Intermediate macroeconomics

• L = kY - hi

  L - Money demand (liquidity)

  kY - transactions demand varies positively with income, Y

  hi - speculative demand varies inversing with nominal interest rate, i
• kY

  Transactions demand varies positively with income, y

  Increase in income, more money, higher demand = positive relationship

  With sensitivity k (income elasticity of money demand)

  Bank of England works on the assumption k=1
• hi

  Speculative demand varies inversely with nominal interest rate, i

  increase i - if interest rates increase bonds become more desirable

  Decrease L (demand for money is going to fall)

  Negative relationship

  With sensitivity, h (interest elasticity of money demand)

  Nominal interest rate is the quoted interest rate not the same as real interest rate as that is nominal interest rate - rate of inflation
• Money supply (M) is controlled by central bank

  • policy variable
  • exogenous - not determined by anything else in the system
  • not dependent on i, Y
• Increase Y - Increase L - L > M - Increase i

  Increase income - Increase liquidity - liquidity > money supply - increase interest rate
• Downward sloping money supply curve

  Increase M - Decrease i

  Increase money supply, interest rates will fall
• Y = AE

  AE = Planned or aggregate expenditure
• Closed economy

  Y = C + I + G

  C - consumption

  I - Physical capital investment

  G - Government spending
• Consumption

  C = cY

  c - marginal propensity to consume

  Y - sensitivity

  Typically a high number such as 0.9
• Investment (I) (physical capital)

  I = ī - bi

  ī - autonomous investment

  b - interest elasticity of investment - (typically 0.5 can vary)

  i - Interest-sensitive investment - Investment is inversely related to the normal interest rate (cost of investment)

  Increase interest rate - more costly for firms to expense - leads to a fall in investment
• Government spending

  Financial

  1. taxes today (e.g. income tax, t)
  2. Issue bonds (borrows), B - taxes tomorrow
  3. Seigniorage (printing money) - increase 5% - π increase 5% - inflation tax
• b - 0, di/ dY = ∞ Vertical IS curve

  b - ∞, di/dY = 0 Flat IS curve
• So if inflation is 0 then nominal is the same as real interest rate

  With this we are assuming that prices are fixed. This is fine if we are in a recession (If prices are fixed there is no inflation (0)) .
• What would happen with a fall in the interest rate?

  Increase in investment
• Why is the IS curve downward sloping?

  fall in the interest rate thus would simulate investment and because investment is a component of GDP, GDP will rise

  Decrease nominal interest rate (i) - Increase investment (I) - Increase Output (Y)
• Increase government spending ?

  G0 - G1

  This shifts the IS curve outwards due to an increase in G

  Would be disappointed if a rise in government spending doesn't lead to an increased output
• Government spending (G) only affects the IS curve

  Money supply (M) affects the LM curve
• What happens if you increase money supply (M) ?

  M0 - M1

  Only changes the LM curve

  A rise in M shifts the LM curve in a positive direction
• An expansionary money policy leads to an increase in GDP (similar to fiscal policy).
• In a recession you need to boost government spending and money supply
• Money policy is effective but leads to a fall in interest rates. This is neither good nor bad globally it depends on the person in the situation
• what happens when b tends to infinity ?(Monetary policy)


  Flat IS as b is tending to infinity

  Monetary policy is very effective and there is no change in interest rate
• What happens when b tend 0 ?(Monetary policy)

  Vertical IS

  Interest rate has fallen however there is no change in output this means that this monetary policy is ineffective
• What happens what b tends to infinity ? (fiscal policy)

  Flat IS

  Fiscal policy is ineffective
• What happens when b tends to 0? (Fiscal policy)

  Vertical IS

  Fiscal policy is effective when it is vertical subject to the normal caveat of the crowding out effect.
• What happens when h tends to infinity ? Monetary policy


  Flat LM

  Monetary policy is ineffective (liquidity trap)

  Zero - lower bound problem
• What happens when h tends to 0 ? Monetary policy

  Vertical LM

  Output increases and has the normal falling interest rates so it is effective (classical view)
• What happens when h tends to infinity ? Fiscal policy

  Flat LM

  Not only is there an increase in output but there is also no crowding out (keynesian view)
• What happens when h tends to 0 ? Fiscal policy

  Vertical LM

  Output has no change and all the government spending has passed through to the interest and then us complete crowding out. (classical view) Ineffective
• Limitations

  Fixed prices - inflation assumed to be zero π = inflation

  r = i - π

  As inflation is 0 then the equation is r = i

  This is so we can draw IS and LM on the same diagram (i on the vertical axis)
• fe = full employment

  Yfe = output at full employment (the maximum a country can actually produce)
• Counterargument to if fixed prices are a limitation

  There are independent central banks which target inflation

  It is based on the Taylor rule:

  • this says that if inflation increases higher than 2% then they will look at increasing interest rates.
  • This bank will look at the economy to see whether increasing interest rates is suitable
• If there is no interaction with the money market (no exchange in interest rate then we can see that it is a basic multiplier )(didn't take into account that the LM curve will move)
• Nominal exchange rate - the price of one unit of foreign currency in terms of the domestic currency - E

  Uk - Norway. E = 0.08. costs 8 pence to buy 1 krone

  (UK / US media: often use inverse definition)

  1/E = 12 12 kroners to £1
• Real exchange rate (R)

  R = EP^w / P

  nominal x relative price level
• Purchasing power parity (PPP) - R = 1
• Rise and falls

  appreciation fall in E

  Real appreciation fall in R

  A fall in R is the domestic currency is "less competitive" ("stronger")

  [fix : revaluation]

  depreciation rise in E

  Real depreciation rise in R

  This means the the domestic currency is "more competitive" (weaker)

  [fix : devaluation]
• Imports (IM)

  IM = m,Y

  m = marginal propensity to import MPM

  m2R - real exchange rate sensitivity of imports

  Decrease in R is less competitive (our goods more expensive compared to foreign goods) - increase IM
• Exports (EX)

  EX = x1Y* + x2R

  x2R - real exchange rate sensitivity of exports - increase in EX

  Increase R more competitive (i.e cheaper than others)
• Balance of payments

  BP = CA + CP + OR

  current account + capital account + official reserves