Résumé de ‘Macroeconomics’ de Burda & Wiplosz (4th edition)

Chapter 2 : Macroeconomic AccountsGDP – 3 definitions :

1. Sum of all net final sales

2. Sum of value added

3. Sum of factor incomes earned from economic activities

The division of the value added is arbitrary and potentially separate from the issue of whether

value added is generated at all.

GDP doesn’t measure happiness: Painful expenses (having a tooth removed) enter the stats in the

same way as pleasurable ones. Used-goods sales are not counted at all (second hand market). Sales

by retailers from inventory accumulated in earlier periods actually reduce GDP, as they represent a

depletion of stocks (?).

GDP: location-based

GNP: Ownership-based

GDP deflator: Ratio of nominal to real GDP (Ex: Nominal Growth: 10%, Real growth:

6%, GDP deflator growth: 4%). Prices rose therefore roughly by 4% (inflation).

Alternative measure of inflation: price index (average of prices with fixed weights). An

example is the consumer price index (CPI): based on a basket of goods consumed by a

representative or average individual.

GDP Deflator and CPI are normally congruent, only when there are external shocks on

import prices (oil shock, etc.) they might differ.

*PPI: Producers Price Index (closest to the GDP Deflator)

Many indexes and strategies how to use them! For example in Italy, linking wages to the CPI

rather than to the PPI resulted in higher profits for firms whose incomes are better described by

PPI.

Both the GDP deflator and the CPI measure the price level, or the price of goods in terms of

money.

Further drawbacks of GDP as a measure of economic activity: Underground economy and

unpaid work (if you pay a femme de ménage and report it, it’s counted for GDP, if you do

the work on your own, it’s a ‘loss’ in GDP output). In Holland, e.g., unpaid work

represented 36-58% of the potential GDP.

As long as the distortions do not change much over time, measured GDP growth rates offer

a good picture of average economy performance.

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Why GDP per capita comparisons have to be accompanied by caution

1. GDP is a measure of income (flow), not wealth (stock).

2. Large numbers of transactions are not recorded especially in developing countries

(informal economy).

3. GDPs measured in local currencies and then converted. But local costs in poor

countries are often lower.

Economists use adjusted GDP figures including purchasing power.

Balance S - I: Private sector’s net saving behaviour (can be positive or negative)

Net taxes: difference between taxes and transfers

Private income: Y (GDP) – T; Private income is ultimately earned by those households

which own the factors of production involved in creating the value added (wages and

salaries, rents and royalties); the rest: gross profit (saved by firms or redistributed to firm

owners as income).

Financial intermediation: banks channel money

Productive equipment, including structures, is referred to as physical capital, and

purchases of new equipment are called investment.

Total national spending, sometimes called absorption: C+I+G

Net exports: X – Z: Negative: Total domestic demand is bigger than demand for domestic

production.

Investment in economics: Creation of new productive capacity (excludes acquisition of

existing assets of financial instruments like stocks, etc.)

As net final sales, the GDP is broken down into four main categories: final sales of consumption

goods and services (C), final sales of investment goods and additions to inventory stocks (I), final

sales to the government (G), and sales to the rest of the world (X).

*Y=C+S+T

C amounts traditionally to about 60% of GDP, Government expenditures: 14-23% (transfers not

included)

If savings of the private sector exceed investment spending, for example, it means that net

accumulation of assets in the private sector was positive.

*Disposable income: Part of GDP that reaches the households (minus net taxes and retained

earnings, saved by firms), in CH: 66%, Sweden: 46%

Additionally depreciation (obsolescence of productive material) should be subtracted from GDP:

Also depreciation of nature, common goods, etc? Net domestic national product (NDP)

*English: VAT: Value Added Tax; Excise taxes: on petrol, tobacco, alcohol

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* Current Account: Balance of Payments of Goods, Services, invisibles (Royalties, Investment

income), and unilateral transfers. CA=Y – (C + I +G) = Y-A; A = Absorption

By definition, the CA is the excess of income (GDP) over spending. It signals whether the

country is a net borrower or a net lender.

The rest of the BOP describes financial transactions. All items in balance must add up to zero. CA

deficits imply borrowing from abroad, so financial capital is flowing into the country.

Who is balancing? First the CB: by selling or buying foreign exchange reserves: foreign exchange

market interventions.

Distinction between long-term (FDI, acquisition of foreign companies, portfolio investment,

establishment of subsidiaries abroad) and short-term (hot money) transactions.

*CA + FA (Financial Account) + Off (Official interventions) = 0, corrected by ‘Errors and

Omissions’.

A CA surplus can be financed privately, publicly, or both.

*BoP = CA + FA = -Off

A BoP surplus means that the authorities have acquired foreign exchange reserves. Put differently,

they have sold the domestic currency, thus preventing or reducing pressure for an exchange rate

appreciation. Accordingly, the official account is in deficit.

*GDP = Y = C + I + G + CA = C + S + T (e.g. CH: I is bigger than S Government buys

foreign currency to balance and to avoid depreciation of the CHF in the CA this is marked

as ??????? in any case as a negative as the acquisition of a foreign currency means a net outflow

of CHF. This negative CA balances the positive I.

*CA = (T – G) + (S – I) So the CA is already negative and not because I overdose was

balanced.

Chapter 4: Labour Markets and Unemployment

The supply of labour is seen as a trade-off between consumption and leisure. This is known as the

consumption – leisure trade-off. This can best be drawn using indifference curves.

*MRS of consumption for leisure

*Real (consumption) wage: price of leisure (its opportunity cost)

*time budget constraint: it explains why the real wage is often referred to as the relative price of

leisure in terms of consumption.

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*Wage increase: the relative attractiveness of leisure declines Robinson works more: the

substitution effect

*Income effect: More leisure due to higher wage

*Man-hours: Aggregate supply; total amount of hours supplied by all workers during that same

period.

*MPL: Marginal productivity of labour; Enterprise’s maximum profits are when: MPL (=

firm’s labour demand curve) = w

Labour can become more productive either because more capital is put in place, or because

technological progress makes labour more productive using the existing stock of equipment.

*Technical change and unemployment: If output rises as fast as labour productivity, employment

must have increased. It is usually the case that real wage rises faster than productivity. In the end,

in the long term, if hours worked per person decline, there is no need for employment to decline.

And this is what happened.

*fallacy of composition: what applies to a particular industry will generally not apply to the

economy as a whole.

*equilibrium on the labour market: Supply curve derived from household behaviour, and

demand curve derived from firm behaviour. Thus both the real wage rate and employment are

endogenously determined in the labour market. What is unsatisfying: Any unemployed labour –

literally, labour not employed – reflects the voluntary decisions of households and firms. There are

no hours which are involuntarily unemployed at the given wage.

The ILO and the OECD define an individual as unemployed if he or she does not have a job during

the reference period and is actively looking for one and is ready to work.

*Ls = L + U u = U / LS LS being labour supply

One interpretation of unemployment is the failure of the wage to decline that perpetuates

unemployment (‘failure of markets to clear’). So, involuntary unemployment must be explained by

real wage rigidity.

*trade unions (union membership, union coverage); the ‘budget line’ faced by the union is the

demand for labour. Demand for labour is given by the MPL. When a trade union values both

higher wages and more employment, its preferences are described by indifferences curves. A

‘hard-line’ union is not willing to give up much in lower wages to raise employment. A union

mainly preoccupied with employment is represented by steep indifference curves.

As the labour demand schedule shifts, successive tangency points map out the collective labour

supply curve. The slope of the collective labour supply curve thus reflects the preferences of the

union for employment and wages as well as its economic environment. Union members who are

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currently employed or who enjoy seniority or job protection tend to fight for a hard-line union: if

their influence is high, the slope of the collective labour supply curve will be steep.

Unemployment is involuntary for affected individuals, but voluntary from the union’s point of

view. Why do unions enforce wage rigidity, apparently against the will of unemployed workers?

One reason is that the leadership is typically elected by the employed, sometimes called insiders.

*’hysteresis effect’: Step-wise increase in the unemployment rate following each oil shock. Labour

unions, while owing to a circle of insiders, reduce the employment level permanently. The split

between unions and unemployed workers cannot go too far, though. Since unemployment

increased to high levels in Europe in the 1970s and 1980s, unions have become more employment

conscious and real wage growth has moderated. One reason is that members become worried that

they too might become unemployed. A second reason is criticism from the non-unionized

component of society. It would be unfair to assert that unions are solely responsible for real wage

rigidity. While it is in the firm’s interest to keep wages low – trade unions were often created to

prevent employers from exercising rather ruthlessly their power and imposing very low wages.

Other factors contribute to wage rigidity: Social minima, or minimum standards of income and

earnings mandated by the government for reasons of social equity or protection (i.e. minimum

wages). One reason for minimum wages was to prevent employers with too much market power

from depressing wages artificially. Another reason was to protect young people from exploitation.

The primary economic effect of minimum wages is to discourage firms from hiring workers

with low MPL, which tend to be the young, the unskilled, those with little training, or those with

the wrong skills. The minimum wage to serve any purpose at all needs to be higher than the union-

negotiated wages or individual-supplied labour wages (?).

*Minimum wage in France: SMIC (Salaire Minimum Interpersonnel de Croissance).

*efficiency wages : Firms pay deliberately a w > MPL to ensure a better work effort of labour

(because work effort is not easily observed by firms). A worker who is dismissed for lack of effort

is unlikely to obtain such a good deal elsewhere, especially if dismissals are interpreted as a sign of

poor work effort.

All these arguments go beyond simply equilibrating demand and supply in labour markets.

Labour market equilibrium attempts to capture the unemployment rate that would occur in the

absence of cyclical disturbances. Equilibrium unemployment can be viewed as the sum of

frictional and structural unemployment. Frictional unemployment occurs because it takes time

for a match to occur between a worker seeking a job and a vacancy needing to be filled (sort of

transaction cost). It depends on the efficiency of the labour market. Structural unemployment has

many causes. A number of institutions and regulations, collective labour supply, etc. Europe has

experienced a fall in the finding rate after the oil shocks. Is the social safety net to blame? There

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seems to be some evidence for it (comparison Europe-USA), but also some disturbing counter-

evidence. The social safety net is even more developed in Denmark, Sweden, and Norway, where

long-term unemployment has remained lower. Really important is arguably not the safety net itself,

but the disincentives that it may generate. The strikingly different evolution of the equilibrium

unemployment rate across countries also points to the importance of institutions in influencing

wage levels. In Europe high unemployment is related to steep real wage increases (European ‘wage

shock’).

*It can take a long time, often years, before real wages actually adjust to their long-run values.

*The two oil price shocks acted like large negative productivity shocks Labour demand -, plus

I-.

*Individual labour supply seems to be inelastic in the short run, but in the long run is more likely to

be backward bending.

*Very centralized or decentralized wage negotiations deliver lower real wages and less

unemployment than negotiations taking place at intermediate levels of centralization (industry by

industry, or by craft).

Chapter 8: Money

1. Narrow definition:

Monetary aggregate: M1 = currency in circulation + sight deposits (current account)

2. Broader aggregates:

M2 = M1 + time (or savings) deposits at banks with unrestricted access

M3 = M2 + larger, fixed-term deposits + accounts at non-bank institutions

All the aggregates measure the ‘liquid wealth’ of the non-banking sector.

The computer revolution has made complex transfer agreements virtually costless and has thereby

rendered money definitions increasingly arbitrary.

*“The vision of Wicksell: A Moneyless Society”

Definitions of money:

1.) A medium of exchange (solves the double coincidence of wants)

2.) A unit of account (the common denominator)

3.) A store of value (savings)

4.) A standard of deferred payment (numeraire for debts)

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Money is a dominated asset (in comparison to short-term government bonds, e.g.); this yield

disadvantage can be seen as the cost of ‘staying liquid’. This is the reason for the systematic

inverse relationship between liquidity and returns. The price of liquidity is forgone interest.

Money’s desirability stems from its unique ability to resolve the problems of the double

coincidence of wants and of information asymmetry.

*phenomenon of dollarization in the 1980s in the Easter European (roughly one third) and Latin

American countries

Money as a public good: (left to the market, this public good – as so many others Mister Wasescha

- would be undersupplied, no matter how useful it is). Plus the problem of information

asymmetry, the fact that others know less about the customer than he himself does.

The creditworthiness of the state is essential for fiat money – non-commodity money – to circulate.

Confidence emerges as the key characteristic of money.

Balance sheet approach – 3 actors:

1.) Central Bank

2.) Commercial Banks

3.) Consolidated Government and Nonbank Private Sector

Cash held by the public is a liability of the CB.

Gold, silver don’t play any role anymore. Precious metals have been replaced in most balance

sheets of CB by dept of the government, private financial institutions, or foreign CB. These assets

have become the backing for currency.

Money is thus as good as the consolidated assets of the CB and the commercial banks, and

that is the indebtedness of the government and of the private sector. This is why, in the end,

modern money – in contrast to gold and silver money – ultimately rests on the trust of agents in

their own economies.

*Real money stock = M / P (M being the nominal stock of money and P the CPI)

*The neutrality of money: If prices double as does the money supply: no effect on real economy

Determinants for Money Demand:

1.) Price

2.) Real income (Money demand is about proportional to income)

3.) Nominal interest rates: The nominal interest rate matters for the demand for money because

it is the opportunity cost that households and firms face for holding wealth in this form.

*M / P = L (Y, I, c), + - + (c: average cost of converting other forms of wealth into money:

transaction costs; M / P: Real money demand)

Two theories of money:

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a.) inventory theory of money (trade-off between the cost of holding that inventory – interest

costs – and the transaction cost of converting interest-bearing assets into money)

b.) portfolio balance of speculative demand for money (interest rates high and expected to

decline traders acquire bonds to take advantage of capital gains speculative demand

for money declines) + precautionary motive

*Discounting: Evaluation of future incomes or expenditures in terms of resources today

When expected inflation is constant, real money demand is constant (anticipated movement in the

rate of change in the price level) and nominal money demand just moves with the price level. As

inflation increases, real money declines, which means that the nominal money demand grows less

quickly than prices.

*Velocity of money: V = PY / M; V = Y / L (Y, I, c)

In the particular case where real money demand is proportional to real GDP, velocity is

independent of GDP.

*interest rates are procyclical

If the nominal cost of converting wealth between interest-bearing assets and money decreases,

wealth is held in the form of interest-bearing assets and less in the form of money. Demand for

money declines ( interest rate declines until opportunity cost is low enough to persuade agents to

hold the existing money supply).

Equilibrium in the money market: the long run

a.) Inflation is determined by the rate of money growth

b.) The rate of nominal exchange rate depreciation is determined by the rate of inflation

Real interest rate (r) = Nominal interest rate (i) - expected inflation

For decisions such as consumption and investment, we have seen that the real interest rate is the

one that matters. In principle, no one would lend money at a nominal interest rate lower than

expected inflation.

The nominal rate can therefore be seen as the sum of the reward to the lender, or the cost of

borrowing (the real interest rate) and expected inflation. This relationship linking the nominal

interest rate, the real interest rate, and the expected rate of inflation is called the Fisher

principle or the Fisher equation. It shows that the negative effect of expected inflation on real

money demand works itself through the nominal interest rate.

Fisher equation: Nominal interest rate = real interest rate + expected inflation

In countries with chronically high inflation nominal interest rates are often indexed.

*The real exchange rate (Sigma) is defined as the ratio of domestic to foreign prices. The real

exchange rate is constant when equal to the inflation differential (between foreign country

and domestic one).

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*Relative purchasing power parity (PPP)

Bringing together PPP and the explanation of long-run inflation, we see that the long-run rate of

exchange rate depreciation depends on the difference between the rate of money growth at home

and abroad.

A much stronger version of this idea is absolute PPP, which asserts that price levels are equalized

across countries when converted into the same currency. The evidence on this is rather spotty, but

in Europe it might just as well work in the future (works only in very integrated markets).

*The demand for money increases with transaction costs because agents have an incentive to limit

the number of transactions between money and other assets.

*Inflation reduces purchasing power of money. An expected increase in inflation leads agents to

reduce their real demand for money. This effect is captured by the nominal interest rate, the sum

of the real interest rate, and the expected rate of inflation (the Fisher principle).

*In the long run, in the absence of real disturbances and relative purchasing power, parity holds.

Then the rate of nominal exchange rate depreciation is equal to the inflation differential.

Chapter 9: The Supply of Money and Monetary PolicyCB are typically required to deliver low and stable inflation.

*ESCB: European System of Central Banks (or Eurosystem)

Inflation may be the objective, but central banks cannot control it directly. Inflation is determined

by the confrontation of the real demand for money with a nominal money supply. The ‘art of

central banking’ is to match the supply of money today with its ultimate, long-run impact on

inflation. Thus achievement of the inflation objective is indirect. To that effect, CB rely on targets

and instruments.

Instruments:

a.) Bank refinancing rates

b.) Open market purchases and sales

c.) Reserve ratios

Targets: (intermediate objectives)

a.) Long-term market interest rates

b.) Monetary aggregates

c.) Exchange rates

d.) Inflation rates

Objectives:

a.) Price stability

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b.) Short-term growth

c.) Exchange rate stability

Nowadays, interest rates set directly by the CB have become the instrument of choice. The money

supply is then determined by the market.

CB control only cash and bank reserves held by commercial banks at the CB. Secondly, it regulates

commercial banks’ money creation by limiting the volume of their reserves.

The sum of currency in circulation and commercial bank reserves is known as the monetary

base, sometimes called M0.

Were it not for banks, the only circulating medium of exchange would be currency. Contrary to

all other financial intermediaries, commercial banks issue money by lending money that they

do not directly possess.

It is the CB that shifts the money from one reserves account to another, when a customer cashes in

a cheque. For such transactions, a positive reserve balance is obviously necessary at the CB. In

other countries there are reserve requirements (a certain reserve ratio). EU: 2%, USA: 3%, none in

CH, UK who rely entirely on prudential behaviour.

The linkage between loans and reserves implies a relationship, known as the money

multiplier, between the monetary base and each monetary aggregate.

*Reserve multiplier = 1 / rr (reserve ratio)

Since the CB is interested in controlling the aggregate money stock (M1, M2, or broader

aggregates), rather than reserves per se, more attention is paid to the monetary base multiplier, or

money multiplier, which relates the monetary base to a monetary aggregate, for example M2:

Monetary multiplier = M2/M0.

The larger the share of currency is in M0, the fewer reserves which remain in the banking system,

and the smaller is the multiplier.

Leakages: Deposits in non-bank financial institutions which operate with a 100% reserve

requirement plus, money can leak abroad. But the reserve availability is less automatic than

implied by the money multiplier formulae. As conditions change, or are expected to change, the

actual multiplier can fluctuate.

At a time of globalization, reserve requirements subject the domestic banking sector to a

competitive disadvantage relative to other countries with lower or non-existent minimum ratios.

*MOd = M / m;

(Derived demand for the monetary base equals the nominal demand for money devised by the

money multiplier m)

Any change in the demand for the overall money stock M is transmitted to a change in the demand

for the monetary base.

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*The market for the monetary base is called money market or open market, the linchpin of all

financial markets.

Open market operations:

1.) short-term loans from CB to commercial banks, guaranteed by a collateral MO

rises M1 as well

2.) Purchase or sales of assets (foreign exchange, government securities)

3.) Changing the binding reserve ratio

Because these loans are short-term, commercial banks continuously need to pay back and borrow

again, a procedure called rolling over. This increases the precision of CB intervention.

* The money market rate reflects the cost of money to banks (the rate they use for trading reserves

among themselves); in EU: EONIA

The CB cannot define the supply of money and the level of money market interest rates at the

same time (see Fig. 9.6)

As long as the public’s demand for monetary aggregates is stable, money growth ultimately

determines inflation.

Lately, the link between money growth and inflation has become less predictable over the policy

planning horizon (two, three years), much as the link between money base and wider monetary

aggregates has become clouded. Monetary targeting has become unreliable, main reason is the

variable money multiplier: control of MO does not deliver a precise handle on the wider

aggregates.

A promising approach is inflation targeting.

Monetary policy in an open economy: CB use their foreign assets to intervene on the foreign

exchange market to influence the exchange rate.

There is a similarity between exchange and open market interventions. Both affect the liabilities of

the CB (monetary base) as well as its assets and in both cases the money multiplier then amplifies

the initial effect of the intervention. The difference lies in which asset holding changes (domestic

or foreign).

Monetary policy autonomy is lost when the CB is compelled to intervene on foreign exchange

markets to fix the exchange rate (in case of fixed exchange rate). Sterilization (‘quick fix’)

strategy: Do the opposite intervention on both holdings. This is a reshuffling of the asset side of

the CB’s balance sheet – an increase in domestic asset holdings matched by a reduction of foreign

exchange – leaving the liability side, in particular the monetary base, unchanged.

monetization of the public debt

Seigniorage is the main source of profit for the CB (counterpart for printing bills for the

government)

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Inflation tax: Erodes all nominal government liabilities that are not protected against

inflation, not just the monetary base (tax because the household – the ultimate borrowers –

pay for it: it’s an indirect tax like the TVA and consequently an unjust one).

Since most of the money stock is created by commercial banks, control of the money

supply by the central bank is only indirect.

The public’s demand for money translates into a derived demand for the monetary base.

This demand is expressed in the money market.

There exists an automatic link between foreign exchange market interventions and the

money supply. Sterilization is one way of breaking the automatic link.

As a public institution, a CB can assist the government in the financing of its expenditures

in three ways:

a.) it can lend directly to the government

b.) it usually remits most if not all of its seignorage profits

c.) by allowing inflation to rise, it creates an inflation tax which lowers the burden of

the public debt when the latter is not indexed.

In addition to establishing the standard of payment, the CB ultimately guarantees the value

of money. This is done by a variety of regulations and the lender-of-last-resort function. Bank

deposits are guaranteed – sometimes up to a certain level – through a combination of insurance

schemes and implicit understanding that the CB will create sufficient monetary base in case of

bank failure. In return, the CB may impose on banks constraints designed to reduce their

vulnerability.

Chapter 10: Aggregate Demand, Output, and the Interest Rate

*Keynesian assumption: the sticky price assumption (prices are constant over the short run):

implies that output is determined by demand, and that production adjusts passively to shifts in

aggregate demand.

*trade openness: % of international trade in GDP

*CH share of world GDP: 0.8% (USA: 32.1%), openness: 40.9% (USA, Japan, EU: 10.5-11.8%)

*General macroeconomic equilibrium: Interactions between several markets, focusing on the

conditions required for their simultaneous equilibrium. Through the interest rate, the money market

affects the goods market, and thus the level of output. The goods market, in turn, influences the

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demand for money and thereby the interest rate. The real exchange rate influences the demand for

domestic goods and the money market affects exchange rate.

*Y = C + I + G + PCA (primary account which represents the net demand from the rest of the

world: X – Z)

*Consumption function:

*Investment function:

‘Tobin’s q’: business expectations or entrepreneurial ‘animal spirits’ (exogenous)

*Import function:

*Export function (‘Z of the rest of the world’):

*Primary current account function:

Those factors which boost domestic absorption A (increases in wealth, disposable income, Tobin’s

q, real growth, or a decline in the interest rate) increase imports and worsen the PCA. Finally, a

real exchange rate appreciation leads to a deterioration of the primary account as imports rise and

exports fall.

*Rewritten PCA function in terms of GDP:

*Desired demand function:

GDP has thus two effects. The consumption effect dominates, because Z represent a fraction of

domestic spending.

*The 45° diagram: the schedule is flatter than the 45° line because, when income or GDP rises,

demand for domestic goods and services increases by less. One reason is that part of any spending

falls on imported goods, plus consumers usually save part of any additional income plus parts of

the additional income is taxed away (is this missing tax share not already mathematically indexed

in the original 45° parameters?).

*Consumption smoothing behaviour: Not sure whether an increase in Y will last, the consumer

saves parts of it.

This schedule (Fig. 10.3) only captures the effect of GDP on demand, taking all other

variables as constant. If they change, the DD schedule will shift. For instance, an increase in i

reduces D for I goods, which shifts DD downward. *goods market equilibrium and

*equilibrium GDP

Firms use their inventories as a buffer to meet temporary changes in demand; the accounting

identity remains verified off equilibrium because inventory changes are treated as demand –

positive when inventories raise, negative when they decline – and demand, and therefore sales,

may differ from output.

The Keynesian model explains how output fluctuations are driven by exogenous changes in

demand.

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*Keynesian demand multiplier: Effect that explains that GDP increases by a multiple of the

initial demand increase (process that may take several months to complete). ‘Everybody’s

additional spending is someone’s income.’ The Keynesian multiplier is not infinite because, at each

step, some fraction of income is not plugged back into further consumption (leakages: T, S, and Z).

Theses three leakages represent domestic income not automatically re-spent on domestic goods

and services. In fact, they might trigger new multipliers but, since we consider G, q, and Y* as

exogenous, we cannot logically treat them as responding automatically in the circular flow of

income. In the end, the larger the automatic leakages, the flatter is the DD schedule.

*Estimates of the Bundesbank: Most of the effect occurs within one year, and the multiplier is

indeed larger than 1 in most cases. There is still some impact left over the second year.

Problem of endogenous and exogenous (prices, e.g.) variables in the Keynesian model: Some

variables are exogenous (fixed exchange rate) under a given exchange rate regime, and endogenous

under another one (flexible exchange rate the exchange rate and thus P). So, when the exchange

rate is flexible and endogenously determined by market forces, the CB can control the money

supply, which is then treated as exogenous (M = M). Similarly, when the CB pegs the exchange

rate, the chosen parity S is treated as exogenous, while the money supply M is endogenous.

*IS curve: For given values of exogenous variables, the IS curve represents the combinations of

nominal interest rate i and real GDP that are consistent with goods market equilibrium.

The IS curve’s slope is flatter the greater the sensitivity of C and I to changes in i, as measured by

the vertical shift of the desired demand schedule and the larger the multiplier that translates the

initial exogenous change into higher total demand.

*excess supply and excess demand region in the IS graph

The economy can temporarily stay off the IS curve, while firms use their inventories as a buffer

stock, but fairly soon they will adjust their output, returning the economy to goods market

equilibrium on the IS curve.

Important: No confusion between shifts of the IS curve with movements along it! It describes

how the two endogenous variables, Y and i, are combined to achieve equilibrium, ceteris paribus

(all the variables that we treat as exogenous when we draw the IS schedule). Any change of these

variables delivers another IS curving accordingly (shift). As long as they rest unchanged, we move

along the curve. What exogenous variables are relevant? – G, T, q (affecting I decisions), wealth

(which result from fluctuations in the value of assets such as stocks, bonds1, housing, and foreign

disturbances (change in Y* that affect the IS curve through the PCA), including changes in the real

exchange rate or domestic and foreign prices.

1 Traduction en français : stocks actions ; bonds obligations

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*Over the 1990, US stock prices increased on average more than fourfold (‘information technology

revolution’)!

*Tobin’s q is measured as the inflation-adjusted value of the stock market index. It sometimes

precedes GDP as an indicator for market evolutions (mid-1990s) sometimes it lags GDP (2000

onwards).

*The PCA is not only source of leakages, but also transmits foreign disturbances.

The LM curve is the combination of income and interest rates for which the money market is in

equilibrium, given the price level and the exogenous variables.

*Money market equilibrium: M / P = L(Y, i, c)

The LM curve is steeper the more sensitive the demand for money is to changes in real GDP (large

income elasticity of money) and the more sensitive the demand for money is to interest rate

changes (low interest elasticity of demand).

To summarize, the LM curve is steeper, the more sensitive money demand is to output, and the less

sensitive it is to the interest rate.

All points off the LM curve signal conditions of disequilibrium in the money market. The region

below and to the right of the LM curve represents disequilibrium situations of excess demand

(below) or supply (above) on the money market. Restoration of equilibrium requires either a rise in

the interest rate, or a reduction in GDP.

To avoid confusion between shifts of the LM curve and movements along it, the same rule applies

as for the IS curve: it remains unchanged as longs as the exogenous variables (L, c) do not change.

In international financial markets, the foreign rate of return i* is exogenous and constantly adjusted

worldwide through arbitrage of the sharks interest rate parity condition: i = i*: BP line

Three schedules: IS, LM, BP line: drawn ceteris paribus

*General equilibrium: Goods, money, and international capital markets are in equilibrium.

The open-economy IS-LM model is an efficient way of understanding the working of an open

economy in the short run, when the sticky price assumption is defensible (supply fully adjusts to

demand; this is the traditional Keynesian view2). More precisely, it allows us to ask what happens

to the model’s two endogenous variables (i, GDP), when any of the exogenous variables changes.

Example of expansive monetary policy under fixed rate conditions

(M +) LM shifts to the right i < i* I in domestic assets + danger of depreciation CB:

exchange market intervention (buys domestic currency with its accumulated stock of foreign

exchange reserves M - LM shifts to the left initial general equilibrium point restored.

Monetary policy has no effect under a fixed exchange rate regime!

2 So, if demand exceeds supply, producers won’t rise prices but adjust with increased production. This works quite well for regimes with fixed exchange rates. If prices are flexible, it is rather demand that adjusts to supply.

15

Graphically we find that the LM curve is endogenous and must always move to pass through

where the two other schedules IS and BP intersect.

Same procedure on the balance sheet: M0 (liability side) = F + DC (asset side), F being foreign

exchange and DC domestic credit or securities. What the right hand gives – more M0 and more DC

– the left hand takes away – less M0 and F – and M0 must return to its initial level to keep i in line

with i*. This foreign exchange market intervention procedure that follows the initial open market

intervention that expanded MO is called an unsterilized intervention. In principle, the CB could,

instead, conduct a sterilized intervention. This would mean to re-inject in a second step the gained

MO into the market (trading off with DC) which would lead to the situation where the CB has just

reshuffled its balance sheet’s asset side. A sterilized intervention fully shields the monetary base

and, therefore, the domestic supply.

*Capital controls: mean to dissociate i from i*. In practice, however, the rewards to dodging the

controls – exploiting the difference between asset returns – are so high that many investors develop

great skills and invest large amount of resources to circumvent the controls.

Example of G + under fixed exchange rates: IS shifts to the right GDP + money demand +

i + (so crowding out) capital flows in exchange market under pressure of appreciation

government: M0 + LM shifts to the right GDP +

The end result is that the demand disturbance does affect output. A fiscal expansion (G +, T -)

succeeds in raising output. In fact, the expansionary effect is more powerful in a small open

economy than in a closed one. The crowding-out effect vanishes, simply because i cannot depart

from i*. The CB is forced to expand the money supply as it intervenes on the foreign exchange

market to thwart an appreciation.

One more illustration that monetary independence is lost under fixed exchange rates.

*policy mix: co-ordinated use of monetary and fiscal policies

In a situation of international financial disturbances (i* + or -), economy with fixed rate is not

shielded LM to the left GDP -, while a flexible rate quickly depreciates X + IS to the

right GDP +

*Devaluations and revaluations can restore certain monetary policy independence.

Parity change is not merely a declaration of intention, but must be backed by action.

Devaluation must be accompanied by a monetary expansion, a revaluation by a monetary

contraction. Thus, monetary and exchange rate policies are just two sides of the same coin.

This important observation qualifies the previous, radical conclusion that monetary policy is lost

under fixed exchange rates when capital is freely mobile.

Flexible Exchange Rates: IS to the right The CB doesn’t intervene in the foreign exchange

market and can therefore control the money supply. Put differently, the position of the LM curve is

16

exogenous i > i* K flows in S +, the real exchange rate as well PCA - demand for

domestic output - IS to the left

The return to the GE is not instantaneous, the effect of S on trade and the CA needs time to

complete.

Aggregate demand disturbances leave output unaffected! Increases in D entirely leak abroad as

a result of the loss of competitiveness. So, domestic demand impulses are eventually neutralized by

exchange rate changes and, beyond a transitory period, the economy is insulated from foreign

demand disturbances. The IS curve is now endogenous and moves to meet the two other

schedules, LM and BP.

Monetary expansion: LM to the right K flows out nominal exchange rate depreciates

external competitiveness + demand for domestic goods + CA + IS to the right

Works! Monetary policy works entirely through its effect on the exchange rate and the CA, rather

than through the interest rate, which remains governed by foreign returns.

*beggar-thy-neighbour policy: policy that diverts world demand away from foreign goods and

toward domestic goods. This unfriendly policy is one of the historical reasons of the Euro.

The firms that benefit from a monetary expansion are those that are export oriented, while the

policy mix favours firms that cater primarily to domestic customers. Depreciation benefits firms,

but hurts customers. Plus, policy mix doesn’t hurt the foreign competitors.

International financial disturbances K flows out depreciation external competitiveness

and CA + IS to the right. Monetary contraction has thus an expansionary effect at home, which

results from the fact that their exchange rate appreciation is our depreciation. This is called a

negative transmission. This feature is important to international monetary cooperation.

The exchange rate regime is best understood through the prism of monetary policy.

Among the countries that adopt the freely floating exchange rate regime are those that have

developed sufficient economic and political stability to entrust the CB with the task of delivering

price stability. Other countries let their exchange rate float for the opposite reason, because

inflation is so high that any peg would quickly lead to over-evaluation or countries that have been

bruised by speculative attacks against a previous peg (Argentina, Brazil, Chile, Russia, etc.).

*The PCA improves when income and output in the rest of the world expands and the real

exchange depreciates, and worsens when the domestic GDP and absorption rise at home.

*When the exchange rate is fixed, demand disturbances affect domestic GDP while monetary

disturbances, including fiscal policy, have no effect on real GDP. The exchange rate is set

exogenously and the money supply becomes endogenous, hence the LM curve moves to meet the

IS and BP schedules.

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*When the exchange rate is freely floating, the economy is shielded from demand disturbances,

while monetary policy is effective. The exchange rate is now endogenous while the central bank is

able to set money supply exogenously. It is the IS curve that moves to meet the LM and BP

schedules.

*Monetary and exchange rate policies are just two side of the same coin: the CB can control the

money supply or the exchange rate, not both. Under fixed exchange rates, the CB controls the

exchange rates and must give up the control money supply, under flexible rate regime it retains

control of the money supply and lets the exchange rate be determined by the market.

Chapter 11: Output, Employment, and Prices

The sticky price assumption is clearly not tenable in the long run. It is the flexible-price assumption

that provides the tool to understanding. Prices will thus be made endogenous in this chapter. It

shows that when all prices, including wages, are flexible, the GDP is determined by the supply

side. Demand-side disturbances, the usual source of business cycles, have no effect. The classical

approach has another way to achieve equilibrium, the equality between demand and supply of

goods and services: through the flexible prices. It argues that firms do not have to adjust supply to

demand. They will do so only if it is in their interest.

*Capital stock is not exogenously given in the long run, but for sake of simplicity it is here. This

assumption leads us to an interesting observation: Equilibrium in the labour market determines

the equilibrium level of output supplied by firms.

The IS/LM model shows complementarily how much households, firms, and the government want

to spend on today’s output Y given prevailing interest rates (aggregate demand). The position of

the supply line in the IS/LM graph is found by ‘reflecting’ the output level found in the production

function using the 45° line. S is vertical because the supply side here is independent of the

demand side: it is determined by labour productivity – itself determined by the existing capital

stock – and labour supply behaviour of workers and their representative organizations.

Plus we introduce flexible prices in the money market. As long as the price level is constant, the

nominal and real money supply behaves identically. But the CB controls nominal, not real money

supply. So, when prices rise, the purchasing power of money declines and real money supply with

it. Putting real and nominal money supply into one graph allows us to determine the price

level.

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We thus have considered three markets (goods and services, money, and labour), and we now have

a way of finding the output level, interest rate and price level that corresponds to the simultaneous

equilibrium in these markets. It is important to recognize that there has been no assertion that the

price level is explained – or caused – by the conditions described. Causality would imply that the

price level is endogenous, an assertion not yet made.

But the just described three markets need not be a priori in equilibrium. In the neoclassical view, it

will be the price that steps into the game at this point. When it is flexible, all three markets will

always be jointly in equilibrium.

Example of a case where the level of demand and income compatible with goods and money

equilibrium Y is less than output Y produced and supplied by firms, given labour market

equilibrium. Excess supply P- At unchanged money supply M, the real money supply M / P

increases LM shifts to the right.

This process starts to work once the firms stop to pile their inventories and under the assumptions

that the CB doesn’t change money supply and that nominal wages adapt to the market (real wages

staying the same). So price flexibility restores general equilibrium.

For the neoclassical approach to work, it is not just the price level that must be flexible, but

all prices. This includes the price of L, but also the price of foreign currency, the nominal

exchange rate. If one of these prices is sticky, the whole process breaks down.

That nominal wages are sticky, at least downward, was at the centre of Keynes’ critique of

classical economics.

We conclude that under full price flexibility, output is supply determined. Price adjustments restore

equilibrium through the real value of money (S > D P - real value of money + real i -

D +

2 important conclusions of the neoclassical model:

1. Real variables (real GDP, employment, relative prices, including the real exchange rate) are

unaffected by the level of the money supply. (IS and S schedules both describe the real side of

the economy, respectively the goods market and the labour market, while the LM curve

describes the nominal side of the economy, the money market. The general equilibrium is

entirely determined by the real side).

2. Changes in the money supply affect all nominal variables (i.e. those denominated in terms of

the domestic currency) by the same proportion.

Example of M + real money supply + LM to the right D > S P + real money

supply - LM shifts back. The prices increase thus necessarily in the same proportion

than M did. Nothing changes. (In an open economy nominal exchange rate would have to

change as well to leave the PCA unchanged and the IS curve on the spot.)

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The property that money does not affect the real side of the economy is known as monetary

neutrality.

When the price level adjusts immediately in order to maintain the economy in general equilibrium,

the classical dichotomy principle holds: nominal variables do not affect real variables. Only

real disturbances, changes in technology and tastes or in public spending and taxes, can affect the

real side (growth, employment, real consumption, etc.). Monetary factors, such as the money

supply and nominal interest rates, play no role.

This seems to be a good assumption for the long run. At the same time, the wealth of evidence

suggests that strict monetary neutrality does not obtain for the short run, say from year to year.

Changes in nominal money do not lead to instantaneous price changes.

The Keynesian approach turns around the neoclassical view: fixed prices and variable

output. (Common day-to-day experience suggests that firms do not change prices every day. Why

this is so is not entirely well understood.) Consequently real money supply is exogenously fixed

and the LM curve cannot move.

Example: D < S Supply adjusts to the left less labour employed (w are also fixed)

unemployment + disequilibrium on the labour market

We find that the GE is not achieved. The labour market becomes the escape valve for

disequilibria that arise in the market for goods and services. A key message from the

Keynesian view is that unemployment, over and beyond its collectively determined equilibrium

level, becomes the only available margin of adjustment. With sticky prices, the flexible-price

GE does not occur, except by chance. Goods and money markets are in equilibrium, but the labour

market is not. This seems realistic.3

*Non neutrality of money, the classical dichotomy no longer holds. Changes in the nominal

money surplus shift the LM curve, and thereby affect output, employment, and all the other

real variables. When the price level is fixed, it is money demand that adjusts to money supply.

Changes in nominal money have thus real effects.

Chapter 12: Aggregate Supply and Inflation

Phillips curve: Negative relationship between unemployment and inflation. The message of the

Phillips curve to policy-makers was simple and appealing: pick a point on the Phillips curve, i.e.

choose a politically acceptable combination of unemployment and inflation, and then steer the

economy to that point (either by moving LM of IS curves depending on the exchange rate regime). 3 ‘Sticky price GE is sometimes called non-Walrasian equilibrium.

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Okun suggests an inverse relationship between output and unemployment. More precisely, we look

at fluctuations of output around its long-run trend. The distance between actual and trend output is

called the output gap. The inverse relationship between the gap and unemployment is known as

Okun’s law.

U – U = -g(Y – Y)

Bringing Okun’s law and the Phillips curve together implies the positive relationship between the

output gap and inflation. This schedule is called the aggregate supply curve. The intuitive logic is

the following: The Keynesian assumption is that supply responds to demand, but what are the

economic incentives behind it? When demand expands, for instance, under what conditions are

firms willing to supply the extra output and employees willing to work more to produce that extra

output? The short answer is: inflation must increase to boost wages and profits.

The Phillips curve was attacked by Phelps and Friedman. They argued that, assuming neutrality of

money, the trade-off between inflation and unemployment was only possible if workers and firms

suffered from money illusion. In the long run, inflation is just a growth in nominal money supply

which has no impact on the real side of the economy. The supply curve and the Phillips curve must

thus be perfectly elastic (vertical) in the long run.

And indeed, in the mid-1970s and early 1980s, both inflation and unemployment started to rise

(stagflation). So, policy-makers started to put greater emphasis on long-run monetary neutrality as

a guiding principle for monetary policy.

Nearly everywhere inflation and unemployment increased sharply, first around 1973-4, and then

around 1979-80, precisely at the time of the two oil shocks. Interestingly, in between the oil

shocks, and after the second oil shock, Phillips curves re-emerged, each time further above and to

the right of the previous one.

If we view prices as sticky in the short run but flexible in the long run, then their medium-run

behaviour holds the key to understanding the disappearance of the Phillips curve. To study the

medium run, we break down inflation into its most important components. Consolidating price-

setting and wage-setting shows not only why the Phillips curve exists, but also under which

conditions it can disappear.

Behind each price decision – and therefore behind the price level – lie two components: the profit

objective, constrained by competition, and production costs. Price-setting, the firm’s capacity to

mark-up prices above nominal production costs, is only possible with market power (customer’s

loyalty, monopoly, extreme differentiation).

*Unit costs (UC) = unit labour costs + unit non-labour costs

*Nominal unit labour costs

= (total labour costs / output)

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= (gross hourly wages / average labour productivity)

Or, formally: Nominal unit labour costs

= WL / Y = W/ (Y/L)

*Real unit labour costs

= Labour share of output = SL

= (wage bill / nominal GDP) = WL / PY

Mark-up pricing means that firms set the price of goods as much as they can above their nominal

unit costs.

P = (1 + )(WL / Y), where > O is the price mark-up.

In collective negotiations both sides bargain directly over the nominal wage W and indirectly over

the expected labour share WL / PeY.

A simple way of describing the outcome of the negotiations is to consider that they mark up the

labour share over its ‘normal’ level SL, with the mark-up depending on the situation at the time

negotiations are held:

SL = WL / PeY = (1 + ) SL, with as the wage mark-up (which can be positive or negative and is 0

on average if the historical pattern of income distribution is preserved).

Another way of describing the negotiation outcome is to note that agreeing on the expected labour

share is the same thing as agreeing on unit labour costs.

We have described prices as a mark-up over unit costs, agreed to ignore all non-labour costs and

therefore to focus on unit labour costs, and found that the expected labour share is a mark-up over

its normal level. In the end, prices depend on wages and wages depend on expected prices.

P = (1 + )(1 + )SLPe

*Battle of the mark-ups: in the end actual prices depend on expected prices. Expected prices will

be the central determinant of inflation in the medium run.

*Changes in labour productivity influence costs

* Labour share is stable in the long run is stable (productivity gains and real wages cancel each

other). Firm can offer higher wages when these are paid for by higher productivity, and they can do

so without facing higher labour costs. This is how technical progress continuously generates higher

incomes.

What determines the two mark-ups? They tend to move over business cycles, to rise during

boom years and decline in recession. The battle of the mark-ups shows that the expected price

level drives wages via the wage mark-up, that wages drive labour costs, which drive prices via the

price mark-up. Theses mark-ups tend to move together over the business cycle and, the higher they

are, the more the actual price level tends to rise above its expected level.

Inflation = Core rate (expected) inflation + mark-ups

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(mark-ups) = a(Y - Y) = -b(U – U)4 = + a (Y – Y) = - b (U –U)

The dissection of the rate of inflation shows that it depends on the core rate of inflation and

the state of the business cycle.

Core inflation is anticipation and indexation of past mistakes. The risk of mistakes of this kind

explains why, during periods of high inflation, wages are set for short periods because forward-

looking guesses are too difficult and errors lead to very significant distortions; indexation then can

become automatic.

It is now time to look at the non-labour costs of production (K, T, intermediate inputs: unfinished

goods, materials, and energy). The costs of intermediate inputs to a firm are the prices charged by

another firm so, at the country level, they are automatically reflected in the overall inflation rate.

However, this logic does not apply to imported intermediate goods and raw materials, which are set

abroad and translated into domestic costs via the exchange rate. As long as PPP remains

approximately true, the costs of imported intermediate goods simply follow domestic inflation. So,

in normal circumstances this analysis can be neglected.

Exceptions are the supply shocks. Examples are sharp oil price rises, deep devaluations that move

clearly away from PPP, tax hikes, or additional regulation that raises production costs. For this case

we add an additional component s for supply shock to the equation.

Further supply shock can be: Changes in the labour share, tax changes5

The original Phillips curve claims that inflation depends only on the level of unemployment. The

inflation account shows that that cyclical labour market conditions do indeed matter, but so do core

inflation, equilibrium unemployment, and occasional supply shocks. For a Phillips curve to be

visible, the latter factors must be stable. The Phillips curve’s demise reflects the emergence of core

inflation and supply shocks as additional explanatory factors of inflation, over and beyond cyclical

fluctuations.

As long as the exogenous variables remain constant, the curve does not move, but it will ‘vanish’

when they change. This modern interpretation of the Phillips curve is often called augmented

Phillips curve (real inflation equals core inflation if s = 0 and U equals its equilibrium level.)

The core rate and equilibrium unemployment are thus exogenous; they determine the position of

the curve. As long as they remain unchanged, the curve does not shift and we move along the

curve.

Core inflation must be guessed. More often than not, the guesses are wrong. Although forecasts are

almost never correct, the errors are largely unsystematic and average to zero. This implies that

there must be a link between real inflation and core inflation. The backward-looking component

4 b = a / g5 It is important to note that all of these government-induced costs affect only the price level; to have an effect on the rate of inflation, they would have to increase continuously, which is unlikely.

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implies that core inflation lags behind actual inflation, but the forward-looking component implies

that core inflation leads actual inflation.

The second implication related to the long run. As business cycles unfold and GDP moves around

trend, actual unemployment U fluctuates around its equilibrium level U. This is Okun’s law (output

+ unemployment -). This allows us to think about the long run. Inflation is driven by money

growth. This is why the long-run Phillips curve is vertical. How long is the long run? It is the time

it takes for core and actual inflation to catch up with each other and stabilize at whatever rate

monetary policy allows for. In the long-run as the vertical curve implies, there cannot be a long-

lasting trade-off between unemployment and inflation. But the equilibrium level can very well shift

over time, for instance as labour markets undergo structural changes. It has massively increased in

the Euro-area over the 1970s and 1980s and modestly declined in the late 1990s.

The aggregate supply curve follows the same logic like the Phillips curve. Is output above trend,

unemployment is below its equilibrium rate, and inflation, fuelled by the mark-ups, rises above its

current core rate. The aggregate supply curve conveys two messages. In the short run, it is possible

for GDP to fluctuate about its trend growth path, and such fluctuations are accompanied by

movements of inflation about the core rate. In the absence of supply shocks, output and inflation

move in the same direction. In the long run, GDP must return to its growth path, regardless of what

the inflation rate is. Example: D+ U- (le long de la courbe Phillips) inflation + mark-ups

curve shifts upwards equilibrium U restored in the long run, but higher inflation rate.

3 reasons why the aggregate supply curve shifts:

1.) Change in the core or underlying inflation rate

2.) Equilibrium unemployment and trend GDP change.

3.) Supply shock

*In the long run the Phillips curve and aggregate supply schedules are vertical. The economy is

dichotomized, growth and real rigidities determine the GDP and unemployment, money growth

determines inflation, and there is no trade-off between inflation and unemployment.

*The Phillips curve describes the supply side and can be transformed into an aggregate supply

curve using Okun’s law. The supply curve says that, for increased output to be supplied, inflation

increases because production – mainly labour – costs rise faster than anticipated, or than is

reflected in core inflation. The core rate of inflation and the equilibrium unemployment rate

determine the position of the short-run Phillips curve. The position of the aggregate supply curve is

determined by the core rate of inflation and trend GDP. Any change in one of theses variables

leads to shifts in the short-run schedules.

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Chapter 13: Aggregate Demand and Aggregate Supply

Assumption: PPP is constant over the long run (domestic and foreign inflation as well)

Ex: fixed exchange rate regime: π > π* σ + external competitiveness worsens PCA - D

for domestic goods - π comes back down.

As long as the exchange rate is truly fixed, the assumption that PPP holds in the long run

guarantees that deviations between domestic and foreign inflation can only be temporary and the

CA cannot improve or worsen indefinitely. The domestic inflation rate is thus exogenous. This

restriction is represented as the long-run aggregate demand (LAD) line. This is a demand-induced

restriction because any permanent deviation would lead to infinitely large CA deficits or surpluses,

shunting world demand away of toward domestic goods and services.

*As long as domestic inflation exceeds the foreign rate, the real exchange rate keeps depreciating

all the time. It is thus a dynamic process.

Factors that shift the AD curve: Not the price-level, for prices are now endogenous. Since the LM

curve is endogenous under a fixed exchange rate regime, so is monetary policy. On the other hand

any exogenous variable that shifts the IS curve also shifts the AD curve. Missing in that list is the

real exchange rate, which is now endogenous because it depends on the evolution of domestic

prices.

The new equilibrium corresponds to a long-term one because the two short-run schedules also go

through the long-run equilibrium point. At this point Y is at its trend level Y, actual and core

inflation are both equal to the world inflation rate π*, and money growth is compatible with this

inflation rate and with real GDP growth. Fiscal policy expansion doesn’t work, because the

inflation-induced deterioration of the PA will lead to a reverse of the short-time AD shift. Plus,

from the AS point of view, backward looking mark-ups will have to be done in wage negotiations

which increases inflation and short-run AS shifts to the left. If the wrong policies are to continue,

we will have to live through a stagflation. Eventually, the government will have to reverse the

fiscal expansion.

*Whenever we are to the left of the long-run AS curve, by construction, actual inflation is below

core inflation.

*Fiscal policy and more generally demand disturbances have no effect on output under rational

expectations. The reason should be clear: along each AS curve, core and actual inflation rates differ

except where the curve intersects the LAS line. Indeed the LAS line is constructed for the case

where the output gap is zero and, in the absence of supply shock, actual and core inflation are

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equal. Under rational expectations, actual and core inflation cannot be systematically different, so

we never depart from the LAS schedule and shifts of the AD curve only take us up or down the

LAS line.

A demand disturbance is necessarily temporary; this is simply a consequence of the government’s

budget constraints.

The different models: Keynesian Phillip’s curve expectation-augmented Phillip’s curve

radical view: rational expectation hypothesis.

Under flexible exchange rates, aggregate demand reacts differently to inflation, because the roles

of nominal money and nominal exchange rates trade places. The nominal money supply,

endogenous under fixed exchange rates, is now exogenous and under the control of the CB. The

nominal exchange rate, in contrast, is no longer exogenously fixed, but is determined by market

forces and is endogenous.

Example: Exogenous increase in π L- LM shifts to the left CA- IS shifts to the left

Thus the short-run aggregate demand has the same shape under both fixed and flexible exchange

rates, but for different underlying reasons. When the exchange rate is fixed, a higher π reduces D

through external competitiveness, not though the real money supply which is endogenously

supplied by the CB through exchange market interventions. Under flexible rates, the situation is

reversed. Competitiveness declines too, but not directly. The dominating influence on the real

exchange rate is the behaviour of the floating nominal exchange rate, which appreciates as the

shrinking real money supply tends to raise i and thus attracts K inflows.

What shifts the AD curve? What factors are exogenous? Under flexible exchange rates, the IS

curve is endogenously driven by the exchange rate to meet the LM and BP schedules. The AD

curve shifts when either the LM or the BP curves do. Under flexible exchange rates, therefore, the

growth rate of the nominal money supply μ = ΔM / M is a key determinant of the position of the

AD curve along with i*, which determines the position of the BP line. Ignoring trend growth, the

long-run inflation is simply equal to the growth rate of the nominal money supply: π = μ. In

the long-run equilibrium actual output is equal to trend output – a zero output gap – as required by

the supply side, and inflation is set by money growth as required by the demand side. The PPP

principle also allows us to infer the evolution of the exchange in the long run. The exchange rate

makes up the difference between the domestic and foreign inflation rates.

In the short run an expansionary effect of an increase in money growth in a flexible exchange

regime, output raises, U-, π increases, but by less than the money growth rate; and therefore the

real money supply still expands. In the medium run, the transition phases, the core interest rate

26

starts to hunt the superior actual rate of inflation. The real money growth rate is eroded by the

rise in inflation.

In the case that monetary neutrality occurs instantaneously, the dichotomy principle is verified at

all times, and monetary policy loses its effectiveness. This is the case under two conditions: First,

core inflation must be entirely forward looking. Second, price- and wage-setters must be willing

and ready to raise prices and wages to the full extent of the change in core inflation. The existence

of either price or wage stickiness or of a backward component in core inflation is what makes

the short run different from the long run.

Fiscal policy cannot move IS or AD.

*The interest rate parity principle: i = i* - ΔS/S

*The AD-AS model was developed largely in response to the oil shocks, just as the IS-LM model

was a response to the Great Depression. During the oil shocks, the countries that did not wish to let

inflation rise maintained a flexible exchange rate.

*Negative supply shock AS to the left stagflation. If after a one-off increase the new price

level remains constant (and there is no constant rate of increase), the AS curve should shifts back.

If it doesn’t do it quickly, mark-ups and the backward-looking component of core inflation rises.

Stagflation constitutes a serious policy dilemma for politicians. They can do nothing, apply an

expansionary policy or react with a contractionary policy. The nature of the dilemma: the

authorities can either aim at maintaining output and employment, but at the cost of higher inflation,

or they can prevent a sharp inflationary impact, but at the cost of a low output and high

unemployment. The reason behind this dilemma is also clear: macroeconomic management

policies are demand-side policies and they are ill adapted to deal with supply shocks.

Three general lessons can be drawn. First, an unfavourable supply shock is bad news. It adversely

affects growth, unemployment, and inflation at the same time, in contrast with the Phillips curve

trade-off. Second, demand management instruments are not appropriate for a supply shock. When

the aggregate supply curve moves up and to the left, demand management cannot deal with both

inflation and output. Demand-side policies must make the difficult choice between taking the

shock as an increase in inflation or as a drop in output with higher unemployment. The appropriate

response should be supply-side policies, aiming at bringing back the aggregate supply schedule as

soon as possible to its initial position. This is not easy. The best hope is to shape the forward-

looking component of core inflation and to try to ‘disconnect’ the backward-looking

component. This requires a clear and credible signal from the authorities that they are determined

27

not to accommodate the shock. Third, the exchange regime becomes crucial. A fixed exchange rate

can be maintained only among countries that adopt the same strategy.

*disinflation

*If the exchange rate is not fixed, it is the credibility of the CB as an inflation-fighter that becomes

crucial. This is why a number of countries have given formal independence to their central banks,

instructing them to aim at price stability. The faster core inflation adjusts, the lower the costs of

disinflation.

*In Germany indexation is illegal.

Chapter 14: Business Cycles

There are two ways of thinking about business cycles. One is that business cycles are largely

predictable, self-renewing phenomena. A second, more fruitful, insight conceives of the economic

system as a black box, which receives stimuli at one end and transforms them into business cycles

at the other. This ‘impulse-propagation’ mechanism approach is now generally accepted among

business cycle researchers as the most fruitful way of proceeding, and is the subject of the rest of

the chapter.

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