in the labour supply
curve and forces the representative consumer to supply more labour (since current leisure has now become more
expensive relative to labour). Total employment, as a result, rises and consequently also more output is produced.
The increase in output supply leads to a situation of excess output supply with respect to output demand, which
triggers a rise in saving for reasons of consumption smoothing. The increase in S causes a situation of excess saving
at the current interest rate r , for which S > I. In order to reach clearing of the market and ensure equilibrium,
output demand rises, since both investment and consumption must rise. At the same time, though, on the labour
market, labour supply falls due to the intertemporal substitution of leisure (the 𝑁𝑆 curve shifts left)

→ the effect of an expansionary fiscal policy (increase in government spending): when the government undertakes
an expansionary fiscal policy, the increase in taxes and government spending has two kinds of effect on the
intertemporal model. The direct effects of an expansionary policy reflect on the labour market: first of all, indeed,
an increase in government spending increases the present value of taxes and hence lifetime wealth of the
representative consumer falls. This first modification of the equilibrium condition causes a negative income effect
both on leisure and on consumption, since the representative individual consumer will be brought to consume less
leisure and therefore supply more labour. As a result, the output supply curve shifts to the right. As a consequence,
the increase in consumption relative to leisure raises aggregate demand for output: the government, indeed, is
asking for a larger portion of goods which the household and the firm were previously enjoying; this leads to a
situation in which both the household and the firm will be demanding more to offset the additional amount of
goods they need to give to the government in the form of taxes. For a moment, then, we have a situation of excess
demand for output, since both investment and consumption result in being higher than saving. This leads to a raise
in interest rates if the direct aggregate demand effect is larger than the effect on aggregate supply.
As an indirect effect, the rise in interest rate caused by the movements in the capital market has two fundamental
implications. First of all, it leads to crowding out of both investment and consumption choices performed by the
representative firm and household (causing them to fall). Secondly, labour supply shifts further to the right as the
higher interest rates make it more attractive to supply current labour (intertemporal substitution of labour effect).

Total effect of expansionary fiscal policy:

• output rises
• lower consumption, lower investment (→ lower future capital stock)
• less leisure
• lower real wage

→ negative demand shock: a negative demand stock can be represented by an exogenous fall in investment.
Following such a shock, the output demand curve will shift to the left and r will decline. As a matter of fact, the
shock will create a situation of excess supply, since at this point savings will be exceeding investment at the initial
interest rate. In order to discourage the representative household to consume, interest rate falls, thereby causing
a reduction in saving. With r falling, output demand will rise (movement along the new curve), thereby causing
investment to rise a bit (still remaining below its initial level) and consumption rises.
On the labour market side, the fall in r brings about a leftward shift of the labour supply curve, which leads to a
higher equilibrium real wage and to lower labour demand. Lower labour demand implies a reduction in output on
the supply side, which will restore equilibrium.

SUMMARIZING: INVESTMENT, OUTPUT AND INTEREST RATE FALL, WAGES AND CONSUMPTION RISE
The effects of a negative demand shock within the neoclassical model do not match the stylized facts of the
business cycle. As a matter of fact, the stylized facts indicate that Y, C and I comove (which is not the case as proved
by the example). In addition, the real wage behaves either a-cyclical or mildly pro-cyclical, but never counter-
cyclical.

SESSION 4 – THE MONEY MARKET AND THE COMPLETE NEOCLASSICAL MODEL

Money Demand History reveals that people used certain commodities as money – namely commodities which
were usually rare and sought after resources, such as gold, salt, furs,…Overtime, metals and precious metals, such
as copper, silver and gold, replaced other goods as money and
this can be interpreted as a way that within the private sector
certain commodities and metals evolved as money in order to
reduce “double coincidence of wants” in a monetary economy
facilitating the exchange of goods. In a barter economy, as the
one described by the neoclassical model, exchange, of course,
also depends on a double coincidence of wants. If this
prerequisite is not given, no exchanges can take place despite
all types being eager to exchange the goods they produce.
Using a commodity as money, reduces the needs for the double
coincidence of wants to a single coincidence of wants problem,
since money can be exchanged by one of the two parties with
whatever other good this party wants and needs. By doing so,
money basically facilitates the exchange. When the commodity
money turns into fiat money, then it is possible to do exchanges without making use of a commodity as money. As
money is demanded as a mean of payment, money demand depends strictly on the amount of transactions to be
conducted. As this amount correlates with the amount of nominal income (higher income households conduct
𝑀 𝑑
more transactions) the money demand can be expressed as: 𝑀𝑑 = 𝑘𝑃𝑌 → ( ) = 𝑘𝑌, where the fraction M/P
𝑃
indicates real money supply or real balances. k also represents a fixed parameter determined by institutional
features of a country’s payments system and by the payment habits of agents. When k remains constant, the
demand for nominal money is proportional to nominal income, and with real income, Y, fixed, demand is
proportional to P, meaning to the current price level. With a constant k, real money balances demand are
proportional to real GDP.

EMPIRICAL EVIDENCE: k IS NEVER CONSTANT

Rearranging the money demand equation, and with the velocity of money, v, being set as v = 1/k, we get the
quantity equation → Mv = PY. Evidence, nonetheless, suggests that the velocity of money fluctuates.

Empirically, then, the rate of interest is significant in explaining the demand for money: people demand (hold) less
money when the nominal interest rate rises, and they demand (hold) more money when the interest rate drops.
With demand being influenced by the interest rate, it cannot be derived from the means of payment function only.
Money demand has also to account for the store of value function. Thus, money has to be seen as an asset,
competing with other assets such as a machinery and equipment: money is a “temporary abode of purchasing
power” and is not immediately spent after it has been received. The demand for this asset depends on how well or
how poorly money is able to perform the function of a store of value compared to other assets. In a situation of
hyperinflation, money is not considered as an asset anymore and the demand for money approaches zero.
Introducing the rate of interest as a determinant of the demand for money is a challenge within the neoclassical
model. As a matter of fact, the real interest rate can be described as the price which clears the capital and output
market in the neoclassical model (note that money is not part of the real intertemporal model). In addition to this,
if money is neutral, it cannot be an asset comparable to the machinery and equipment (capital stock) needed by
the firm. Indeed, fiat money is nothing but “pieces of paper that are essentially worthless in that, for instance, most
people do not value US Federal Reserve notes for their colour or for the pictures of them.
The Baumol – Tobin Model meets the challenges of squaring the needs of depicting money as an asset, but still
focusing on the means of payment function and, hence, staying in line with the money neutrality postulate. It does
so by depicting money as an asset, but as a very special asset, namely one with a return of zero. This implies that,
if money were not needed to conduct transactions, than agents would not hold money as it has an opportunity
cost: foregone interest income. The value of money as an asset, then, depends on the belief that others will accept
this money in exchange for goods in the future.
Fundamental assumptions of the Baumol/Tobin Model:
• agents need money to engage in transactions, i.e. there is a cash-in-
advance constraint;
• exchanging other assets against money has a cost, which materializes
in terms of fees, time needed to exchange other assets into money,…
Under these assumptions, the Baumol/Tobin model demonstrates that agents
increase money demand when the interest rate falls, because the opportunity
cost of holding money falls. By contrast, agents hold less money when interest
rates rise in order to minimize the costs associated with the use of money as
means of payment. Money demand is negatively linked to the interest rates.
The Neoclassical Model embraces these ideas when specifying the money
demand function. In line with the transaction function, money demand rises
when P rises. As a consequence, money demand can be depicted by an upward
sloping line in a P-M space. Moreover, the discussion also suggests that money
demand rises when real income rises and money demand falls when the real
interest rate rises. Y and r are shift parameters of the curve, but they are not
determined by monetary factors → money neutrality prevails.

Money supply Money supply is exogenously set and determined by the central
bank. They are, therefore, called central bank money/ base money/ monetary
base (B) and they are equal to cash (C) + reserves (R) held by banks at the central
bank: B = C + R. Consequently, commercial bank money is equal to demand
deposits by the firms (D) → money supply by central and commercial banks are
known as monetary aggregate M1= C+D.

Other money aggregates

M2 = M1 + deposits redeemable at notice up to three months + deposits with an agreed maturity up to 2 years
M3 = M2 + marketable instruments issued by bank- repurchase agreement – money market fund shares/unit and
money market paper - debt securities with a maturity up to two years

The money multiplier depicts the relationship between central bank money and the money supply (monetary
𝑀
aggregates): 𝑚 = . The money multiplier can be derived in a simple setting which is based on the following
𝑃
assumptions:
• the central bank issues base money by crediting domestic banks
• closed economy (no foreign claims and liabilities)
• banks offer only current account deposits (sight deposits) which implies that we can define M1 as money.
From a simplified central bank balance sheet, we can then derive that: B = Cr (from the central bank to domestic
banks) = C+R

The monetary base (B) of the money multiplier is then derived by the sum: B = C + R. The non- bank private sector
wants to hold a specific percentage of money in cash ( b = cash holding ratio of non- bank institutions ): C = b*M.
Commercial banks have to hold minimum reserves (R) at the central bank depending on the minimum reserve
ratio (r): R = r * D. Therefrom it follows that B = b * M + r * D and since D = M – C, the monetary base is given by:
B = b * M + r ( M-b M) = M [b + r (1-b )]. The money multiplier can, then, be expressed as:

𝑀 1
=
𝐵 𝑏 + 𝑟(1 − 𝑏)

The money multiplier rises when b and r drop and vice versa.

The money multiplier and the exogeneity of money are related in the sense that the central bank exogenously
supplies the amount of base money in the form of reserves and as the amount of reserves places a limit to the
ability of commercial banks to create deposits, the money supply is also exogeneous as depicted in the neoclassical
model. The money multiplier is consequently volatile and indicates that it does not represent a stable link between
the monetary base and the money supply in the sense that a rise in the monetary base by x % mechanically causes
a rise in the money supply by x%.

Money Market The money market is cleared by changes in P, meaning by

changes in the price level. As an increase in the money supply leads to a
disequilibrium between the money demand and the money supply, there
is a momentaneous situation of excess supply of money. Agents hold “too
much money” in the sense they do not demand the money supplied. Since
money is primarily seen as a mean of payment, people actually respond
by trying to purchase more goods and services. Nonetheless, the amount
of goods totally purchased (and supplied) actually remains unchanged
and, thus, P rises. When P rises, money demand also rises and we move
from a situation of disequilibrium to a new equilibrium but with higher
price level.
In addition to this, when real income is rising (i.e. as a consequence of positive TFP shock), then people demand
more money and the money demand curve turns to the right (it basically rotates clockwise with respect to the
origin. When the bank does not respond with more money supply, then the price level actually falls since people
want to hold more money than the central bank provides and they spend less money on goods. An increase in real
interest rate leads to a rise in the price level.
Usually, sight deposits (D) issued by commercial banks are considered to be
a perfect substitute for cash (M1 monetary aggregates are equal to C+D).
However, in times of turmoil, current accounts held at some banks stop
being perceived as a perfect substitute for cash. As a consequence, people
will demand more money in the sense that they will actually take their
money out of the bank and require cash. A bank run represents exactly an
autonomous rise in money demand. This exogenous increase in money
demand leads inevitably to a fall in the price level. Therefrom we derive that
a shift factor for the money demand can be the desire for liquidity of
households, which will most likely be followed by a scenario of recession.
The objective of modern monetary policy is to keep prices stable. To do
this, two principles must be taken into account: price level itself is basically a-cyclical, whereas money stock is
intrinsically pro-cyclical, meaning that when income is rising, money demand is also increasing, which at the
original money supply will imply a decrease in prices. In order to respect the price-stability mandate, money
supply becomes procyclical (the central bank will increase money demand as soon as income rises and
consequently money demand rises).

The Complete Neoclassical Model

CLASSICAL DICHOTOMY

The classical dichotomy signals the fact that anything what happens on the money market has no implication on
what happens to the real market. Conversely, everything what happens on the real market has an implication on
whatever happens to the money market.
→ a rise in money supply: with the introduction of the concept of the neutrality of money, money are no longer
seen as consumption goods, but rather as the real numeraire of the model economy (all prices are expressed in
money). Nonetheless, it is a widely accepted position in the economic profession that, in the long run, i.e. after all
adjustments in the economy have worked through, a change in the quantity of money in the economy (all other
things being equal) will be reflected in a change in the general level of prices and will not induce permanent
changes in real variables such as real output or unemployment. A change in the quantity of money in circulation
ultimately represents a change in the unit of account (and thereby of the general price level) which leaves all other
variables unchanged. So the principle of the neutrality of money also holds when there are autonomous shifts in
the money demand and shocks to money demand are not a source of business cycle fluctuations in the neoclassical
model.

→ a persistent increase in total factor productivity (TFP): a persistent increase in TFP implies and increase in both
current and future TFP. As we have seen in the previous example, an increase in current z creates a disequilibrium
between 𝑀𝑃𝑁 at the current wage w. As a matter of fact, at the current wage, there is an excess demand for labour
(rightward shift of the 𝑁 𝑑 curve). Excess demand leads to a rise in w which triggers higher labour supply along
the given 𝑁 𝑆 (𝑟1 )- curve: employment rises. Rise in employment shifts the aggregate supply curve to the right,
which everything else equal leads to an excess supply on the output market. This would lead to a decline in the
real interest rate, stimulating C and I, and hence to a new equilibrium on the goods market (movement along the
𝑌 𝐷 -curve). However, there is also an increase in z’ , which must be taken into account (i.e. an increase in future
TFP). This triggers a parallel rightward shift in the output demand curve. The net effect on the market clearing
interest rate depends on the relative strengths of the aggregate supply and the aggregate demand shift. Here:
aggregate demand curve shift is more pronounced than the aggregate demand curve shift. Thus, the interest rate
falls.
The fall in r and the increase in Y leads unambiguously to a rise in money demand. With a constant money supply,
this creates an excess demand on the money market given P. excess demand on the money market is counteracted
by a fall in P and the decline in r leads to a leftward shift of the labour supply curve as households reduce their
labour supply at a given wage rate due to an intertemporal leisure substitution effect. Overall this means that a
persistent increase TFP, a rise in z and z’, leads to: a rise in employment at a higher real wage; a rise in output at
lower interest rate and a fall in the price level (inflation).

Comparison with stylized facts of the business cycle

• consumption, investment, hours worked and employment are strongly correlated with output and also
among each other → YES
• productivity is procyclical → YES
• real wage is only weakly correlated with GDP → NOT REALLY
• real interest rate (YES) and price level (NO, but in the real world monetary policy follows price stability
mandate which ensures a-cyclicality) are basically a-cyclical

Business cycles are fundamentally triggered by exogenous TFP shocks, i.e. technology shocks and changes in the
relative prices on energy (oil price shocks), to which agents respond optimally in a utility and profit maximizing
way. Confronted with a negative TFP shock, employment declines occur because agents reduce their supply of
labour following their preferences, i.e. their labour-leisure choice, given the changes in w and r. Thus,
(un)employment always reflects agents’ decisions of how to use their time: the labour market always clear after
being hit by TFP shocks. Unemployment is always voluntary. As market always clear and money is neutral there
is no need to assess the effects of demand and monetary shocks as well as the potential of fiscal or monetary
stabilization policies.
Real and nominal variables With the introduction of money, the need arises to distinguish between real and
nominal variables, i.e. between real and nominal GDP, the real and nominal wage, the real and the nominal interest
rate. In general, nominal variables are defined as real variables multiplied by the price level (nominal GDP = PY
and nominal wage = Pw). Money neutrality implies that the real variables are unaffected by changes in the money
supply and hence by changes in P, since – everything else equal-P changes when the money supply changes:
• Y (determined by labour and capital market)*P(determined by monetary policy) → nominal GDP
• w (determined in the labour market)*P(determined by monetary policy) → nominal wage
When distinguishing between the real and the nominal interest rate ( i ), we have to account for the fact that the
interest rate is an intertemporal price, i.e. the real interest rate (r ) expresses how many goods in the future can
be bought with one good in the current period. Hence, when transforming the real into the nominal interest rate,
the change between the current price level P and the future price level P’, i.e. the inflation rate (𝜋 = (𝑃′ − 𝑃)/𝑃)
becomes relevant → 𝒊 = 𝒓 + 𝝅 + 𝝅 ∗ 𝒓. Since for small real interest rates and inflation the product, 𝜋 ∗ 𝑟 is very
small, real interest rate can be expressed in the following way: 𝑖 = 𝑟 + 𝜋. Again, money neutrality implies that the
real interest rate is unaffected by changes in the money supply and hence by changes in P, as- everything else
equal- P changes when the money supply changes.
PART 2 – KEYNESIAN MACROECONOMICS

SESSION 5 – STICKY WAGES, AGGREGATE SUPPLY AND IS/LM CURVES

The IS/LM model is a model without micro-foundations and hence is subject to the Lucas critique. In the early
1980s the new Keynesian macroeconomics emerged, which can be interpreted as an effort to combine the
methodological tools developed by the real business cycle theory with some of the general tenets of Keynesian
economics, tracing back to Keynes’ own General theory, published in 1936. A key element of Keynesian economics
is seen in the assumptions that nominal wages/prices are sticky. Thus, New Keynesian macroeconomics is in
essence a neoclassical model with sticky nominal wages/prices.
The New Keynesian macroeconomics is Keynesian in the sense that:
a) the model is able to derive the IS/LM curve as well as the AD/AS curve, which looks familiar to the non-
micro-founded models usually presented;
b) derived Keynesian outcomes, notably involuntary (Keynesian) unemployment.
However, it can be also argued that “New Keynesian economics has little to do with traditional Keynesian models
and it is rather an RBC (real business cycle) model with sticky prices and wages”.

The Labour Market and the aggregate Supply Curve with sticky nominal wages According to the stickiness of
wages principle introduced by Keynesian macroeconomics, the real wage ( w ) is equal to the nominal wage (W)
divided by the price level (P): w = W/P. In the short run, the nominal wage W is imperfectly flexible due to
institutional rigidities. For instance, it is costly to get workers and firms together frequently to negotiate wage
arrangements, so that wages are typically set at a given firm for one year or more. This is in line with empirical
evidence showing that nominal changes are rare (probability of a change
from one quarter to the next quarter at about 25%). Moreover, there is
substantial evidence of downward nominal wage rigidity in micro data.
During the period of sticky nominal wages, shocks can lead to situations
where the actual real wage is higher than the market clearing real wage and
the labour market does not adjust (Example : negative shock to z which
shifts the labour demand curve to the left). The actual real wage w*
(=W/P) is greater than the market clearing real wage 𝒘𝑴𝑪 . This implies the
presence of a situation of excess supply of labour which causes more people
to supply labour than actually demanded by the representative firm. At this
real wage we have a situation of unvoluntary employment. Indeed, at the
real wage w* employment is determined by the representative firm’s
demand for labour which is N*. However, the representative consumer wants to supply N** units of labour at the
real wage w *. The difference N**-N* is Keynesian unemployment: workers cannot work as much as they would
like at the going wage. The quantity of labour is determined, then, by the labour demand curve only. Because of
the stickiness of wages, then, labour supply does not play a role at all in determining the quantity of labour.
The aggregate supply curve reacts accordingly to what happens on the labour market. With a fixed nominal wage,
the real wage can only be changed by changes in P. Since w = W/P, an increase in the price level from 𝑃1 → 𝑃2 ,
reduces the real wage at W = 𝑊𝑓𝑖𝑥𝑒𝑑 . With a lower w, labour demand and employment rise (movement along the
labour demand curve) and as firms employ more labour, more output can and is produced at the given production
function. Employment and output thus depend on P (nominal variables matter). The AS curve is, thus, upward
sloping in the P-Y space.

Factors shifting the sticky wage aggregate supply curve:

• an increase in the nominal wage W shifts the labour demand and the aggregate supply curve to the left
 • current TFP shocks continue to shift the labour demand and the aggregate supply curve (the latter also
via the production function (for instance, a negative shock to current TFP shifts the 𝑁 𝐷 curve and the AS
curve to the left;

Hierarchy of markets Sticky wages and the upward sloping

aggregate supply curve in the P-Y space imply that the labour
market needs help from the capital and the money market in
order to ensure equilibrium between labour demand and supply.

Deriving aggregate Demand Curve from the IS and LM curve Given that the aggregate supply curve has been
depicted in the Y-P space, we have to derive the aggregate demand curve in the Y-P space, as well. To this end, we
analyse equilibrium conditions between saving and investment as well as been money demand and money supply.
IS stands for Investment (I)-Saving (S) and we derive the IS curve which depicts all combinations for the real
interest rate (r ) and the real income (Y) where I = S. L stands for liquidity (money demand) and M for the money
supply, and we derive the LM curve which depicts all combinations of the real interest rate and real income where
L=M.
In the sticky wage model, saving and investment continue to represent the
outcome of utility and profit maximizing decisions by the representative
individual under an intertemporal budget constraint. We know that S
responds positively to a rise in the interest rate (substitution effect) and rise
in income (consumption smoothing). Investment also depends negatively on
the rate of interest. The IS curve is supposed to depict all combinations of r
and Y where I=S. The latter is downward sloping in the r-Y space. Let us start
from any combination of r and Y where S=I. When output rises, the
consumption smoothing effect implies that S rises and we find ourselves
consequently at B, where saving is greater than investment (situation of
excess saving) and this cannot represent an equilibrium. In order to return
to equilibrium at the higher level of Y, r has to fall, which leads to a rise in
investment and a fall in saving, i.e. excess saving falls. At point D, one returns
to a phase where I=S. Thus, the IS curve in the sticky wage model is identical
to the 𝑌 𝐷 curve in the neoclassical model, which we derived from the
equilibrium condition that the amount of goods demanded (C,I,G) has to be
equal to income. This condition is nothing else than saying that S=I.
The IS curve shifts to the right when there is:
• an increase in current government purchases G because, at the same level of the interest rate, there is
more demand (in form of government expenditures). Therefrom it follows that, in order to ensure
equilibrium, either private expenditures have to fall (which requires a rise in the interest rate) or saving
has to rise which requires a rise in income or a combination of both;
• a decrease in the present value of taxes because at the given level of the interest rate there is a rise in
demand by households in the form of more consumption, i.e. a fall in saving;
• a positive future TFP shock as it triggers as rise in I at the given level of interest rate.
The analysis of the Keynesian money market (LM curve) starts out with the
assumption that the price level is fixed. This implies that the price level can
actually not clear the money market as it is the case in the neoclassical
economics. Money demand continues to depend positively on real income
and the price level, and negatively on the real interest rate for the reasons
we discussed in the neoclassical model. Money supply is set exogenously by
the central bank. Given that the price level P is fixed, the money demand
function is now depicted in an r-M diagram. And since money demand rises
when r falls (the opportunity costs of holding money falls), the money
demand curve is downward sloping. The exogenous money supply is
represented by a vertical line in the r-M space and for any given level of
money supply there is one real interest rate which is able to clear the market.
Usually, when money supply increases (shifts to the right), then the interest
rate drops in order to ensure money market equilibrium: as a matter of fact, if money supply increased and the
interest rate r remained constant, then a single individual will have too much money. In order to spend them,
he/she will buy more assets, thereby causing the assets’ price to increase and the yield to decrease. Therefrom it
follows that the fall in interest rate is caused by a situation of excess supply of money, which justifies an increase
in asset buying of the whole population. Since by changing the money supply, the central bank changes the real
interest rate, we can conclude that in the Keynesian model money stops being neutral. The real interest rate drops
as- in contrast to the neoclassical model- agents do not spend the excess money in the goods market, leading to a
rise in the price level (which would trigger a rise in the money demand) but turn to the capital market where
money competes with other assets as a store of value. Note that this capital market is the “real world” capital
market, where financial assets are exchanged against money. It is not the capital market of the neoclassical model
where the representative consumer offers good to the representative firm in order to increase the capital stock.
Thus, in the Keynesian money market, the function of money as a store of value dominates when being confronted
with disequilibrium conditions: at the initial interest rate, agents do not want to hold the increased money supply
and substitute money with other stores of value. As agents purchase bonds and other financial assets, prices of
those assets and yields (the interest rate) declines. As the price level is assumed to be fixed, this is a decline in the

real interest rate. Nonetheless, when the real interest rate falls, money demand rises. Thus, adjustment process
stops when the interest rate has fallen to a level at which agents are willing to hold the larger money supply
provided by the central bank.

In the Keynesian model, money demand continues to be

positively related to Y due to the means of payment function.
Thus, Y acts as a shift parameter of the money demand
function. When Y rises from 𝑌1 → 𝑌2 , the money demand
curve shifts to the right: at the same interest rate, agents want
to hold more money. At a constant money supply, the real
interest rate has to rise in order to clear the money market.
Thus, for a given price level P, we can establish output-
interest rate pairs for which the money market is in
equilibrium. Connecting each point representing such an
output-interest rate pair leads to the LM curve.
The LM curve is upward sloping because, given the real money supply M/P, real money demand increases when
income increases (L> M) at point B. thus, for the money market to return to equilibrium, the real interest rate
must rise to reduce real money demand until L=M at point C. Any interest rate-output combination which is not
on the LM curve represents a disequilibrium on the money market which triggers an adjustment.
If P increases, the LM curve shifts to the left: as a matter of fact, if the price level falls, the real wage will fall in real
term and more people will be getting unemployed (meaning also less output is produced). Money demand is rising
at the same level of income and a situation of excess demand for money is created. Interest rates will go down and
restore equilibrium, thereby allowing the real income level not to change since the same output is now associated
with a higher interest rate.
Instead, if there is an autonomous rise in money demand (caused by a bank run or a situation of general distress),
the LM curve shifts to the left. Finally, if money supply M increases, then also the LM curve shifts to the right
(expansionary policy → shift to the left; restrictive monetary policy → shift to the right).
SESSION 6- AGGREGATE DEMAND AND THE COMPLETE MODEL

Deriving aggregate Demand Curve from the IS and LM curve As we suggested beforehand, there is only one
combination of r-Y, for which I=S and L=M. All other combinations represent a disequilibrium point as at least
one market shows disequilibrium. We usually make use of the IS-LM diagram to derive the aggregate demand cure
of the Keynesian sticky wage model. To this end, we recall that the IS-LM diagram is constructed for a given price
level P. As a consequence, (𝑌1 , 𝑃1 ) denotes a combination of real output and the price level where the neoclassical
capital market and the money market are in equilibrium.
Suppose that the price level rises from 𝑃1 → 𝑃2 . The increase in price level causes the LM curve to shift leftward
𝐿𝑀2 , thereby signalling the fact that changes in P impact the positioning of the LM curve. As a result, the money
market and the neoclassical capital market are in equilibrium at a lower level of output 𝒀𝟐 . Thus,( 𝑌2 , 𝑃2 ) is another
output and price level combination for which I=S and L=M holds. The AD curve depicts all combinations of P and
Y, where I=S and M=L.

Shifts of the aggregate demand curve:

• if the IS curve shifts to the right, the AD curve shifts to the right. This is due to the fact that – at a given
price level P- there is an excess demand for money (situation of excess saving → I>S), but L>M. hence,
the interest rate has to rise in order to restore equilibrium. The resulting equilibrium output is 𝑌2 . The
aggregate demand curve shift can be associated with a higher level of demand being equal with income;

• if the LM-curve shifts to the right, the aggregate demand curve shifts to the right, as well, since a lower
interest rate is now associated with a higher level of demand being equal with income. The LM-curve shift
can be initiated by the central bank expanding or reducing the money supply and by autonomous shifts in
money demand. The central bank can control the price level and the inflation rate. Thus, the central banks
with a price stability mandate will adjust the real interest rate via money supply changes in a ways that
they meet their inflation target.
The complete Keynesian Sticky Wage Model In contrast to the Neoclassical model, the price level and the real
variables are jointly determined, and the money is not neutral (Keynesian interdependence). This implies that
nominal variables do have real effects!.

→ positive money demand and negative credit supply shock: a negative credit supply shock can be caused by the
fact that agents suddently do not want to hold fiancial assets in the same extent as before and consequently want
to exchange then into money. Autonomous increase in the demand for money or autonomous decline in the supply
of credit have several implications:
1) the LM curve shifts to the left (and moves from the LM to 𝐿𝑀1 );
2) the real interest rate rises, which leads to a fall in C and I, i.e. a fall in aggregate demand (leftward shift of
the AD curve)
3) the price level falls, the real wage rises and employment and output fall
In line with the stylized facts of the business cycle, then, output, consumption, investment and employment co-
move. In addition, in keeping with the evidence provided by the Great Depression, also the price level is
fundamentally also co-moving with the just-cited variables. With the fall in P, moreover, the LM-curve shifts
somewhat tot the right and the rise in r is associated with a rightward shift of the labour supply curve due to the
intertemporal substitution of leisure effect.

→ increase in money supply: an increase in the money supply has real effects as it leads to al fall in the real interest
rate. As far as the goods market is concerned, investment, consumption, AD, output and price level are stabilized,
thereby being in line with the central bank mandate. In the labour market, w does not rise (the wage is sticky) and
employment is stabilized. Keynesians think of monetary policy as having these real effects through the so-called
Keynesian transmission mechanism for monetary policy: thanks to the increase in the supply for monetary policy,
interest rates fall, thereby boosting both investment and consumption. The AD – curve, hence, shifts to the right,
causing the price level to increase. The nominal wage will fall, causing employment to rise and, as a consequence,
also output to increase. Nonetheless, if monetary policy immediately adjusts the monetary supply to keep the real
interest rate constant, it can avoid a decline in P, keeping r at its natural rate level – a level consistent with price
stability.
→ negative demand shock: a negative demand shock can be represented by a sudden willingness on behalf of
households to save more and consequently increase their demand for future consumption.
the implications of such a shock happening are the following:
1) the IS curve shifts to the left which leads to a leftward shift of the AD curve, a fall in P, a rise in w and a
decline in N;
2) the fall in P and r shift the LM curve somewhat to the right and the labour supply curve to the left.
As it already was for the Neoclassical model, the model implications of a negative demand shock are inconsistent
with the stylized facts of the business cycle. C and I, indeed, do not co-move, as I rises with a decline in the real
interest rate. Expansionary monetary policy, by lowering the real interest rate further, can restore aggregate
demand, the price level, the real wage, employment and output.

→ fiscal policy: increase in government expenditure: the maintenance of price stability and full employment can
also be achieved through an increase in government expenditures G (expansionary fiscal policy). With the increase
in G, the natural and the actual rate of interest rise gain. The increase in the real interest rate causes investment
and consumption to fall (compared with the situation before the policy intervention but after the shock). That is,
there is a situation of crowding out of private expenditures by the government expenditure. Moreover, the labour
supply curve shifts to the right because a rising interest rate raises the attractiveness of current work relative to
current leisure.
→ inflation and unemployment (stagflation) in the sticky wage model: policy challenges arising from a negative
shock in the current TFP: negative shock to current TFP can be caused by many factors, such as a raise in oil prices
and other raw materials or by breakup in the supply chain. A fall in current TFP causes a shift of the labour demand
curve and of the aggregate supply curve. A decrease in total factor productivity, indeed, forces the firm to demand
less labour and consequently produce less output. At the given nominal wage (W/P)= w , this causes a fall in
employment. Moreover, at P* there is now a disequilibrium with AD > AS, which causes a general rise in the price
level. When P rises, the LM curve shifts to the left (from LM to LM 1) and the real interest rate rises causing
aggregate demand to decline (movement along the AD curve). In the labour market, the rise in P leads (given a
fixed W) to a fall in the real wage w. Thus, Nd rises (movement along the curve) and employment and output supply
rise (through upward movements along the AS1 curve). The rise in the real interest rate shifts the N S curve to the
right (intertemporal substitution effect). Overall there is a fall in output and a rise in Keynesian unvoluntary
unemployment. Monetary policy results in being unable to stabilize Y and N without violating price stability
mandate. Addressing unemployment by expansionary monetary policy, indeed, leads to a further rise in P;
whereas addressing inflation by a restrictive monetary policy (rightward shifts of the LM curve) implies a fall in
demand and a rise in real wage, causing a rise in unvoluntary employment. This is consistent with the evidence of
the oil price shocks in the 1970s: with a negative supply shock the decline in the real wage needed to restore full
employment has to be achieved by a decline in the nominal wage (nominal wage growth moderation) and by
efforts to undo the negative supply shocks (structural reforms).

SESSION 7- THE GENERAL THEORY OF KEYNESIAN MACROECONOMICS

The sticky wage model: when nominal wages stop being sticky What happens when monetary and fiscal policies
do not respond to shocks and eventually nominal wages respond to disequilibria in the labour market (i.e. stop
being sticky?) start by considering a situation in which an unanticipated shock has hit the economy, causing the
real wage to be higher than its equilibrium level in the labour market. After the shock hits the economy, the
nominal wage is W, the price level is P and the real wage is W/P, which implies that employment is stable at a
level N and there is a situation of Keynesian unemployment given the labour supply curve 𝑁 𝑆 (𝑟). At this level of
employment, aggregate output is Y and the price level is P, whereas the real interest rate is stable at r . Because
the real wage is initially above its equilibrium level, the nominal wage will tend to fall (movement along the curve).
The decrease in real wage will cause the labour demand to raise. As a result, there will be more employment and
the aggregate supply curve shifts to the right. At this point, given the current price level, a situation of excess output
supply is there and this puts downwards pressure on the price level, which decreases in order to restore
equilibrium on the goods market. This, in its turn, causes the LM curve to shift to the right, because the decline in
the price level lowers the demand for nominal money, or alternatively, raises the real money supply (M/P). This
is the real balance effect. The decline in the demand for money, as well as the increase in the real money supply,
reduces the real interest rate. This raises investment and aggregate demand.
In the long run, the nominal wage and the price level decrease to the point where the price level is 𝑃2 , output is 𝑌2
and the nominal wage has fallen to 𝑊2 . At this point, the real wage W/P is such that labour supply is equal to labour
demand. Ultimately, reductions in the nominal wage and the price level restore full employment in the long-run.
Deflation is consequently stabilizing!

1
3

Keynesian stabilization policies in the sticky wage model are grounded on the rationale that the long run is too
long to wait given nominal wage stickiness. Stabilization policies can restore equilibrium before self-adjusting
markets achieve this on their own:
• if shocks kick the economy out of equilibrium, because there is a failure of private markets to clear in the
short run, and
• if fiscal or monetary policymakers can move precise and fast enough.
Nonetheless, from a theoretical point of view, stabilization policies are not needed as in the long run the economy
operates as described in the Neoclassical model.

The General Theory The General Theory is not built on micro-foundations and utility/profit maximizing agents,
despite the fact that Keynes accepts the utility and profit maximization approach for individual behaviour under a
budget constraint. According to Keynesian theory, macroeconomic outcomes reflect decisions of optimizing agents
transacting with each other (i.e. not decisions of optimizing agents as such) and these transactions which they
perform can lead to a “fallacy of composition” problem. The problem can inherently not be modelled in the
representative agent model and, accordingly, the methodology on which the representative agent models are built
upon are not useful at all for explaining macroeconomic outcomes. The fallacy of composition relies in the fact that
one cannot infer from the outcome of a decision by one individual (more general: for some part of a population)
on what is the outcome of a decision if the whole population takes such a decision. As a matter of fact, despite each
individual marking the optimizing decision, the outcome in the aggregate might be sub-optimal.

Paradox of Nominal and Real Wages Workers maximize their utility by assessing the real, not the nominal wage.
however, they negotiate the nominal wage, and not the real one (which is strictly dependant on the price level). If
an individual worker faces unemployment, it might be utility maximizing for her to accept a lower nominal wage:
nominal wages are flexible. The real wage falls as the price level
remains constant and labour demand rises. As a result, at a constant
price level, flexible nominal wages translate into flexible real wages →
both move in the same direction! The fallacy of composition arises,
though, when an individual worker accepts a fall in their nominal
wage, which causes the real wage to drop, as well. When all workers
accept a fall in their nominal wage, their real wage does not fall, since
the fall in nominal wages leads to a fall in aggregate demand which
leads to a fall of the price level. What is true for the individual does not
hold for the aggregate!
Why does price level respond differently? When the nominal wage of a
worker declines, they automatically will reduce their consumption
demand. This has a negative impact on goods prices and the assumption
of a constant price level still is a useful one as the nominal wage decline
is observed for a very small part of the labour force only. The fall in
nominal wages of one or a few households has little influence on the
nominal income (the budget constraints of other agents). As a result,
their investment and consumption decisions are highly unlikely to
be affected by the nominal wage cut accepted by a one agent or a
(small) group of agents.
However, when there is a dop in the nominal wages in the
aggregated (meaning on behalf of the whole economy), nominal
demand and hence nominal income of all agents fall. Thus, while
the AS curve shifts to the right 8as with constant P, W/P would
decline leading to a rise in labour demand and employment), the
decline in nominal income leads to a drop in nominal demand (a leftward shift of the AD curve → this movement
is not in line with the logic by which the model is driven. According to the model, indeed, when the real wage is
dropping, the price level will not remain constant which implies that the shift in the labour demand curve will not
happen). As a result, there is downward pressure on the price level. Moreover, when the price level drops, the real
wage rises despite the decline in nominal wage and the resulting real wage does not need to fall. Indeed, it might
even rise despite the fall in the nominal wage.
Conclusion: the labour market is not in a position to ensure equilibrium (full employment) on its own by moving
the nominal wage, since this does not guarantee a corresponding movement in the real wage. The labour market,
conversely, needs help from monetary and fiscal policy preventing the leftward shift of the AD curve associated
with a fall in the nominal wage and thereby also ensuring that the decline in the nominal wage is translated into a
decline in the real wage. For those countries which dropped off the gold standard, nominal wages were fairly
flexible (they declined against the background of rising unemployment); conversely, in those countries which
remained on the gold standard, real wages did not decline but even rose. In those countries, the deflation rate was
actually higher than the percentage decline in the nominal wage rate, implying that the decline in the price level
was so high that the real wage actually rose (they had more purchasing power given a lower wage). This is in line
with the paradox of nominal and real wages in countries which are unable to make use of stabilizing monetary and
fiscal policies.

Empirical evidence from the Great Depression

At the beginning of the 1930s, many countries were on gold standard. The latter was a monetary regimen where
the use of stabilizing monetary and fiscal policy is not feasible as the central banks had to defend the parity of their
currencies to gold. As a consequence, the central institutions were not able at all to supply more money because
they needed to be able to cover the amount supplies with gold at a fixed and pre-established exchange rate. When
the Great Depression set in, countries left the gold standard- some earlier, some later. Consequently, for the early
1930s, we can distinguish between: countries which could not use stabilizing monetary and fiscal policy as they
remained on the gold standard (“On” countries) and countries which could use these policies as they had left-off
the gold standard (“Off”-countries). This implies that during the Great Depression, countries remaining on the gold
standard could not make use of monetary and fiscal policy, whereas off countries going off the gold standard were
able to make active use of monetary and fiscal policies.

The liquidity preference theory of money demand The paradox of nominal and real wages argues that wage
flexibility alone does not lead to a return to equilibrium when monetary an fiscal policy do no engage in stabilizing
activities. Nonetheless, the fall in the price level is associated with a decline in nominal wages, which might have a
stabilizing influence via the real balance effect. As already discussed, the real balance effect serves as a substitute
for expansionary monetary and fiscal policy in terms of demand stimulation as deflation creates a disequilibrium
on the money market with M>L. In the model, this leads to a decline in the real interest rate and hence more
investment and consumption. Thus, the model predicts that ha deflation should be associated with a fall in the real
interest rate.

Nonetheless, during the Great Depression, price level fell substantially (up to 25%), how did interest rates behave?
During these years, nominal interest rates closely approached zero and the real interest rate rose instead of falling.
This was mainly due to the huge power of the decline in price level (remember that the real interest rate is given
by: r = i - expected inflation ). Nonetheless, the moment when the US could engage in monetary policy because of
dropping off of the gold standard, then the interest rate effectively dropped. Why did nominal interest rates not
fall below zero and hence allowed the real interest rate to decline further despite deflation? According to the
General Theory, money demand rose substantially when the nominal interest rate declined to very low levels due
to the rising in liquidity preference, causing the nominal interest rate to fall big times. Liquidity preference is not
captured at all in the neoclassical money demand function, as this theory postulates that all goods and all assets
are equally liquid.
In the General Theory, like in the Neoclassical Theory, money is demanded as a medium of exchange which Keynes
calls the transaction motive of the demand for money: 𝑴𝑫 = 𝑴𝑫 (𝒀). In addition, money is also demanded as an
asset and in contrast to the Baumol/Tobin model, it is not only an asset with the peculiarity of a zero nominal
return. Money is also considered as an asset which provides better liquidity services than other assets (such as
bonds or loans). Liquidity services refer to the costs of transforming an asset into liquidity which can be used to
redeem debt and to purchase goods and services. Agents choose between holding/demanding money or supplying
credit (portfolio choices) paying attention to the liquidity services they derive from holding them. Agents demand
for money, then, depends on the benefits of holding liquidity (the cost of holding other assets) with the cost of
holding liquidity (the benefits of holding other assets). Benefits of holding liquidity include avoiding losses on
other assets in case agents needed to liquidate them to get money. The cost of holding liquidity, instead, represents
the opportunity cost of losing the interest paid by other assets. (Example: in normal times, the benefits of holding
cash compared to holding a bank deposit are negligible as we do not expect to incur in losses when exchanging
bank deposits into cash. By contrast, the cost of holding cash are quite high as there is the risk of loss and theft
and- in normal times, opportunity costs in the form of foregone interest).
The idea of liquidity preference can be generalized by comparing money with its superior liquidity characteristics
against other assets. From this, the General Theory develops the liquidity preference motive of demand for money.
A key insight from this motive is that any increase in liquidity preference increases the demand for money. This
implies uno actu a fall in the supply of credit as the demand for money (with no increase in the money supply by
the central bank) is met by agents selling claims that they have acquired versus other agents giving these agents
credit. Thus, a rise in money demand and a fall in credit supply are two sides of the same coin.
This can be illustrated by analysing the agents’ choice between holding money or supplying credit in the form of
buying/holding government bonds. For simplicity, bonds are assumed to be perpetual bonds; agents consider
buying such bonds in order to hold them for one year and holding such bonds must yield a return of 𝒊𝑩 𝑩 (meaning
coupon rate* face value of the bond earned periodically). Capital gain/losses reflect change in the value of the bond
𝒊𝑩
year to year and as the market value of the bond can be expressed as 𝒕 , then capital gain or capital losses within a
𝒊
𝒊𝑩 𝒊𝑩
year amount to ( 𝒕+𝟏 − 𝒕 ) 𝑩. Agents will exhibit liquidity preferences when: the return from holding bonds is
𝒊 𝒊
𝒊𝑩 𝒊𝑩 𝒊𝒕
lower than the return from holding money (which is equal to zero) → 𝒊𝑩 𝑩 + ( 𝒕+𝟏 − 𝒕 ) 𝑩 > 𝟎 → 𝒊𝒕+𝟏 >
𝒊 𝒊 𝟏− 𝒊𝒕
The inequality describes the maximum increase of the market interest rate from t to t +1 for which the holding
of bonds is still superior to holding non-interest-bearing money. Agents will hold money if they expect an increase
in the interest rate that exceeds the critical rate: the lower 𝒊𝒕 , the smaller the rise in the interest rate which has to
be expected in order to exert liquidity preferences. Agents exhibit a stronger liquidity preference and a higher
demand for money, the lower the current rate of interest. Money demand is negatively related to the nominal
interest rate: at very low nominal interest rates, basically all agents expect rising rates. Hence, money demand
becomes completely elastic.
ùAs a result, the real balance effect (as well as the expansionary monetary policy) does not lead to a rightward
shift of the LM-curve and the associated fall in the real interest rate. indeed, as money demand gets completely
elastic at a nominal interest rate close to zero, the price level fall implies a rise in the real interest rate. This
indicates that the real interest rate is the result of the nominal interest rate and the inflation rate (determined in
the output market) → r = i- inflation. This is not independently determined on a neoclassical capital market
equilibrating S and I. however, this implies that deflation is destabilizing as it is associated with a rising real
interest rate which leads to lower aggregated demand as investment and consumption fall. The real balance effect
does not stabilize the economy at a very low nominal interest rate.
Deflation, demand and the paradox of thrift There is another negative effect of deflation: the Fisher- debt deflation
effect. This effect captures the idea that debtors and creditors respond differently to a fall in the price level: debtor
agents reduce consumption and investment demand as the decline in price level triggers a rise in their real debt.
This is not compensated by a rise in demand by creditor agents experiencing a rise in the real value of their claims
as- almost by definition- creditor agents have lower marginal propensity to consume and are less likely to invest
(which is why they are creditors in the first place). Thus, deflation exposes the economy to a negative demand
shock. Nonetheless, a fall in aggregate demand unrelated to a rise in the real interest rate, is associated (in the
neoclassical model) with excess saving on the capital market. Thus, the real interest rate should fall and trigger
both:
• a reduction of saving by the household sector (movement along the saving curve)
• a raise in investment by firms (movement along the investment curve)
This absorbs the excess supply of saving triggered by the negative demand shock. Moreover, as shown before, a
demand shock is associated with C and I moving in opposite directions which contradicts a key standardized fact
about the business cycle: namely, consumption and investment should co-move with output. From this we can
conclude that demand shock cannot trigger the business cycle.
In the General Theory, Keynes argues that a negative demand shock does not lead to excess saving in the aggregate
as the attempt by all individuals to save more leads to a fall in come which keeps aggregate saving constant. This
is explained in detail by the paradox of thrift, which is a fallacy of composition argument: what is true for the
individual does not hold for the aggregate.
The paradox of thrift can be summarized in the following way: “the act of an individual saving means – so to speak-
a decision not to have dinner tonight. But it does not necessarily imply that the representative agent is deciding
between having dinner today and buying a pair of boots next week, or to consume any specified thing at any
specified date. therefore, it depresses the business of preparing today’s dinner without stimulating the business of
making ready for some future act of consumption. It is not a substitution of future consumption demand for
present consumption demand- it is rather a net diminution of such demand”.
In detail, this implies that for any individual, the decision to save means that they save more than what they had
consumed, but for at least one individual the decision to save by another individual implies a lower income. In
general, a decision to save means-everything else equal- that the income of other individuals who would have
benefitted from consumption declines. In the language of the neoclassical model: the endowment point E and the
intertemporal budget constraint agents are endogenous, since they fundamentally depend on the decisions and
actions of utility maximizing agents. We can depict this by looking at the balance sheets of a restaurant customer
and a restaurant owner. Before the restaurant customer decides whether to have dinner or not, her balance sheet
looks as follows:

If the restaurant customer (RC) goes to dinner, she pays the restaurant owner (RO) from her bank deposit. Thus,
the deposit moves from the customer to the owner.
More in detail, the fallacy of composition can be explained as follows: the decision by the restaurant customer to
forego dinner at the restaurant implies that customer saves more (keeping her deposit), but does not rise
aggregate saving as the restaurant owner is unable to build up a deposit as they miss the income from selling the
service to the customer. Thus, aggregate saving is unchanged compared to the situation where the restaurant
customer would have had dinner. How can this be as the restaurant customer saves more? The restaurant owner
responds to the decline in his income as depicted in the neoclassical model: they will both consume and save less
(consumption smoothing). By consuming less, they pass the income decline to a third party. Thus, the fall in saving
by those affected by declining income absorbs the rise in the saving of the individual initially saving more.
The process is captured by the Keynesian multiplier, which informs about the change in income due to an
exogenous shock affecting a component of demand (in this case depicted by consumption). The size of the
multiplier is determined by the marginal propensity to consume for a given exogenous change in income, since the
multiplier is given by 1/(1-MPC) → the larger the marginal propensity to consume, the larger the multiplier.
The multiplier then captures what would happen if all households would start to save more. This rarely happens:
indeed, in normal times, the decision by an individual to save more is compensated by a decision of another
individual to save less. Moreover, as long as the number of individuals saving more is small, the marginal effect on
the income of the sellers of goods is also small. Thus, the latter are unlikely to change their
consumption/saving/investment plans and trigger a downward spiral in terms of demand. Things are different,
however, when all agents want to save more and reduce their consumption simultaneously. Then the rise in saving
merely means that the real income of all agents declines.
But why does investment not rise when an individual decides to save more? In the neoclassical model, the attempt
by any individual to save more, leads to an increase in aggregate saving because:
• saving takes place in the form of goods which the household directly offers on the neoclassical capital
market;
• saving consists “not merely in abstaining from present consumption but in placing simultaneously a
specific order for future consumption” which makes it profitable for the firm to invest more today in order
to prepare for more consumption tomorrow.
The latter argument is a crucial one: even though the real world capital market does not involve the exchange of
goods into claims (by the household of the firm), the restaurant owner could approach his bank for a loan in order
to increase its own investment. The restaurant owner would go for a loan and more investment if he decided to
interpret the rise in saving by his customer as a rise in consumption demand in the future period. This would make
it profitable to expand for future period.
Keynes (1936) argues that this increase in investment demand does not occur as “the act of saving implies not a
substitution for present consumption of some specific additional consumption, but a desire for “wealth” as such,
that is for a potentiality of consuming and unspecified article at an unspecified time”. The fact that the restaurant
eventually decides to take up a loan expresses the desire for wealth as such: the representative customer does not
decide to save now in order to consume more in the future, but it actually decides to keep their net worth rather
stable. In such a scenario investment will not rise, but actually decline because the expectation of future
consumption is so largely based on current experience of present consumption that a reduction in the latter is
likely to depress the former. The restaurant owner will not ask for a loan as they see no need to expand their
business given the decline in demand. In addition, it is highly unlikely that a bank would issue a loan to a restaurant
owner who fails to sell his services. Indeed, the restaurant owner will reduce their investment given the lack of
demand. As a result, income, current consumption and investment falls at a given real interest rate which is in line
with the stylized facts of the business cycle.

Summary

Together with the liquidity preference theory of money, the paradox of thrift indicates that the neoclassical
modelling of the capital market suggest transmission mechanisms which we might not observe in the real world.
Saving households do not meet firms on a market in order to provide them with the goods firms need to possess
in order to expand the capital stock. When households decide to save, they reallocate existing assets and their
decision to save more does not trigger any incentive for firms to invest more. As we will see in the next section,
this implies that investment is independent from saving. Nota that this insight from the General Theory does not
refute the proposition that a rise in investment requires that more resources need to be used for the production
of investment goods- which implies- everything else held constant that less consumption goods can be produced.
The insight only implies that calling on households to save more has no direct impact on firm’s ability and
incentives to invest as suggested by the neoclassical capital market. neither do households foregoing consumption
increase the pool of goods that can be used for investment nor do they contribute with the act of foregoing
consumption to a fall in the real interest rate.
All in all, the general theory has elements suggesting that Keynesian macroeconomics is more than the assumption
of sticky nominal wages to be introduced in a standard neoclassical model. Even with flexible nominal wages
(prices) the economy does not function in the way depicted in neoclassical economics if we account for the fact
that the macroeconomy is not a representative agent barter economy but a monetary economy populated by
heterogeneous agents giving rise to fallacy of compositions problems. A key implication of a monetary economy is
that the capital market works differently that the neoclassical model suggests, as a rise in individual saving does
not lead to more investment.
Moreover, the nominal interest rate is determined on the money market. With the price level and hence the
inflation rate being determined by aggregate demand and aggregate supply, the real interest rate results from the
nominal interest rate and the inflation rate. It is not independently determined on a neoclassical type of capital
market equilibrating S and I. In such an economy stabilization policies are grounded on the rationale that they are
geared to address these fallacy of composition problems agents are unable to address even with complete nominal
wage flexibility.
PART 3 – MONETARY MACROECONOMICS

SESSION 8 – THE MONEY SUPPLY PROCESS, CREDIT, INVESTMENT AND SAVING

In session four, we argued that history suggests a metallist money theory as people used metals and precious
metals (copper, silver, gold) in order to reduce transaction costs in the trade of goods. However, actual precious
materials have never been used as actual means of payment. This is explained by the fact that both the seller and
the buyer knew little about their value, since determining the value of raw precious materials required experts,
which added to both duration of the process and cost of the transaction. Thus, precious metals emerges as means
of payment un parallel with minting only.
The sign put on the metal during the minting process was linked to a state authority as the state was the only
accepted authority guaranteeing the fitness of these coins. In this view, minting solved the problem of assessing
the value of precious metals. As a matter of fact, this role could also be performed by creditable and reputable
private agents, thereby causing the emergence of money to be no longer strictly tied to state government authority.
Private money could have emerged at this point.
Chartalism is an alternative theory about the emergence of money. It argues that money emerged as it improves
the efficiency of tax collection by the state: “the authority declares that people and organizations are required to
pay and keep records of certain specific obligations against the state in that currency”. Thus, the “value and utility”
of money is not linked to its inner metal content to be confirmed by state authorized minting, but to the power of
the state, namely its power to tax. This explains why money issued by the state becomes a generally accepted mean
of payment even though – occasionally- the value of these coins could drop substantially. A fundamental
implication of the chartalist view on money is that money creation implies that the state/government incurs in
debt (and we can observe this more specifically when money is firstly “created” – or better,- emitted by a single
government). When the government “pays wages or buys goods, it finances this expenditure by issuing debt. And
it can only incur in debt because this debt must carry the value which is derived from the obligation to pay taxes
in the given currency. When people pay taxes, it is as if the state accepted its own debt. Therefore, the value of
money can be derived from the fact that is was officially proclaimed to be accepted for paying obligations vis-à-vis
the state”. This is able to explain why modern governments/states are able to issue fiat money. These represent
credit households’ (the private sector) grants to the government. They represent its government debt: an
illustrating example is the introduction of the Deutsche Mark in Jun 1948. The opening balance sheer of the “Banj
Deutscher Länder” (predecessor of the German Bundesbank) reveals that the amount of cash that the central bank
issued was covered by the German government bonds.

Having said this, the central bank (which is owned by the government) can also issue money via transactions that
lead to debt of the foreign and the private sector. Thus, by crediting the government, the foreign sector and/or the
private sector, the central bank issues money: credit to these sectors are the sources of central bank money. Cash
and reserves held by banks at the central bank represent forms or uses of central bank money.

Central Bank Money (base money)

AGGREGATED ITEMS ON THE ASSET SIDE AGGREGATED ITEMS ON THE LIABILITIES SIDE

• net position vis-à-vis foreign sector • currency in circulation (C)

(NPf ) :
• net position vis-à-vis domestic
government sector (NPg )
• credits to the domestic banking
sector (CRb )
• private sector assets (A)
• deposits of domestic banks (R)
• balance of other assets and liabilities
(BAL)
Usually limited to:
• financial crisis episodes when private market become
“dysfunctional”
• zero lower bound episodes when asset purchases substitute for
the interest rate income
Generally speaking, central banks act as monopolistic suppliers of the monetary base, which is defined by sources
as: 𝐵 = 𝑁𝑃𝐹 + 𝑁𝑃𝐺 + 𝐶𝑅𝐵 [+𝐴𝑃𝑅 ] − 𝐵𝐴𝐿, whereas by simple uses and applications it is defined as B = C+R.
In general, demand for monetary base corresponds to
• cash holding by the public,
• the “cash paradox”: meaning the enormous increase in global cash demand despite a continuous decline
of cash used for day-to-day transactions at the point of sale at the same time;
• minimum reserves obligations: banks must hold minimum reserves at the central bank for certain
balances held by the non-finance private sector at banks. The ECB has a reserve ratio of 1% and basically
refers to the following items of the liability base: overnight deposits, deposits with agreed maturity up to
2 years, deposits redeemable at notice up to 2 years and debt securities issued with agreed maturity up
to 2 years and money market paper (basically M1, M2 and M3 aggregates);
• excess reserves: in normal times these kind of reserves are really close to zero, but they actually become
sizeable in times of financial turmoils. They, of course, they actually become really important and gain in
weight when the Central Bank engages in Quantitative Easing.
Major sources of base money coming form the central banks are the following: a) the bank’s interventions on the
foreign exchange market (purchase of foreign exchange); b) interventions on capital markets (purchases of
government bonds and private sector assets,..) and, c) lending to commercial banks (against collateral). Before the
Great Financial Crises, Central Banks usually opted for one major channel in issuing base money. Some examples
are provided by:
• People’s Bank of China (and other central banks with an explicit or implicit exchange rate target)→
intervention on the foreign exchange market. In the specific case of the Chinese Central Bank, the latter
issued base money by purchasing foreign currency from a domestic credit institution and credits the latter
with the counter value on its account at the central bank. This was usually pursued in a monetary policy
framework where the central bank ex- or implicitly has a foreign exchange rate targe (managed float,
pegged exchange rate), i.e. does not have a flexible exchange rate.

Everything else equal, the sale of US dollar by exporting

firm creates an appreciation pressure on the domestic
currency (in the sense that they are “selling” US dollars
for buying local currency → as any other good, an
increased demand causes an increase in the “price” of
the domestic currency)
• United Sates: purchases of government bonds → the central bank issues base money by purchasing
government bond from a domestic credit institution and credits the latter with the counter value on its
account at the central bank. This is usually done in a monetary policy framework, where the central bank
controls the money market interest rate (flexible exchange rates);

Everything else equal, the sale of the government

bonds leads to a rise in the money market
(interbank market) interest rate

• Euro Area: lending to commercial banks → the central bank issues base money by lending against
collateral to domestic credit institutions. This is usually done in a monetary policy framework where the
central bank controls the money market interest rate (flexible exchange rate);

Everything else equal, rising

demand for credit leads to a
rise in money demand
(interbank market) interest
rate.
Commercial bank money and the money supply Money is not only issued by the central bank, but also by
commercial banks. Money = Monetary Aggregates M1-M3 include commercial bank money, namely current
accounts, but also in term deposits, and marketable instruments. Currency in circulation, issued by the central
bank, is only a small of M1 and M3. Commercial banks issue money in basically the same way as central banks do:
they purchase assets from and provide loans to non-banks and pay by crediting the current account of the
respective sellers/borrowers.

Examples 1. A bank purchases foreign exchange from a private household by crediting the counter value in
domestic currency in the household’s current account.

2. A bank lends to a domestic authority and credits the counter value on the authority’s current account.

3. A bank lends to a firm/ a house and credits the counter value on the firm’s / household’s current account.
4. In comparison to the creation of central bank money, commercial bank money can also be created by changes
on the liability side of the balance sheet, namely by households/firms transforming long-term non-monetary
claims on banks into monetary claims.
Example Private household does not prolong the holding of a bond issued by a bank, but rather keeps the amount
at current account.

The money supply can, then, be derived from the consolidated balance sheet of the banking system as a whole, i.e.
central bank and commercial banks (MFIs = Monetary Financial Institutions). Consolidated means that all claims
and liabilities among banks(interbank claims and liabilities), and all claims and liabilities between banks and the
central bank are netted out. On the latter, this refers more specifically in particular to claims of banks on the central
bank, i.e. the reserves held at the central bank, and the claims of the central bank on banks in the form of bank
lending.

M3 definition (application side)

M3 = C + OD+TD+OSL

- C = currency in circulation
- OD = overnight deposits
- TD = time deposits
- OSL = other short-term liabilities

M3 definition (source side)

M3 = NPF + CR G + CR PR − LL − BAL

- NPF = net foreign position of the banking sector

- CR G = credit to the public sector
- CR PR = credit to the private sector
- LL = long-term liabilities of the banking sector
- BAL = all other assets and liabilities of the banking sector

Money, credit, investment and saving The ability of commercial banks to create money by crediting the non-bak
private sector implies that:
• banks can lend to firms without having to have excess reserves and without having to attract deposits
from households;
• households do not have to save fist to finance the firm’s investment

Example Bank A grants a loan to Firm X.

Firm X makes use of the loan by investing: the firm orders and purchases equipment from firm Y. It transfers EUR
1,000 to Bank B, which is the bank of firm Y (from which purchased the goods thanks to the loan given by firm X).
NOTE: nobody is saving in this moment in order to facilitate the investment of firm X. However, with firm X’s
investment, firm Y has an income and (initially) saves it in the form of deposits held at Bank B.
However, Bank B is only able to accept a liability vis-à-vis the firm Y by getting legitimate access to the central
bank reserves, i.e. Bank B insists in being transferred the amount of EUR 1,000 in central bank money.

The overall insight from this example eventually should be that:

• banks can lend to firms without having excess reserves and without having to attract deposits from
households;
• households do not have to save (first) to finance firm’s investment
This, nonetheless, does not at all imply that the creation of money is for free because the central bank grants a loan
to Bank A ( which in its turn grants a loan to firm X, which makes use of this loan to invest in machinery and
equipment) by charging an interest rate. Bank A applies an analysis of credit worthiness of firm X. thus, Bank A
grants the loan only if it is profit maximizing for the Bank to effectively lend these money to the firm.
The fact that households do not have to save first in order to finance the firm’s investment also does not mean that
there is no real budget constrain limiting the real consumption and investment in the current period as depicted
in the Neoclassical model. However, there is no guarantee that this budget constraint is always exactly obeyed by
the consumption/saving and consumption/investment decision by households and firms on a macroeconomic
level as the real interest rate is not determined on a Neoclassical type of capital market. As a result, households
and firms might demand more or less consumption plus investment than output produced which is reflected in a
rising or a falling price level.
The task of the central bank to control the supply of credit and money, and hance the level of economic activity,
notably investment, is carried out by adjusting the rate of interest at which is ready to provide reserves. By
changing the rate of interest it charges for supplying reserves, the central bank makes it more or less attractive for
the bank to issue loans, for the non-bank sector to demand loans and for the non-bank sector to invest. The
criterion for adjusting this interest rate is price stability. Even though the central bank is ready to issue reserves
under a given interest rate (and by insisting on collateral) in an unlimited way, it adjusts the interest rate when
price developments become inconsistent with the price stability mandate of the central bank.
• the central bank lowers the interest rate when inflation is too low given the price stability mandate;
• the central bank raises the interest rate when inflation is too high given the price stability mandate;
This is conventional monetary policy.

SESSION 9 – MONETARY ECONOMICS: THE PRICE STABILITY MANDATE AND THE PHILIPS CURVE

Price Stability Mandate Recall that, according to the Keynesian model, price stability serves as a criterion for the
interest rate policy of the central bank. But why is the criterion exactly price stability and not full employment or
high growth?
In the Neoclassical Model, instead, money is neutral. This implies that the model is inconsistent with a real variable,
such as employment or GDP growth, serving as a monetary target. At the same time, the neutrality postulate also
raises the question about the price stability mandate as price stability is not (strictly or directly) needed for the
representative firm to maximize profits.

Question: why should monetary policy follow a price stability mandate?

According to empirical evidence, high inflation is very bad for growth, even though the relationship is non-linear
and growth are positively correlated. For inflation rates higher than 3%, inflation and growth are negatively
correlated. However, the relationship is convex: and increase from 10 to 20% inflation is associated with a much
lager decline in growth than moving from 40 to 50% inflation. overall, there is a negative inflation-growth
relationship to be found in time and cross-section dimensions of the data.

The figure reveals the bivariate relationship between inflation

and growth:

- inflation above 20% per annum is relatively rare, but it actually

occurs predominantly with negative per capital GDP growth rates
(more than one-third of the observations with inflation above
20% show up at negative GDP growth rates);
- vice versa, almost one-third of negative GDP growth
observations occur at inflation rates above 20% per year.

By looking at the matter from a theoretical perspective, price stability is a prerequisite for money to perform its
functions, i.e. means of payment, unit of account, store of value and hence to sustain a monetary economy.
Moreover, experience suggests that without a restrictive monetary policy, inflation might get out of hand and
might transform into hyperinflation. Hyperinflation is associated with economic collapses and triggers a need for
either monetary or currency reform. The case for price stability largely rests on costs agents incur when being
confronted with anticipated and unanticipated inflation (which suggest the fact that money is nothing but neutral).
• costs of anticipated inflation: menu costs, costs caused by the tax system (they are basically the costs in
which common people incur in; menu costs specifically refers to the costs in which the single firms or
businesses incur, which relate to the re-printing of menus or price cardboards in order to inform the
public of the change in the price level);
• costs of unanticipated inflation: they relate to the transparency of relative price blurred by the inflation
spectrum, to the redistributive effects between creditors and debtors and to the inflation risk-premium
on interest rates;
Price stability is often defined as an inflation rate of =/ ~ 2%. 0% is never the target, mainly because of the
measurement bias in the HICP, the downward nominal rigidities in wages, the inflation differentials within the
currency area and the deflation risks and the zero lower bound on nominal interest rates.

Summary Price stability:

• reduces the information- and transaction-costs;
• limits/prevents the misallocation of resources.
Nonetheless, the main reason for price stability as monetary targe is found in the view that by deviating from price
stability and accepting or engineering higher inflation, monetary policy is unable to achieve higher growth or full
employment in the medium-to-long term.

The Phillips Curve debate (1960s – 1970s) The fact that deviations from
price stability on behalf of the central bank does not allow the achievement
of full employment or higher growth is at the core of the Philipps Curve
Debate. The latter depicts the relationship between the changes in nominal
wages and the unemployment rate and signals the negative relationship
between these two variables.
Since workers and employees are assumed to set the nominal wage by
considering inflation and the change in labour productivity, the new
Philipps Curve describes the relationship between unemployment and
inflation. Basically, the new Philipps Curve depicts changes in the nominal
𝒀
wage as ∆𝑾 = 𝝅 + 𝝀, where 𝝀 is given by and represents the change in
𝑵
labour productivity.
The equation for the new Philipps Curve, then, is given by: 𝝅 = 𝒇(𝑼) − 𝝀
and signals the negative relationship between inflation and unemployment. Changes in labour productivity serve
as a shift parameter: if z rises, the Philipps Curve then shifts to the left; if z
falls than the Philipps Curve shifts to the right. This negative relationships,
of course, has some implications on the different policies which central
banks can actually apply. There is, indeed, a trade-off between inflation and
unemployment monetary policy can exploit. The latter can target/accept
higher inflation to reduce unemployment/ increase employment. The
policy approach is consistent with the Keynesian sticky wage model
suggesting that with higher employment and price level (and the
associated fall in the real wage) more employment can be achieved. This
policy approach was followed in the 1960s and the early 1970s.
Something changed in the 1970s because the Philipps Curve shifted to the
right, and at least in the first place, changes in labour productivity did not
seem to drive the shift. In this case, indeed, the inflation expectations were
the ones driving the shift, making policy makers actually aware of their role
in determining the relationship with unemployment:
• a stable inflation-unemployment trade-off requires constant inflation expectations (“money illusions”):
• inflation expectations rather than current inflation influence the nominal wage developments;
Therefrom it follows that the change in the nominal wage is determined not by current inflation but by the
expected rate of inflation for the future period. ∆𝑾 = 𝒇(𝑼) + 𝝅𝒆 → this equation implies that inflation
expectations determine the position of the Philips curve in the 𝝅 − 𝑼 space (𝝅𝒆 serves as a shift parameter).
Inserting the role of expected inflation into the Phillips Curve equation, we get that: 𝝅 = 𝒇(𝑼) + 𝝅𝒆 − 𝝀. From
these simple equations, we can derive that:
• if inflation expectation rise, inflation rises (at a given level of unemployment) as nominal wages rise
(wage-special spiral);
• if 𝝅 = 𝝅𝒆 , the relationship between 𝝅 and unemployment breaks down, i.e. the Philipps Curve is vertical
in the 𝝅 -U space;
Exploiting the trade-off between inflation and unemployment requires creating a “surprise inflation”, meaning a
situation where inflation is much higher than expected inflation.

Inflation expectation formation

- extrapolative expectations: 𝝅𝒆𝒕 = 𝝅𝒕−𝟏 (meaning that the expected inflation for the current period is
actually relevant in determining the expected inflation for the following period);
- adaptive expectations: 𝝅𝒆𝒕 = 𝝅𝒕−𝟏 + 𝜷(𝝅𝒕−𝟏 − 𝝅𝒆𝒕−𝟏 ) (in this case the expected inflation for the current
period is determined by inflation in the previous period adjusted for inflation forecast error referred to
the previous period);
- rational expectations: 𝝅𝒆𝒕 = 𝑬[𝝅|𝑰𝒕−𝟏 ]

The difference between the short- and long-run Philipps curve has, as obvious, some specific policy implications.
In the short-run, monetary policy can “ride” the Phillips curve when expectations are formed in an extrapolative
or adaptive way. In the medium to long-term inflation expectations catch up with actual inflation. This means that
accelerating and not simply high inflation is needed to keep unemployment below the natural rate of
unemployment (non-accelerating inflation rate of unemployment – NAIRU). Fighting unemployment by an
inflationary monetary policy is not a sustainable policy approach as in the long run, defined as 𝜋 = 𝜋𝑡𝑒 , the Philipps
curve is vertical and monetary policy cannot influence the unemployment rate (employment levels). Moreover, in
the case in which inflation is considered as being costly, monetary policy has to bring inflation down. Nonetheless,
when high inflation expectations are embedded, disinflation is usually associated with high costs in terms of both
output and employment under extrapolative and adaptive expectations (but not under rational expectations) as
unemployment will rise above the natural rate of unemployment (NAIRU). This argument is doubtlessly in favour
of the price stability mandate and central bank independence.

The Time- inconsistency problem of Monetary Policy: Barro-Gordon Model Monetary policy is usually considered
to be time-inconsistent, in the sense that future monetary policy decisions which might seem optimal today could,
in fact, not reveal their optimality at the time in which they are actually put into practice. The Barro – Gordon
Model actually tries and explain this time inconsistency, which eventually leads to the so-called Volker Disinflation.
Actors:
• Central Bank: announces and determines the inflation rate;
• Private Sector: forms inflation expectations
Two Periods:
• 𝒕𝟏 : monetary authority announces inflation target and the private sector decides on inflation expectations;
• 𝒕𝟐 : monetary authority determines the inflation rate and the private sectors acts according to its own
expectations.
When does the central bank follow its own announcement? The loss function of the central bank is:
U = actual unemployment rate;
𝒛 = 𝒃(𝑼 − 𝑼 ∗)𝟐 + 𝝅𝟐 𝒘𝒊𝒕𝒉 𝒃 > 𝟎
U* = unemployment rate the central bank targets, with U* < 𝑈 𝜋 ;
𝑈 𝜋 = is the natural rate of unemployment (i.e. unemployment rate which
is consistent with the price stability mandate)
b = is the preference for low unemployment (low b: strong preference for
price stability

The loss function is minimized at the point when inflation is equal to zero and U=U* (unemployment meets the
target level at U*). Thus, the central bank will announce an inflation target of zero at time 𝒕𝟏 . However, wit high b,
this announcement is time inconsistent if the private sector forms inflation expectations in line with this
announcement. This is due to the Philipps curve which states that U = 𝑈 𝜋 − 𝑎(𝜋 − 𝜋𝑡𝑒 ), i.e. the central bank can
lower the unemployment rate below the natural rate when engineering a surprise inflation. The central bank has
an incentive to do so as its target rate of unemployment is below the natural rate: U* =k 𝑈 𝜋 (with 0<k<1).
Accordingly, the central bank creates a surprise inflation by setting 𝜋 ∗< 𝜋𝑡𝑒 as this minimizes its loss function and
represents the first best solution for the central bank. At this point, the private sector actually understands the
incentives the central bank has to engineer a surprise inflation and therefore, the private sector forms rational
expectations by expecting an inflation rate equal to the rate that the central bank aims at when minimizing the loss
function: 𝜋 ∗ = 𝜋𝑡𝑒 → this is the rational expectations case.
With 𝜋 ∗ = 𝜋𝑡𝑒 losses will be higher than in the first best solution. This is because the central bank has to accept an
inflation rate higher than zero without even achieving an unemployment rate below the natural rate. Third best
solution for the central bank.
In the worst case scenario 𝜋 ∗ = 𝜋𝑡𝑒 and 𝜋 = 0, thereby implying that the central bank – in order to regain its
credibility- keeps its promise of zero inflation despite the private sector expectations are 𝜋 ∗ = 𝜋𝑡𝑒 . Inserting this
into the loss function yields the largest losses for the firm itself. Thus, disinflation has high costs and is the fourth
best solution for the central bank. The lack of central bank credibility explains the high costs in terms of lost output
and unemployment in the Volker disinflation and – at the same time- the Volker disinflation was needed to rebuild
the credibility of the Federal Reserve.
The second best scenario, instead, sees the central
bank not undertaking the initiative of creating a
surprise inflation, and the private sector forms
inflation expectations in line with the target set by
the bank i.e. 𝜋𝑡𝑒 = 0. In order to avoid the time
inconsistency problem, the central bank needs a
rule, which will be the following 𝜋𝑡𝑟𝑢𝑙𝑒 = 0.
Inserting this into the loss function yields losses
that are higher than in the case of surprise inflation,
i.e. 𝜋𝑡𝑒 = 0 but 𝜋 ∗ > 0, but smaller in all other
cases. This represents, then, the second best
solution for the central bank.
Weaknesses of the Barro-Gordon Model The model still has some weaknesses in explaining the central bank
actions in accordance with the public expectations:
• the model assumes that the central bank wants to achieve a situation where U* =𝑈 𝜋 even though the
private sector simply aims at 𝑈 𝑛 and does not wat monetary policy to push unemployment below that
threshold (which will imply, 𝜋 ∗ = 𝜋𝑡𝑒 and 𝑈 = 𝑈 𝑛 . The assumption therefore implies a divergence
between the loss function of the central bank and the loss function of the private sector. The latter can
actually be justified by political arguments: politicians, indeed, usually aim at lower levels of
unemployment and, consequently, central banks are bound to follow an activist employment policy due
to short-term pressures by politicians. This was the political landscape of the 1960s/70s when most
central banks were under political control and influence, i.e. were not independent.
• rule is needed under conditions of repeated games: in the case of repeated games, the central bank has to
take into account the present value of all likely future social costs when deciding about its optimal strategy
at time 𝒕𝟐 . These social costs are high if private sector adjusts its expectations on future innovation over
time, in line with its experience with monetary policy. Thus, the central bank is highly unlikely to opt for
surprise inflation.

Conclusions
When central banks are under tight control by the government and do not have a long-term horizon, periods of
rising and falling inflation (stop-and-go-policies) are to be expected. Independent central banks with a price
stability mandate and central bankers with a long term horizon lead, instead, to sustained price stability as
independent central banks and central bankers with a long time horizon will target an unemployment target equal
to the natural rate, i.e. 𝑈 = 𝑈 𝑛 or k = 1. Under these conditions, there is absolutely no need to put constraint on
central bank discretion.

The independence of Central Banks The constitution of independent central banks, then, was basically the right
alternative in order to avoid the implementation of specific and constraining rules. The main goal of their
constitution was basically their allowance to operate independently within a longer time horizon than the
government (central bank members are usually in change for longer mandates than national government
members), making surprise inflation an low probability event due to the high disinflation costs. The main elements
of the independence of central banks are the following:
• goal independence: the central bank is free to choose its goals or the central target values for a given goal;
• instrument independence: the central bank is given control over the levels of monetary policy and is
allowed to use them;
• personal independence: regards the decision-making body of a central bank, which -by rule- needs to be
in a position to resist formal directives, as well, as informal pressure from the government.
Studies dating back to before the 1980s suggest exactly the fact that the degree of independence of central banks
is negatively correlated with the level of inflation, thereby confirming the solutions suggested to the Barro -Gordon
model. Nonetheless, this relationship of central bank independence with the degree of inflation does not seem to
have a significant effect on real growth. Nonetheless, against what was suggested by the model, an independent
central bank can effectively avoid costly disinflations.

The New Phillips Curve debate From mid- 1980s to 2010s a flattening of the Phillips curve was witnessed,
meaning that the relationship between inflation and unemployment became progressively less relevant. The main
reason why we observed the flattening of the curve was due to the fact that central banks became progressively
more and more independent and, consequently, also more relevant in their operations. A contribution to the
flattening process of the curve was also given by globalization. The latter, indeed, contributed to the flattening of
the curve via the greater contestability from more integrated products in the labour and capital markets (de-
location threats). Ever since globalization occurred, indeed, output in any economy was not only determined by
the output internally produced on a national level, but rather on a globalized level. This implies that when we have,
for instance, an increase in the demand in one economy, this increase does not need to be necessarily fulfilled by
the national output supply, but rather by the globalized output supply available from the whole world. The
flattening of the Phillips curve was also mainly driven by a huge increase in the labour force: “the break up of the
Soviet Union and the global economic liberalisation from the 1980s greatly contributed to the integration into the
global economy of more than half of the world population. Labour supply became so abundant, and production
capacity so large, that even periods of strong demand rarely succeeded in putting persistent upward pressure on
prices and wages.
Explanations of domestic inflation, instead, rely on a series of other “globalization” variables such as global slack,
non-fuel commodities, as well as, global price competition.
SESSION 10 – CONVENTIONAL MONETARY POLICY AND MONETARY POLICY STRATEGIES

Conventional monetary policy: interest rate policy Conventional monetary policy implies the central bank
controlling a short-term policy rate and moves it within a positive range. In the case of the United States, the FED
focuses on adjusting the Federal Funds rate, whereas the ECB focuses on either lowering or increasing the marginal
rate in the main refinancing operations.

Example The European Central Bank According to the latest press release of the European central Bank, the latter
decided to:
• increase the minimum bid rate on the main refinancing operations of the Eurosystem by 25 basis point to
4.00%, starting from the operation to be settled on 13 June 2007;
• increase by 25 basis points the interest rate on the marginal lending facility up to 5%, with effect from 13
June 2007;
• the interest rate on the deposit facility will be increased by 25 basis points to 3% with effect from 13 June
2007.
In order to perform the conventional monetary policy targeting interest rates of interest, the EBC usually relies on
two specific instruments. Namely, open market operations in the form of repurchase agreement and standing
facilities. Other instruments rely on the change in the minimum reserves required (which is, nonetheless, rarely
used). Usually, when engaging in conventional monetary policy operations, the central bank focuses on very short
term operations, most of which were or needed to be reverse transactions. This means that commercial banks
which borrowed from the ECB already fixed a time for giving back at the time of loans. This comes to the advantage
of the central bank, in that it becomes pretty easy for them to change the interest rates because basically every
week you could resettle it and charge different interest rate to the different banks which were asking for lending.

Monetary Policy Transmission When the Central Bank actually moves the interest rate, they basically change the
balance of an investor’s optimal portfolio. At this point, a process of portfolio rebalancing is initiated:
1. the Central Bank reduces the short-term rate (money market rate), so that the demand for money
increases and people would like to have more money to spend;
2. banks and investors buy long-term bonds because it is no longer profitable to hold them in a deposit:
prices rise, yields decline;
3. investors buy corporate bonds, mortgage backed securities: prices rise, yields decline;
4. investors buy equity shares: price rise, yields decline;
5. investors buy real estate properties: prices rise, yields decline.
Steps 2 to 5 imply that the market value of existing financial ad real assets rise (asset price changes are an element
of transmission process). This process causes the issuance of new financial assets and the bought of new real assets
to become much more attractive. Credit’s finance investment, then, rises and this rise is registered by the Tobin’s
q:

𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒

𝐓𝐨𝐛𝐢𝐧′ 𝐬 𝐪 =
𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑛 𝑒𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒

• an indication of q > 1, boosts innovation activity, thereby causing total output to rise and inflation to rise
• a result of q < 1, then investment activity is put at stake, causing output to fall and inflation to fall, as well.
Therefore, we consider changes in asset prices key for monetary policy transmission.

Monetary Policy Strategy: How do Central Banks conduct conventional monetary policy? Usually, central banks
fundamentally pursue conventional monetary policy by setting themselves a monetary target. The potential
formula for this target is the following: 𝑴̂ ∗ = 𝝅 ∗ +𝒀 ̂−𝒗 ̂. Where,:
• 𝑴 ̂ ∗: is monetary growth target;
• 𝝅 ∗ represents normative inflation rate (“inflation target”)
• 𝒀 ̂ represents the growth rate of potential output
• 𝒗 ̂ is the rate of change of the velocity of money.
The initial ECB reference value for money growth was the following: 4.5% = 1.5% + 2.25%-(-0.75%)
According to the policy rule, then, the central bank should:
• raise interest rate when 𝑴 ̂ >𝑴 ̂ ∗(when actual monetary growth is larger than the target level required
by the central bank) since this signals a rise in inflation above the inflation rate target;
• lower the interest rate when 𝑴 ̂ <𝑴 ̂ ∗ as this signals a decline in inflation below the inflation rate target
value;
 • ̂ =𝑴
keep the interest rate unchanged when 𝑴 ̂ ∗ since this signals that money growth is in line with the
inflation target

Evidence from the Deutsche Bundesbank We see that in the panorama of the Deutsche Bundesbank, monetary
targeting was quite flexible in practice and target ranges were missed on the order of 50%. One of the possible
explanations for this was that the Bundesbank was really concerned about their actual objectives output and
exchange rate developments and was fundamentally not focusing much on monetary growth. At the same time,
the money demand function presented itself as pretty unstable, thereby substantially deviating from the assumed
trend growth rate.

Evidence from targeting by the ECB In the end-1998, the ECB adopted monetary targeting in the form of the
monetary pillar (originally, the “fist pillar” of the ECB’s monetary policy strategy). Nonetheless, due to the
instability of the money demand function, the ECB stopped making use of the reference value of money growth in
2007.

In a strategy reform conducted in 2003, the ECB placed greater emphasis on the economic pillar (supply and
demand conditions on goods and labour market according to the NKM model) by making it the first pillar of its
analysis underlying monetary policy decisions.

Inflation targeting was, conversely, a practice developed at the end-80’s without theoretical foundations. It
basically was introduced as a reaction to failures in implementing monetary targeting (as happened in New Zeland
and Canada), or an exchange-rate based monetary policy (UK, Sweden). Today, inflation targeting represents the
dominant monetary policy strategy in countries that do not pursue and exchange rate oriented monetary policy.
According to this new target, price stability is the primary objective and there is an explicit numerical inflation
target (range). Intensive communication between the central bank and the public on inflation developments is at
the basis of the monetary targeting strategy. Inflation expectations are seen as the main determinants of actual
inflation and policy rules reflect the importance of inflation expectations by making interest rate decisions
dependent on differences between inflation expectations and inflation targeting. If the inflation expectations are,
indeed, not met by the Central Bank, than the institution fundamentally looses credibility and therefore:
• inflation expectations > inflation target → rise in interest rate
• inflation expectations < inflation target → fall in interest rate
• inflation expectations = inflation target → keep interest rate stable
Also inflation targeting, nonetheless, presents some fundamental challenges: first of all, it is indeed a simple rule
but forecast on inflation expectations often reveals to be very complex, untransparent and dependent on actual,
recent inflation (“expectations are systematically wrong”). This kind of approach, moreover, is also criticized
because it ignores financial stability as a central bank policy objective.

The Taylor Rule The Taylor Rule basically states that the nominal Federal Fund Rate (the general interest rate set
by the American Federal Bank) should be equal to the real neutral level of the real interest rate plus the actual
inflation rate plus a coefficient giving a specific weight on the forecast accuracy of the inflation target set by the
central bank plus a weighted measure of the so-called output gap.
 𝒀𝒕 − 𝒀 ∗
𝒊𝒕 = 𝒓 ∗ +𝝅𝒕 + 𝝀(𝝅𝒕− 𝝅𝒕 ∗) + 𝜷 ( )
𝒀∗

When does/should the Federal Reserve change the short term nominal interest rate (the rate at which base money
are provided)? The neutral level of the real interest rate is assumed to be constant at about 2%, and exogenous to
monetary policy as it is determined by real factors in the short run (neoclassical model) or long run (New
Keynesian Macroeconomics). Thus, a central bank following the Taylor rule changes the short term nominal
interest rate when:
1) there is a change in the difference between actual inflation and the inflation target as defined in the price
stability mandate;
2) there is a change in the output gap.
𝝀 and 𝜷 indicate the strength of the Federal Reserve’s response to deviations of actual inflation from the inflation
target and of the actual output from potential output. Empirical evidence for the US suggests that the Federal
Reserve responds in a similar way when challenges to price stability and potential output arise. This is in line with
its dual mandate. According to the Taylor principle, then, changes in the inflation rate do not/ should not only
trigger respective changes in the nominal, but also in the real interest rate. When inflation rises, the short term
interest rate should rise; whereas when inflation falls the short-term real interest rate should fall. This is the case
because the actual inflation, 𝝅𝒕 , enters the Taylor rule twice:

𝒀𝒕 − 𝒀 ∗
𝒊𝒕 = 𝒓 ∗ +𝝅𝒕 + 𝝀(𝝅𝒕− 𝝅𝒕 ∗) + 𝝀 ( )
𝒀∗

𝒀𝒕 − 𝒀 ∗
𝒊𝒕 = ∆𝝅𝒕 + 𝝀∆𝝅𝒕 + 𝜷∆ ( )
𝒀∗

The Taylor Rule was basically created as a response to the failure of the previous policies applied during the Great
Inflation period of the 1960s and 70s. At that time, the Federal Reserve raised the nominal interest rate when
inflation rose, but when doing so failed in raising the real interest rate. Thus, aggregate demand was not reduced
and, as a natural consequence, price pressures continued at elevated levels → great inflation.
When confronting with the Taylor Rule, however, there are a series of challenges in terms of both measurement
and identification.
• measurement challenge: output gap → it is very hard to measure the output gap, since estimates in very
broad ranges (up to 3% confidence level) could have a huge impact on the determined value of i ;
• identification challenge: which is the correct measure of inflation?
identification challenge what is the level of the neutral real rate of interest, r *? In the original Taylor
Paper, r*=2% and was assumed to remain constant. This has caused policy makers to the rate as given,
and accordingly, r* was not at all a matter of policy debate until the early/mid-2010s. In the aftermath of
the global financial crisis, interest rates in nominal terms were, nonetheless very low and at this point
inflation decreased instead of rising, despite the very narrow output gap. According to what was stated
by the original Taylor rule, monetary policy at that point basically was too expansionary if the neutral
𝒀 −𝒀∗
interest rate r* had remained constant at 2%: 𝒊𝒕 = 𝒓 ∗ +𝝅𝒕 + 𝝀(𝝅𝒕− 𝝅𝒕 ∗) + 𝝀 ( 𝒕 ) → 𝒊𝒕 = 𝟐 + 𝟏 +
𝒀∗
𝟎. 𝟓(𝟏 − 𝟐) + 𝟎. 𝟓(𝟎) = 𝟐. 𝟓 .
Policy implications of a falling r*, then, will reveal to be the following:
- 𝒊𝒕 set by monetary policy becomes inconsistent with price stability if r* falls, as then the actual real
interest rate becomes larger than r*;
- this brings about a decline in demand and hence in 𝝅;
- monetary policy with a price stability mandate has to adjust the nominal interest rate i in a wat that
leads 𝝅 = 𝝅 ∗ and r = r*;
- thus, with falling r*, i has to fall

Summary

The Taylor rule provides for an assessment of the appropriateness of the current monetary policy stance
expressed by the short terms nominal interest rate. however, the assessment is sensitive the choice of underlying
parameters, including estimates of the neutral/natural rate of interest. Thus, the Taylor Rule itself has become a
cause of debate among economists, central bankers, politicians and the general public,…
SESSION 11 – UNCONVENTIONAL MONETARY POLICY

There are two types of unconventional monetary policies (UMP): unconventional monetary policy to safeguard
the monetary policy transmission mechanism (crisis management) and unconventional monetary policy
addressing the Zero Lower Bound (ZLB).

Financial Crises Typically during financial crises, credit

supply falls and assets are sold as agents increase their
demand for liquid assets, notably money. As a consequence,
a financial crisis is characterized by an excess demand for
central bank money which is reflected on the interbank
market. The excess demand for central bank money triggers
a rise in the interbank market rate. The interbank market,
thus, becomes “dysfunctional” as there are basically only
borrowers but no lenders of reserves. The rise in the
interbank market rate implies that it exceeds the rate at
which the central ban sees as appropriate to achieve price
stability. In this sense, the monetary policy transmission
channel breaks down at the very first chain element, namely
the transmission from the monetary policy rate to the
interbank market.

• Example 1: the global financial crisis-the central bank as lender of last resort
 • Example 2: the Euro crisis: following the revision of
the Greek deficit and debt data, a situation of excess
demand for money by holders of sovereign debt
issued by Greece and other euro area periphery
countries was identified. The selected euro area bond
market consequently became dysfunctional, since
there were only sellers but no buyers of those bonds.
As a result, the monetary policy transmission
mechanism in the euro area broke down. In order to
solve this breakdown problem the ECB launched the
Outright monetary Transactions (OMT) Programme,
whose aim was to safeguard an appropriate
monetary policy transmission mechanism by
providing a fully effective backstop to avoid destructive scenarios with potentially severe challenges for
price stability in the euro area. The fundamental points of such a programme were:
- performance of outright purchases in secondary markets of sovereign bonds particularly those
with a maturity of between one and three years;
- no limits beforehand
- strict and effective conditionality attached to an appropriate EFSF/ESM programme
- Governing council will decide on the start, continuation and suspension of OMT’s in full discretion
and in accordance with its price stability mandate;
- liquidity created through OMT0s will be fully sterilised.
After the adoption of such a programme, the euro area banks in the core were ready to lend again to the
Euro area banks in the periphery. As a consequence, ECB funding of periphery banks and reserves held by
the euro area core banks at ECB drop substantially, as well as, reserves, base money and the total balance
sheet dropped while the money multiplier recovered. Interest rate in the periphery also fell.

Facing the Zero Lower Bound (ZLB) Given the general formula of the Taylor rule:
𝒀𝒕 − 𝒀 ∗
𝒊𝒕 = 𝒓 ∗ +𝝅𝒕 + 𝝀(𝝅𝒕− 𝝅𝒕 ∗) + 𝜷 ( )
𝒀∗
if: r* is close to zero and 𝝅𝒕 < 𝝅𝒕 ∗ and the output gap is strongly negative, then the Taylor Rule calls for a negative
𝒊𝒕 (meaning the short-term nominal interest rate which should be imposed as a policy rate should be negative).
According to the Zero Lower Bound, the interest rate cannot fall (much) below zero, as the non-bank as well as the
banking sector always have the option of holding cash, which pays zero interest. Thus, when short-term interest
rates drop below zero, further monetary easing- as indicated by the Taylor Rule- becomes difficult by using the
conventional monetary policy instrument, i.e. the modification of short-term policy rate. This is because the
transmission of negative rates might get stuck by a massive shift towards holding cash. As a result, most central
banks do no reduce the nominal short term policy rate to levels (substantially) below zero.
This was what mainly pushed unconventional monetary policy to be introduces as a substitute for a further drop
in the short-term policy interest rate. Unconventional monetary policy usually makes use of such instruments as
quantitative easing (in which the ECB alters monetary demand by boosting the quantity of assets purchased and
targeting credit rather than by acting on the short-term interest rates) and forward guidance. UPM aims at
providing the same degree of monetary stimulus a further reduction in interest rates would have achieved, if it
had been possible. Thus, UMP is a substitute for cutting policy rates when rates are stuck to zero.
Portfolio rebalancing: liquidity in the form of reserves or deposits which the central bank creates is not considered
a perfect substitute for the assets sold. Therefore, sellers, at the point when QE has a direct effect on the market,
hold an imbalanced portfolio. Sellers aim at rebalancing their portfolios by purchasing assets which are closer
substitutes to the assets sold and, as a result, prices (yields) of these assets rise (fall) until a new equilibrium is
reached. Higher asset prices/lower yields of these assets reduce funding costs and stimulate investment and
consumption as in the process of relative prices transmission mechanism.

Empirical Evidence on UMP transmission

Financial Sector: the great majority of research finds that central banks’ broad assets purchases achieved the
immediate goals of reducing medium- and long-term yields, including private borrowing costs such as corporate
yields and mortgages.
Real Sector: unclear, as effects are extremely difficult to measure due to endogeneity, simultaneity, omitted
variables, specification error and measurement errors. Many studies assess the macroeconomic effects of UMP as
significant but less strong than effects of interest rate changes. However, effect on inflation overall disappointing.