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Introduction to Macroeconomics
Lecture Notes
Robert M
...
An aggregate is a multitude of economic
subjects that share some common features
...

Example: The decision of a firm to purchase a new office chair from company X is not a macroeconomic problem
...

Why macroeconomics and not only microeconomics? The whole
is more complex than the sum of independent parts
...
Macroeconomics investigates aggregate behavior by imposing
simplifying assumptions (“assume there are many identical firms that produce the same good”) but without abstracting from the essential features
...
Typically, such models have three aspects: the ‘story’, the mathematical model,
and a graphical representation
...
g
...
Because historical episodes allow diverse interpretations,
many conclusions of macroeconomics are not coercive
...

policy targets: traditionally, the ‘magical pentagon’ of good economic
growth, stable prices, full employment, external equilibrium, just distribution
1

of income; according to the EMU criteria, focus on inflation (around 2%),
public debt, and a balanced budget; according to Blanchard, focus on low
unemployment (around 5%), good economic growth, and inflation (0—3%)
...

Examples for further typical questions to macroeconomics: what
causes business cycles (episodes of stronger and weaker economic growth)?
can an increase in the monetary supply by the central bank cause real effects?
what is responsible for long-run economic growth? should the exchange rate
of a currency be kept at a fixed level? can one decrease unemployment, if
one accepts an increase in inflation?
A survey of world economics: three large economic blocks (Europe, USA+Canada, Japan+Far East) with different problems, the remainder mostly developing countries
...
USA: good growth, low inflation, tolerable unemployment rate, persistent external deficit, increasing income inequality
...
EU: moderate growth, low inflation, in some countries high unemployment, inconspicuous external balance (total EU active, in Austria
recently turned active), for some countries large public debt, currently
important unification process, convergence and heterogeneity of individual countries
...
Last come most ‘new’ (2004 accession) countries
(from Malta down to Latvia)
...

3
...

2

2

System of National Accounts

Basic idea (not the definition): Summary of all economic activities within
a country’s territory and within a given time range (e
...
, a year or quarter)
yields the gross domestic product (GDP)
...
System
for compilation of data and bookkeeping of all positions is called the System
of National Accounts (SNA)
...

Economic activity is mainly measured by transactions
...
The transactions take place on
markets
...

Purpose of money: apart from payment and storage of value primarily
unit of measurement (numeraire)
...

gross: many activities serve to repair or replace worn or damaged machines and objects (‘depreciation’), therefore it is not the total GDP that
contributes to the accumulation of aggregate wealth
...

Consumption of fixed capital (in economics, depreciation) of SNA is the
estimated wear and tear of produced means of production (this ‘depreciation’
should not be confused with positions in tax declarations or with changes in
the currency exchange rate)
...
) in
enterprises and in the general government sector
...
By definition, capital contains all produced means of production
...

economic activities: only market activities can be fully accounted for
...
By definition, however, legitimacy of a transaction should not play a role
...
A consequence
of this measurement problem is an exaggerated wedge between developing
countries and OECD countries (with the per capita GDP of Angola you cannot survive in Austria)
...
) and unilateral (unrequited) transactions (transfers)–while value changes of existing objects are not accounted fully
...
Problems in the valuation of public services
...
If data is collected at the net value
(without taxes), taxes must be added
...
Types of institutional units are: private households, general government, financial and non-financial corporations (comprises most so called firms or enterprises), non-profit institutions
serving households
...
The same
person can be part of a private household and of an enterprise (rents out an
apartment, or even only uses his/her own condo but is assumed to rent it
out to him/herself)
...

Citizenship is not the criterion for residence
...

private households: produce and invest relatively little, consume, obtain
wage and profit income from corporations and from the government
...
Small (non-corporate)
firms and farms are counted as private households
...

corporations: produce and invest, do not consume, intention of profit
...
Because depreciation is now
called ‘consumption of fixed capital’, it represents a kind of consumption of
corporations
...
) or non-financial
...
A small sector, for simplification often
added to households
...

imports of services: includes travels abroad by residents

5

exports of services: includes consumption of foreign tourists on the territory of the economy (imputed based on valuta purchases etc
...
The aggregate of all households forms the household sector etc
...
This ‘consolidation’ eliminates the exchange between households, as it does not increase collective
wealth
...

ex post: SNA records only after the economic processes have already
occurred, therefore only limited validity for the assessment of future reactions
in the economy
...

flows and stocks: SNA mainly records flows of goods and services within a
time period (for example, the consumption of Austrian households in the first
half-year of 1996)
...
Changes of stocks are flows (bath tub: water level at
time point 1 = water level at time point 0 + inflow — outflow; inflow and
outflow are flows; water level is a stock)
stocks: also short for ‘common stocks’ (shares) and occasionally for ‘inventories’ (beware of the possibility of confusion)

2
...
The NPIsH
sector is omitted here, an artificial sector ‘value changes’ completes the transaction matrix
...
(private) consumption of households
CP
...
investment of corporations (enterprises, firms)
IP
...
investment without depreciation (wear and tear of the capital
stock)
WF
...
wage payments in the public sector
trH
...
saving (public sector often negative)
subv
...
taxes etc
...
indirect taxes are deductions before the calculation of income

7

(mainly value added tax) including customs, officially production taxes
...
direct taxes are deductions from earned income (wage tax, income
tax etc
...
undistributed profits
Πd
...
)
X
...
imports
Economic circuit: row sums = column sums (inflow=outflow), nothing
is lost, often graphical presentation with arrows
...
The hypothetical value changes sector (global
bank?) loses X − Im and closes the circuit
...
2

Accounts of the SNA

The new SNA consists of a sequence of several accounts, in which many
single positions are recorded, while others result as balancing items (bold
type in the accounts)
...


8

2
...
1

Sectorial accounting

The accounts that are decomposed according to sectors (financial and nonfinancial corporations, public households, private households and NPIsH) are
primarily income accounts, which focus on the contributions of individual
sectors to national income
...

Gross output (all production at basic prices, i
...
without value added tax and
customs) is booked on the credit side of this account
...
The balancing item is net value added
...


Uses

Resources

intermediate consumption gross output
depreciation
net value added
In the generation of income account, the balancing item of the production
account is transferred to the Resources
...
g
...
The position ‘other subsidies received’
represents negative taxes, only the difference is of concern
...
It yields, as a balancing item, the income of the sector
...

The relative contributions by the positions differ widely across sectors
...
The meaning of a primary income is that it is generated
completely in the production process
...
Correspondingly,
production taxes (indirect taxes) show up in the primary account, but not
the ‘direct’ taxes
...
Neither corporations nor private households receive direct taxes,
while other transfers re-distribute income flows among all sectors
...
e
...
The balancing item is the saving of the
sector, with a small correction because of contributions to pension funds,
which we would like to ignore
...
In Austria, this saving rate has dropped in
recent years from double-digit percentages to around 8%
...


Uses

Resources

consumer expenditures disposable income, net
saving, net
11

In the capital account, saving serves as a resource for investment
...
Gross fixed investment is called ‘gross’, as it
comprises depreciation
...
Fixed investment
can be broken up into residential construction, other construction investment
(buildings and structures, i
...
factories, streets, tunnels,
...
Gross fixed investment minus depreciation is called net fixed investment
...
2
...

In these total accounts, we find the primary target variable of SNA, the
gross domestic product (GDP)
...
For production, all activities count that are performed on the
territory of an economy
...
For disposable income,
one is more interested in the persons who earn the income
...
Even for disposable income,
however, residents are not defined by their citizenship
...
are not counted as residents
...
Goods taxes are those indirect taxes
that depend on the quantity of production, i
...
primarily value added tax
(VAT) and customs
...
The balancing item is
GDP
...

GDP and NDP should correspond to the row sums across the values added
of all sectors
...
Otherwise, the generation of income account follows, whose
balancing item is again the operating surplus and mixed income
...
All
subsidies are minus positions (minus items), what really matters is the net
13

position of taxes minus subsidies
...
The NNI should correspond to the sum of primary incomes net across all resident sectors
...
Before all, the net position of border-crossing property income can be sizeable, while the net position of border-crossing wages
and subsidies is comparatively small
...
GNI approximately corresponds to the historical ‘gross national product’ (GNP)
...


14

Uses
property income paid

Resources
operating surplus and
mixed income, net
wages received
production taxes received
— subsidies paid

net national income property income received
By way of the account of secondary income distribution, we obtain the disposable income of the total economy
...
Mainly, the household and the government sectors contribute to this
consumption
...
In a
parallel account for the non-resident sector, this use of income account also
shows the external position ‘external balance of current transactions’
...

Uses

Resources

consumption expenditure disposable income net
saving net
The capital account has again the form that was described above
...
Due to measurement errors, there is no exact correspondence
...
In total, however, the net position of lending and borrowing for
the total economy should be the negative value of the external balance
...
3

Variants of GDP

Once more the most important current and historical (partly still used) definitions
• Gross national income (GNI, formerly ‘gross national product’):
GDP plus primary income of residents from the rest of the world minus
primary income of non-residents from the economy; a GDP according
to the concept of residency of income earners instead of residency of
production units
...
Persons with permanent residence in Austria are always counted as residents!
• Gross social product: obsolete expression for gross national income
(GNI)
...

• Net domestic product at factor costs: Net domestic product without all production taxes (minus Tind plus subv)
...

• Net disposable income of the economy: net national income (at
market prices, i
...
including all production taxes) plus balancing item
of border-crossing transfers
...

• GDP (etc
...
e
...
e
...

Here, only goods taxes (comprises as its most important parts the value
added tax and customs) minus goods subsidies are subtracted
...
g
...

According to convention, the original gross output is compiled at ‘basic
prices’, GDP and NNI are then shown at market prices
...

17

Primary income: defined as income earned by direct participation in
the production process
...
Formerly ‘factor income’
...
4

SNA=3 national accounts

In many countries, GDP was formerly calculated three times
• from production
• from its final uses
• from income
Particularly in the UK, three slightly different GDP variants were computed
...
As already described, GDP is computed by adding ‘goods
taxes minus goods subsidies’ to gross output and subtracting intermediate
consumption
...
), which is not of central interest in macroeconomics
...

Of fundamental interest in macroeconomics is the break-down of GDP
according to final uses
GDP = C + CP + I + X − Im


...
Note that, from the outlined sequence of accounts you obtain C from
18

the consumer expenditure of households (including NPIsH), Cp from the
consumer expenditure of general government, I from the capital account,
X − Im from the external account as an external balance
...
)
and similar small positions
• a statistical difference (formerly often added to the smaller aggregates
as ‘inventory changes and statistical difference’)
Sometimes, the private consumption C is broken down in:
• consumption of durable goods (cars, video recorders,
...
): proximity of purchase and utilization
• consumption of services (dining out, fitness studio,
...
g
...
g
...
The economic meaning of this convention is questionable
...
)
• investment in construction (buildings and structures, includes residential construction)
The meaning of the distribution of income account for the determination
of disposable income etc
...
By contrast to many
other parts of the SNA accounts, which exist in real terms (adjusted for inflation, at constant prices, in the public sector difficult!) and also in nominal
terms (at current prices), the income distribution is calculated in nominal
terms only
...
e
...

The disposable income of households YD serves as the basis for the calculation of the household saving rate
qSH =

YD − C
YD


...


2
...
Household wealth can be estimated from
consumer expenditures on durables and assumptions about the depreciation
of these durable goods
...
The capital stock
(stock of produced means of production) results from depreciation rates for
20

Figure 1: Main components of the SNA (from Dudley Jackson, The New
National Accounts)
...
The stock of inventories results from inventory changes etc
...

The balance of payments registers all transactions of goods, services,
payments across borders
...
goods balance (only goods, in Austria approximately neutral net position)
2
...
external balance of primary income (compensation of border workers,
primarily border-crossing property income, in Austria passive)
4
...
The current accounts balance should match,
with inverted sign, the balance of capital flows (capital accounts balance,
short- and long-run capital flows; note the usage of the word ‘capital’ that
does not denote produced means of production here)
...
All balances together

22

are called the balance of payments
...

Price indexes (deflators) must be calculated for the GDP and for all of
its demand-side components (durable consumption, total private consumption, construction investment etc
...
After selecting a special base year, in which real (‘at constant prices’) and nominal (‘at
current prices’) variables (e
...
, GDP) coincide, a current price index evolves
from
t
Pt = pt pt−1
...

Alternatively, basket indexes are calculated according to the concept of
the Laspeyres index
pt+1
t

P
j pj,t+1 xj,0
= P
j pj,t xj,0

(3)

(by how much did the price of a fixed basket of goods and services increase
over the last year?)
...

It is common to standardize the Laspeyres index in the base year at 100,
though this standardization plays no role
...
g
...

Since 2004, SNA deflators are no more calculated as Paasche indexes but
rather as geometric averages of Paasche and Laspeyres indexes (chaining)
...

What distinguishes de facto the consumption deflator and the consumer
price index? With the Laspeyres index, the households stand no chance
to substitute goods that have become more expensive by relatively cheaper
ones (e
...
, books by computer software), therefore the CPI usually increases
faster
...
Some
experts argue that these should not be valued at the market price, but at the
price of their inner characteristics (fuel consumption, speed of calculation)
...
The concept is partly
used by statistical agencies for the calculation of all indexes
...
e
...
g
...
As long as price inflation remains ‘normal’, the logarithmic rate 100(log Pt − log Pt−1 ) is a convenient approximation and is often preferred for technical reasons
...
According to the traditional (‘Austrian’) definition
unemployment rate =

registered unemployed
employed + registered unemployed

(4)

where the denominator is called the (dependent) labor force
...
In contrast, the official unemployment rate (‘international definition’, ESA rate) relies on census mea24

surement, as registering at employment agencies is not a good indicator for
unemployment (no registration, when there is no chance of obtaining benefits
or if search is hopeless; fake registration of persons working in the shadow
economy) in many countries
...
In Austria, the ‘international’ concept leads to a lower
rate; in Spain, it leads to a higher rate
...
6

Critique of National Accounts

1
...
(borderline to sociology)
(c) SNA measures flows, whereas true wealth is expressed by stocks
of property and possessions
...
SNA measures too much
(a) regrettable necessities should not be measured, such as road accidents, criminal activity, expenditures for longer commute to work,
as these do not increase welfare: definition of boundaries is difficult, strong consequences for international and intertemporal comparisons unlikely (military goods even now only contribute, if they
can also be used for civilian purposes)
(b) damage to health and the environment should be subtracted
...
SNA measures too little
(a) economic activities, which do not touch official markets (household work, so-called shadow economy), are not compiled accurately (household work is deliberately excluded, as: (1) it is difficult to measure, (2) externalizing of services in principle even
now an indicator of welfare, (3) household services as component
of GDP would destroy the differentiation between unemployment
and employment; shadow economy is included in official GDP, although its assessment is concededly difficult; illegal production is
by definition a part of GDP!)
(b) quality of life, leisure, creation of national parks, cleaning of air
and water are not valued sufficiently, as these are not market goods
and do not have market prices (task for environmental economics)

26

3

The goods market

Wherever necessary, it is assumed that households and firms are identical
and produce and consume only one good
...
Demand is assumed to be satisfied
immediately by supply at a given and fixed price
...
At
first, it will be assumed that the economy is closed
...

The sign ‘+’ indicates that consumption rises with increasing income and
falls with decreasing income, i
...
it reacts ‘positively’
...
This so-called Keynes consumption
function contains two parameters c0 , c1 , i
...
not directly observable, fixed
constants
...
By contrast, the simplifying relation
YD = Y − T

(8)

with taxes T is not a behavioral equation, but rather a definitional equation (identity)
...

‘Lump sum’: except for some exercise examples, taxes T are assumed
to be independent of income
...

The parameter c0 is the autonomous consumption of the economy
...

The parameter c1 is the marginal propensity to consume and describes, by how much consumption rises, if households receive an increase in
their income by, e
...
, one euro
...
It makes sense to require c1 < 1, i
...
c1 ∈ (0, 1)
...
C/YD answers the question, how much out of the total income is consumed, not out of a ‘marginal’
28

additional income
...

Investment I, government expenditure G, taxes T : are kept fixed
and are, as ‘exogenous’ variables, not determined in the model; no relationship between G and T ; exogenous (determined outside the model) variables
act like parameters, though, unlike those, they are observed directly
...

The supply results from the quantity of the produced good Y
...
e
...
e
...
We increase government expenditure G by 1 euro
...
Because c1 ∈ (0, 1), for example
c1 = 0
...

¯
2
...
Again Y increases by 1/(1 − c1 )
euro, in the numerical example by 10 euro
...
We increase autonomous consumption c0 , for example by a campaign
of optimism
...

4
...
Now Y falls by c1 /(1 − c1 ) euro
...
This
multiplier effect is caused by the following mechanism: additional consumer
demand leads to an increase in total aggregate demand Z, which is satisfied
by the firms immediately, whereby Y increases once more, as income equals
production, etc
...
e
...
At a saving propensity of 1,
the multiplier becomes 1, i
...
it does not multiply anything
...
This would be nonsense and
must be ruled out
...
A statistical re30

gression estimation yields a value of c1 = 0
...
The propensity
to consume is reasonable (on average, households save 11% of their income),
while autonomous consumption is not plausible
...
The linear approximation yields a good estimate for the slope of the curve in the years 1976—2002,
but a bad estimate for the behavior at very low national income, for which we
do not have observations (and do not want to create any by an experiment!)
...

The solid line shows C = YD , which would correspond to a propensity to
consume of 1 (at c0 = 0)
...
g
...

Saving is investment (the IS identity)
...


(15)

If government runs a balanced budget, then its expenditure G equals taxes
T , G = T
...
If government
runs a budget surplus (at the expense of the rest of the economy), then T > G
and therefore I > SH
...
If one views T − G as
‘government saving’ SP , then
SH + SP = I

(16)

Thus, investment equals saving of households plus government saving
...

Where is the saving of firms? The saving of enterprises corresponds
to undistributed profits
...
In this model, the saving
of firms is therefore 0
...
e
...
Lower c0 decreases aggregate income by c0 /(1−c1 )
...
Because a contractionary effect
of saving appears to be a ‘paradox’, this is sometimes called the saving
paradox (paradox of thrift, first implication)
...
In the long run, the saving paradox disappears,
as saving increases the growth potential of the economy, causes the interest
rate to fall, and increases investment
...
(16) is only an identity and does not describe
economic behavior
...
9 yields
an additional income of 10 billion euro, while a decrease of T by the same
amount only yields 9 billion euro
...


4

Financial markets

Many possibilities are available to a household who has to allocate its income
...
For saving, the following ‘assets’ can be used:
1
...
Universally accepted for transactions, but bears
no interest
...

2
...

Increasingly used for transactions (Quick Cash, Debit Card), very low
interest
...
Included even in
narrow-sense money (M1)
...
saving accounts (and time deposits): longer-run assets at banks
...
Fast exchange for cash with small and standardized
transaction costs, therefore included in wide-sense money (M3)
...
bonds (risk-free securities with fixed interest): promissory notes at
good debtors, can be purchased at banks (brokers)
...

5
...
Uncertain,
though often good interest (return, dividends)
...

6
...

The aggregate stock of these assets is the wealth of households
...
Wealth
and its components are stocks, which increase by adding the flow variable
‘income’ and diminish by subtracting the flow variable ‘consumption’
...

The problem of households consists in distributing their wealth optimally
among money (M) and bonds (B), i
...
to find M and B such that M +
B = $W
...


4
...
Money serves for transactions, whose amount is proportional to national income ($Y for nominal
national income)
...
When interest i
34

on bonds is high, households do not want to forego the additional income
out of interest and keep little money
...
The letter L is for
‘liquidity’
...
At a
high interest rate, relatively little money is kept
...

For fixed income $Y , one sees a falling function (Fig
...
The higher $Y , the more do the curves move to their
right
...

Demand for bonds B d
...
Higher income increases the stock of wealth
but also decreases money demand
...

Empirical evidence for Austria
...
The theoretical concept
35

Figure 3: Money demand curves
of a function L(i) would imply a negative relationship, which is partly supported by the time-series graph and by the scatter diagram
...
Such a long-run fall may be plausible, as today less cash money
(including checking accounts?) is used than some time ago
...


4
...
Assuming the money supply to be
fixed and to be determined exogenously by the central bank, equilibrium

36

Figure 4: Long-run interest rate on bonds (solid) and ratio of money M1 and
nominal GDP (dashed) in Austria 1970—2004
...


37

means
¯
Ms = M
M d = $Y L(i)
Ms = Md
¯
Graphically, the vertical line M s = M intersects the money demand curve
¯
at a unique point, which determines the interest rate i
...
The equation M = $Y L(i) is called LM identity,
which is for ‘liquidity is money’ and is the counterpart to the IS identity
‘investment is saving’
...

Experiments:
1
...
M is set by the central bank and
does not budge
...

¯
2
...
The vertical
line shifts to the right, the money demand curve does not move
...

How does the central bank do it? The central bank can use three
different tools: open-market operations, reserve requirements, discount rate
...
It thus increases or decreases the amount
of money in circulation
...
Currently, the
most important instrument is open-market policy
...
Obligatory reserves of banks that are held
at the central bank
...
The original intention was to guarantee the banks’ savings
accounts, today reserve requirements are just means of controlling the money
supply
...
Thus, this
interest rate be used as another instrument of controlling the money supply
...
An interest rate for transactions between the central
bank and banks
...


4
...
Assume that a bond is in circulation at time point t, while its owner receives at maturity t + 1 a value of 100
...

Then, the price of the bond in t, PBt , determines the interest because of
it =

100 − PBt
PBt

,

i
...
not in percentage points, e
...
, it = 0
...
Conversely, if i is given, the
bond price can be calculated as
PB =

100

...


39

4
...
Today,
usually ‘money supply’ is defined as M1, the sum of currency and demand
deposits:
M = CU + D
The banks can create money far beyond the monetary base
...
The minimum reserves required by the central bank, which are kept by
the banks at low or no interest, lock the ratio θ = R/D from below
...
The economic agents determine their own (street-corner shop, newspapers) cash demand coefficient c = CU/M
...


The value 1/{c + θ(1 − c)} is called the money multiplier, as it indicates,
by how much the money supply increases, if the central bank prints one
additional unit of money
...

Example
...
1, we further assume that c =
0
...
Then, the purchase of a bond for 1000 euro by the central bank
against emission of ten 100 euro notes causes the bond seller to increase his
demand deposit by 950 euro, while 50 euro of cash remain in the trouser
pocket
...
This bond seller keeps 42
...
75=812
...
Even now, money M1 has almost doubled, but the chain continues and
finally leads to 1/(0
...
1*0
...
e
...

How is household wealth really allocated in Austria? Most Austrians do not own shares or stocks, the largest part is still kept in saving
accounts
...
The graph (Figure 6) shows
how the shares of these components have developed during the most recent
decades
...


42

5

The IS-LM model

If one looks at the goods and financial markets jointly, then both the equilibrium condition on the goods market (IS) and on the financial market (LM)
should hold
...
For this purpose, the model
needs a reaction to interest rates on the goods market
...


5
...

Investors react to two important variables:
1
...
These are not known,
though observed output Y should be a good indicator for expected
sales
...
the interest rate determines the costs of loans that are required to
execute investment plans
...

Empirical evidence
...
The graphs
show scatter diagrams of the investment ratio I/Y and of its real growth
rate against a (nominal) interest rate and only vaguely indicate a negative
43

relationship
...


Figure 7: Investment growth and nominal long-run interest rate on bonds
1977—2002
...
It is a difficult task to specify good investment
functions that are both empirically and theoretically satisfactory
...
The important role of expectations
will be mentioned in a later section
...


5
...

¯
¯
and at equilibrium again Y = Z
...

The curve of all such equilibria in the (Y, i) space is called the IS curve
...
A graphical derivation is found in Blanchard (Figure 5-3)
...

The interest rate i rises
...
In a (Y, Z) diagram, the
demand curve Z = Z(Y, ¯) shifts down, intersects the Z = Y diagonal further
ı
left, the intersection point on the demand curve is, however, the equilibrium
point
...

The interest rate i falls
...

Taxes T are increased
...
One obtains a lower demand Y at the same i, the whole
IS curve shifts left, as one obtains a lower output Y for every given i
...
The IS curve shifts right,
as for every interest rate i there is a higher demand Y
...
Again, the IS curve shifts
right
...
Because investment depends on Y and the
functional form I () is left unspecified, the positivity of autonomous demand
¯
¯
c0 + I(0, i) + G − c1 T is not guaranteed, at least not for high interest rates
...


5
...
For money demand
M d we assume M d = $Y L(i), the money supply is fixed exogenously by the
¯
central bank , i
...
M s = M
...
e
...
Division by the price level P yields real money supply
¯
M
Ms
=
(18)
P
P
and real money demand
Md
= Y L(i)
...
e
...
The left side of the equations M/P is called real money
...
The real money demand
curve is a downward sloping curve, at a higher interest rate i less money is
demanded
...
On the money demand
curve, Y is kept constant
...
This implies a curve of equilibria
in the financial market in the (Y, i) space, the LM curve
...
It is, however, no supply curve, but rather describes equilibria in
the financial market
...
On the LM curve in the (Y, i) space, one
moves to the right, therefore the equilibrium income Y increases
...
If i increases, a wedge of
disequilibrium opens, as less money is demanded than supplied
...

Money is printed
...
Because for every Y there is now a lower i , the LM curve shifts
to the right
...
This implies a fall in real money supply, ex¯
pressed by the vertical line M s = M
...
The reaction is easier to see from a nomi-

47

nal (M, i) diagram
...
Therefore, a higher i corresponds to
the same real income Y
...
4

Fiscal policy in the IS-LM model

Fiscal policy is any economic policy by the government that concerns a
change in government expenditure G or in government revenues T
...
Both cases are summarized as restrictive fiscal
policy
...
This is called expansionary fiscal policy
...

In its narrow sense, the IS-LM model is the cross that consists of the
IS and LM curves in the (Y, i) plain
...
Typically, interest focuses
on the question whether the change has resulted in a rise or fall of i or Y
(comparative statics)
...

Government raises taxes T
...
The LM curve does not budge, as T does not occur in the money
market model
...
Y and i must both fall
...
One can
only surmise the dynamics
...

Only then do the investors adjust I = I(Y, i) to the decreased Y and the
consumers will also decrease C
...
Therefore, one
may assume, that the economy moves on the LM curve to its new equilibrium
...
These effects are partly ambiguous, though one may assume
that, on the whole, a contraction will lower the goods demand curve
...
Government raises T and lowers disposable income YD
...
Households decrease consumer spending C, aggregate income Y drops
...
Money demand curve shifts, interest rate i falls
...
Investors show ambiguous reaction, as i is lower, but so is Y
...

Aggregate income (aggregate demand) Y falls again
...
Steps 3 and 4 are repeated, until the new equilibrium is obtained
...
It could be that the contractive fiscal policy generates additional investment demand, as firms substitute the activities of government
(crowding-in and crowding-out)
...


5
...
The question whether monetary policy or fiscal policy is
more important (more efficient), used to be one of the more controversial
topics of economics
...
The LM curve shifts to
the right, as described
...
A new equilibrium is created, at a
lower interest rate i and a higher output Y
...
Regarding dynamics, one could imagine the following steps:
1
...
The interest rate i reacts
strongly and falls, as Y does not react immediately
...
Firms increase their investment I(Y, i), and aggregate demand Y increases
...
Money demand increases and therefore the interest rate rises, but less
strongly than it dropped before
...
The higher aggregate demand Y increases consumer expenditure and
investment
...
Steps 3 and 4 continue to the new equilibrium
...
However, if all market
participants know the new equilibrium, it could be that the economy really
moves along the IS curve, just as it is depicted in the text book
...

Mix of monetary and fiscal policy
...
Then
both the IS and the LM curve shift, with clever coordination an unchanged
output Y may be obtained at a lower interest rate i
...

Does the policy mix really work so well? If the same output is
obtained at a lower interest rate, there is a danger of inflation, as in the
longer run P is no more exogenous and constant
...

Empirical examples
...


51

6

The labor market

Together with the goods and financial markets, the labor market, as a third
market, completes the (open or closed) economy
...

Supply and demand: Contrary to the goods and financial markets,
where supply comes from the mighty firms or the powerful central bank and
the demand side are the small households, in the labor market the suppliers
are the households and demand comes from the firms (and the government)
...
The share of the labor force in the active population
(definitions vary, e
...
, resident population from 15/18 and 65) is called the
(labor) participation rate
...

The quotient of unemployed (=labor force minus employed persons) and labor
force is the unemployment rate, which today is mostly measured by census
methods
...

Austria
...
A stock of around 200,000 unemployed
(in winter more, in summer less) corresponds to a flow of 40,000—50,000 persons, who become unemployed within every month or (while hitherto unemployed) find an employment (or reach the age of retirement, though these
are relatively few)
...
If the Austrian participation rate is
52

measured only from the dependent labor force, then it shows a long-run increasing trend and is higher than in the European south, though lower than
in the north Europe
...
There
are several conflicting trends: increasing participation by women, decreasing
participation due to longer education, and formerly ‘self-employed’ farmers
joining the dependent labor force
...

The economically active population (some older statistics use the slightly
misleading wording ‘able-bodied population’, though fortunately most handicapped are also economically active) amounts to around 5
...

Thereof, almost 3
...
After subtracting 380,000 self-employed, 3
...
Not all persons in the resulting difference are unemployed, however,
as around 100,000 must be subtracted as soldiers or on leave for childcare
etc
...
According to Austrian
definition, this rate evolves from dividing the around 230,000 unemployed by
the labor force
...
1

Wages

The assumption that all workers are equal (the labor force is homogeneous)
is unrealistic, though it is helpful in macroeconomic theory
...
Because workers want to use their wage to consume goods from the
goods market at market prices, they are not so much interested in a high
53

Figure 9: Austrian unemployment rate according to its traditional definition
...


54

nominal wage W (money wage) as in a high real wage W/P
...
Even for a homogeneous work force,
firms often tend to pay higher wages than the reservation wage or a legally
determined minimum wage, in order to tie workers to the firm, to avoid
search costs, to enjoy the production effects of firm-specific training costs,
and to prevent shirking (sloppy work, bad workers’ morale)
...

Efficiency wages
...
The point is that workers’ productivity is
assumed to depend positively on their wages
...

[from a web dictionary]
As a wage function, one could use
W = P e F (u, z)

(20)

where P e denotes the expected price level in the goods market, u is the unemployment rate, z is used for ‘other influential variables in the labor market’
(Blanchard’s catchall variable), and the function F represents bargaining
power
...
For example, increased
fluctuation to and from unemployment reduces the fear of unemployment,
even at rather high u, as it appears to be easier to find a job
...
Because the
55

wage is fixed in negotiations for a considerable time span (there is no continuous bargaining process), W/P e is the expected real wage for the immediate
future
...


6
...
If wages are
set, we must also be able to determine prices
...
At first,
Blanchard uses the simple production function
Y = AN

,

(21)

where N is the labor input (‘employment’) and A is labor productivity
...
In the last 100 years, the ratio A has increased by a multiple
...

At perfect competition (microeconomics), it is known that prices and
wages must correspond to the marginal product of labor ∂Y /∂N = A
...
In reallife economies, however, producers succeed in adding a mark up µ to wage
costs, such that
P = (1 + µ)W/A
...
µ can be viewed as a measure for the ‘market
power’ of firms, or as a compensation for other ‘production factors’ (capital,
energy, land)
...


6
...
As already explained, this is a falling curve (in fact, it is a labor
supply function, which is positively sloped but drawn as negatively sloped,
as instead of employment the x—axis shows the unemployment rate u)
...

The intersection of both curves implies an equilibrium real wage and an
equilibrium unemployment rate un
...
Although wages and prices are in their
equilibrium, there is unemployment, i
...
the labor market does not ‘clear’
...
Because of Y = AN , there is also a natural
output Yn , determined from
F (un , z) = F (1 −

Yn
A
N
, z) = F (1 −
, z) =
L
AL
1+µ

or, using the simplifying assumption A = 1
F (1 −

1
Yn
, z) =
L
1+µ

,

which determines Yn implicitly
...

Is there an equilibrium in the labor market? In the interpretation of Blanchard’s textbook, the labor market is in equilibrium whenever
price and wage determination coincide and when there is natural unemployment
...
Alternatively, one might define
short-run equilibria at unemployment rates different from the natural rate,
or one may argue that the market is in equilibrium only when there is no
unemployment, excepting short episodes of job search
...

Does labor productivity A affect the natural unemployment
rate? In the price determination equation, higher A clearly raises the real
wage that firms are willing to pay
...
However, it is likely that A affects the bargaining function, as workers demand for their share in the added
value of the productivity increase
...
However, this is not a coercive consequence of the
model, as F (u, z) has been introduced simply as bargaining power and not
as labor supply
...
Conversely, no other economic variables
appear in this condition, such as: fiscal policy, monetary policy, consumer
sentiment, inflation and prices
...


59

7

The three markets jointly: AS and AD

Idea: The IS-LM model describes the short-run equilibrium on the goods
market and financial market, which presupposes that prices P are fixed and
that the short-run demand for goods creates its supply at current prices
(Y = Z)
...
The short-run equilibrium
˜
Y of the nominal IS-LM model in the (Y, i) diagram need not coincide with
the ‘natural output’ Yn of the labor market
...
Blanchard calls the stage that is
attained in this section the ‘medium run’, in order to reserve the name ‘long
run’ for growth models
...
In the shortest run, prices P are fixed and thee price and wage determination in the labor market plays no role
...

2
...
This time horizon is
treated by the AS-AD scheme
...

3
...
Natural employment and natural (potential) output determine an invariant
equilibrium
...

4
...

This long run is the subject of growth theory, which, e
...
, wants to
explain growth and welfare differentials between OECD and developing
countries
...
1

The aggregate supply: the AS curve

AS is for aggregate supply
...
Inserting the first into the second equation yields
P = (1 + µ)P e F (u, z) = (1 + µ)P e F (1 −

Y
, z)
L

(22)

For fixed µ, P e , z, L (and A), this defines a functional relation between P and
Y
...

A
AL

Is this function increasing or decreasing?
If Y rises, there will also be higher employment N = Y (or, for the more
general form Y = AN analogously N = Y/A), therefore the unemployment
rate u falls, hence the functional value F (u, z) increases, as F is a falling
function of u (bargaining power)
...
The function defined in
(22) is also increasing in a (Y, P ) diagram
...
It can, however, also be
interpreted as the quantity that is produced and supplied at a given price P
using the required amount of labor, when it is read inversely, with Y as a
function of P
...

Attention: the AS curve derived here contains characteristics of imperfect markets, such as unsatisfied price expectations and mark-ups
...
Some economists think that the long-run
(Blanchard: medium-run) AS curve indeed is vertical
...
It will be shown that this is the only
longer-run equilibrium indeed
...
If
prices equal their expectations, it holds that
P =

1+µ
Y
P F (1 −
, z)
A
AL

or
F (1 −

Y
A
, z) =
AL
1+µ

,

which was the definition of natural output Yn
...
The point (Yn , P e ) lies on the AS curve for
exogenously givens P e
...
If Y > Yn , then P > P e , or vice versa
...

2
...
Therefore, an ‘unnaturally’ low
output occurs if prices are lower than expected
...
2

The aggregate demand: the AD curve

The IS-LM model
Y
M
P

= C(Y − T ) + I(Y, i) + G
= Y L(i)

implies, for a given price P , a uniquely defined Y
...
Higher P therefore implies less output Y , as the
62

increased interest rate negatively affects investment demand and, by way of
the multiplier effects, decreases Y even further
...

In summary, one gets a falling curve in the (Y, P ) diagram, the AD curve
(aggregate demand)
...

The negative slope of the AD curve is unequivocally accepted among
economists
...
In short, this implies
Y

M
, G, T ) ,
P
+ +−

= Y(

as it is used by Blanchard
...
As M/P has a positive influence on Y , the price level in
the denominator has a negative effect on output, just as it should be
...
3

Movements in the AS-AD world

˜
What happens if Y at the intersection point of AS and AD exceeds
Yn ? The labor market is not in its medium-run equilibrium, as u is less
than the natural un
...
By
a mechanism that is not described in the model, price expectations adapt to
actual prices
...

(A possibility for a formal derivation would be the specification Pte = Pt−1
suggested by Blanchard
...
An upward movement occurs on
the AD curve
...
The game continues,
until Yn has been attained
...

What happens if an expansive monetary policy is pursued? We
know that this leads to a lower i and a higher output Y
...
Therefore, in
˜
the AS-AD diagram, output and prices increase
...
As in the previous point, this development
˜
stops when Y = Yn
...

What happens if an expansive fiscal policy is pursued? Just the
same, except that, at first (in Phase 1), the interest rate rises instead of
falling
...

Output finishes again at Yn , though with lower investment and higher G
...
Finally, output is at the same level as before
the tax cut, but investment has fallen and private consumption has increased,
and so has the price level
...
At first, this causes a contraction,
leading to lower Y at lower interest rate i
...
Because Y < Yn , there is higher
unemployment than un , wages and prices are reduced, the AS curve shifts
˜
down
...
A lower price level
is obtained, at lower government expenditure
...

Conclusion
...

In the longer run, both fiscal and monetary policy are neutral with respect
to income
...
How long it takes, until the economy will return to its
‘natural output’, cannot be stated exactly, a cycle of several years appears
to be realistic
...

Exogenous change of supply parameters
...

phase by an opposite movement of the AS curve
...
The upward
shift of the AS curve yields a decrease in Y at increasing prices
...
The disequilibrium in the labor market leads to a further
˜
reduction of output at increasing prices, until Y = Yn
...

In this case, the natural output changes, permanent effects occur
...
also trade cycles) are fluctuations
in output that may be caused by diverse ‘shocks’ to aggregate supply or
demand
...
Contrary to their name, these
fluctuations are irregular rather than strictly cyclical
...
The diagram showed a strong negative
correlation
...
Instead of wage inflation πw , later authors used
price inflation π and obtained similar patterns
...
g
...
e
...
We know that ∂F (u, z)/∂u < 0
...

Derivation by linearization: Putting F (u, z) = 1 + z − αu yields for

Pte = Pt−1

Pt
= (1 + µ)(1 + zt − αut ) ,
Pt−1
Pt − Pt−1
πt =
= µ + zt − αut
...

e
Here the expected rate of inflation πt is defined by (Pte − Pt−1 )/Pt−1 , i
...
by

the inflation that is expected in t − 1 for t
...

Conclusion: The rate of inflation πt tends to rise at higher inflationary
expectations, as the wage earners demand for a higher wage rise, to compensate the price increases; it also rises at a higher markup, as then firms
will even add more to wages; it falls with higher unemployment, as the
bargaining power of workers drops; many more factors z affect this relation
...

Friedman explained this disappearance by several factors :
1
...
This implied high inflation
at rather high unemployment
...
A closer view of the modified Phillips curve reveals that a negative
e
relationship is only possible when πt 6= πt
...
Trade unions, firms, wage earners learn sooner or later, how to
form expectations rationally
...
The popularity of the Phillips discovery may have seduced governments into exploiting this statistical relationship as a trade-off between
the evils of inflation and of unemployment, e
...
, into increasing inflation
in an election year, in order to lower u and to optimize the outcome
of elections
...

Evidence for Austria
...
It is indeed negatively sloped, though one recognizes several
subsamples with different slopes, for example for the years 1960—1980 and
1990—2004
...


Figure 11: Phillips curve for Austria 1955—2004
...

If price expectations are formed simply from Et−1 πt = πt−1 , then the
68

(modified) Phillips curve implies the relationship
πt = πt−1 + µ + zt − αut
and one obtains a relation between changes in the rate of inflation and unemployment rate
πt − πt−1 = µ + zt − αut

(24)

This function, which is in the focus of the text book and which is called the
‘accelerating Phillips-curve’, is not satisfactory either, as a long-run stable
variable (u) is equated with the growth rate of inflation
...
e
...
If one trusts in (24), one sees that there is a value of u, for
which the right side equals 0
...
Therefore, un is also called the NAIRU (nonaccelerating inflation rate of unemployment), as for this value the inflation
does not accelerate
...


Because, however, z is only a catchall variable without known numerical
value, one cannot really calculate the NAIRU from this formula
...

Note
...

69

Empirical evidence
...
A systematic negative relationship is not
visible
...
A medium-run constant NAIRU cannot be calculated from
such data
...


Figure 12: Accelerating variant of the Phillips curve for Austria during the
years 1955—2004
...
If price expectations are assumed to follow the specifie
cation πt = θπt−1 , one obtains the modified Phillips curve

πt = θπt−1 + µ + zt − αut


...
Blanchard
interprets the disappearance of the US Phillips curve as an increase in θ
70

from nearly 0 to nearly 1
...
6
...
Such indexation
plays a strong role during episodes of hyperinflation: if wages are indexed to
the current rate of inflation, then θ can be greater 1
...


Summary: Out of the AS—curve, which plots prices against output (or
the unemployment rate), Phillips created the Phillips curve, which plots
price inflations against u, even later followed a variant of the Phillips-curve,
which plots growth rates of price inflation against u
...
This is, of course, not systematically possible
...
1

Okun’s law

Apart from the Phillips curve, another empirical relationship enjoys great
popularity among empirical macroeconomists, the so-called Okun’s law
...
Therefore, it would
be interesting to know how strongly deviations from natural output are reflected in deviations from the natural unemployment rate
...
If the unemployment rate is one
percentage point below the NAIRU, then output will be 3% above natural
71

output (or potential output)
...
The equation assumes that, instead of ‘natural output’, there
is a natural growth rate gn , which should be around 2-3%
...
If the unemployment rate in
t − 1 exactly matches the NAIRU, then it falls below the NAIRU in t
...
Most authors find that β > 0 is around 0
...

Where does β come from? At low flexibility of the labor market, at
high costs of hiring and firing (adaptation costs), it may be rational for the
firms to meet an increased demand for goods with overtime work instead of
new hirings of workers and, conversely, to ‘hoard’ workers if demand is low
...
If the costs of labor mobility decrease, β will rise
...

Where does the natural growth rate come from? From the growth
of labor productivity
...

Evidence for Austria: For Austria, the evidence on the existence of
Okun’s law, in the above indicated form, remains unconvincing (see Figure
13)
...
Comparative country studies confirm that
Austria is an exception
...

Note
...
These are the main subject
of so-called growth theory, which addresses long-run economic developments
...
g
...
Then, if the labor
force L, and in consequence also N, grows at 1%, the labor productivity A at
2%, then output should grow at 3%
...
g
...
play a non-negligible role
...
2

Growth of money and inflation

Blanchard closes his medium-run model, which contains a Phillips curve
in a debatable variant in differences
πt − πt−1 = −α(ut − un ) ,
73

(27)

and an Okun’s law
ut − ut−1 = −β(gt − gn ) ,

(28)

by a third equation that relates growth rates
...


This yields, for constant γ, the relationship among growth rates
gY,t = gM,t − gP,t = gM,t − πt

,

(29)

as growth rates obey the same rules as logarithms
...
e
...
The growth rate of Y is written in a clearer notation as
gY , while it is denoted by g in Okun’s law
...
Then π not does not change any more, the level of
inflation is determined by the expansion path of money supply
...

Growth rates and logarithms
...


If the 3 variables depend on time, this equation can be differenced with
respect to time t:
d log Z
d log X d log Y
=
+
dt
dt
dt
dZ/dt
dX/dt dY /dt
=
+
Z
X
Y

(30)

These would be growth rates in ‘continuous time’, i
...
if time passes continuously, not in jumps or intervals
...
In the longer run,
however, the time interval from t to t + 1 is comparatively small, so one may
work with the approximation
...
The three-equations model can be used
to describe a process of disinflation
...

In order to do so, they reduce gM
...
Alternatively, one
could decrease gM gradually
...
e
...
This theorem is
true for most variants of these dynamic linear models, though not for all of
them
...
It does so on three markets:
1
...
The idea that exports are good while
imports however are bad, insinuates restricting the free trade across
borders
...

International tendency toward abolition of all restrictions on goods
trade
...
financial market (capital mobility): bonds, shares, and other domestic securities are bought by non-residents, then interest and dividends are paid to non-residents
...
g
...
Increasing international tendency
toward abolition of all restrictions on such action
...
labor market: international wage differentials cause migration (immigration = inward migration, emigration = outward migration) and
the re-allocation of productive capital to countries with a low wage
level
...

The increasing openness of economies has advantages (higher welfare by
international division of labor) and disadvantages (loss of national autonomy, above all, of economic policy, ‘exposure’ to international crises)
...

76

9
...
Both ratios develop roughly in parallel movements (Reasons: tendency toward a balanced current account, increase of
transit-like flows: imported goods are re-exported after minor modifications)
...


Figure 14: Import and export ratios for Austria 1976—2004
...
In the longer run, exports and
imports increase faster than GDP, the share of imported durable consumer
goods and of imported investment goods for equipment investment is particularly high (and rising)
...

Main trading partner of Austria is Germany (around 42% of exports
and imports), followed by Italy (more than 8%)
...
Minor fluctuations of trade shares are mainly due to changes in the
exchange rate
...
For example,
from Figure 15, note the drastic fall of the UK share in the 1970s, which may
be due to the British switch to the European Community from a common
economic area with Austria in the EFTA, and the fall of the Japanese share
in the 1990s, when Austria joined the European Union
...


Figure 15: Shares of selected countries in Austrian imports for the time range
1960—2004
...


78

Figure 16: Share of Germany in Austrian imports 1964—2004
...


9
...
g
...
From the viewpoint of the domestic economy (Austria), the nominal exchange rate (E) is defined as the
quantity of dollars that is paid for one euro
...
[Pure convention; this corresponds to the current
official euro rates that are quoted in newspapers
...
In case you use
an older edition of Blanchard’s book, note that the convention differed in
editions #1 to #3
...
This
is only a theoretical variable, as there are, in the real world, many different
goods with diverse price movements (indexes in the domestic and in the foreign economy contain different goods and different weights)
...
The numerator EP and the denominator P ∗ represent
prices that are both measured in the foreign currency (e
...
, dollars or sterling
in Austria)
...

If the price of the domestic currency decreases in the foreign currency, i
...

if the nominal exchange rate falls, this is called a (nominal) depreciation
...
Thus, at low
inflation in Austria and higher inflation on the ‘world market’ there is a real
depreciation, even if the nominal exchange rate is constant
...
e
...
A relatively high inflation
in Austria or a price reduction on the world market and constant nominal
exchange rate would imply a real appreciation
...
Note the ambiguity of ‘depreciation’ as exchange rate change and
consumption of fixed capital]
real effective exchange rate: a weighted average that is formed over
all real exchange rates of an open economy (with all trading partners), with
80

all weights determined by the share in the trade volume (average of export
and import), yields the real effective exchange rate
...


Figure 17: Nominal and real exchange rates for Austria
...

Is a real appreciation good or bad? Real appreciation implies a
stronger rise of domestic prices than of world market prices or a nominal
appreciation
...
On the other hand does an increase of export prices (not
of domestic prices per se) indicate that exporters are able to sell their goods
at a high price because of the high quality of their products
...
In any case does a real appreciation exert an incentive for quality improvement and rationalization (productivity increases) in the exporting
sector of the economy
...
]
81

9
...
Such transactions make
part of the capital accounts
...

‘Arbitrage condition’: A domestic and a foreign bond are held at the
same time, only if both promise the same return
...
The expected return
is composed of the expectations for the exchange rate and the interest
...
The left-hand side describes
the interest on a domestic bond
...
The latter transaction includes a risk, as next year’s
exchange rate is unknown today, hence the expected exchange rate E e is
substituted
...

Expected depreciation of the domestic currency causes a negative ratio
e
(Et+1 − Et )/Et and thus a relatively higher interest in the domestic economy,

expected appreciation means a higher interest abroad
...


9
...
The correction factor 1/ε indicates that
foreign goods in imports Im differ from domestic goods in their value
...

Domestic demand C + I + G follows the hitherto used pattern
¯
C(YD ) + I(Y, r) + G

(35)

The import function (import demand)
Im = Im(Y, ε)

(36)

(+, +)
lets imports depend positively on domestic demand, without decomposition
into imports by particular demand categories, and positively on the real
exchange rate
...


83

The export function (export demand)
X = X(Y ∗ , ε)

(37)

(+, −)
lets exports depend positively on foreign demand Y ∗ (demand on the world
market), and negatively on the real exchange rate, as a real depreciation
makes exported goods cheaper and more competitive
...
Therefore, at low Y net exports NX = X − Im /ε are positive,
and at high Y net exports are negative
...
This
YT B need not correspond to the equilibrium on the domestic goods market
...
e
...
Currently, the Austrian foreign trade may be balanced
...

1
...
Therefore, higher Y results, with
multiplier effects in I and C likewise reflected in imports
...
Therefore, the
trade balance becomes more passive
...

2
...
Although the additional demand in NX and thus in Y is satisfied partly by imports,
there remains a positive net effect
...

84

Conclusion: An increased foreign demand is good, an increased domestic
demand is bad for the trade balance
...

At given fixed prices in the domestic economy (P ) and in the foreign economy (P ∗ ), a nominal depreciation causes a real depreciation (ε decreases)
...

Exports tend to increase and imports tend to decrease: these two effects tend
to increase NX
...
The condition by Marshall-Lerner
tells that the net effect is positive
...

Conclusion: a depreciation together with a restrictive fiscal policy leads
to the (sometimes desired) disappearance of a trade deficit and to constant
Y at reduced domestic demand
...

Dynamics: Because the contrary direct effect of ε in the equation for
NX occurs immediately, while the effects on export demand abroad and on
import demand in the home economy occur with a delay, after a depreciation
one often observes at first a fall in net exports (imports become more expensive immediately) and then a gradual increase, according to MarshallLerner beyond the starting value
...
The time range to an
improvement in the trade balance appears to last up to one year
...
5

Investment and saving in an open economy

In a closed economy, the simple identities SH + T − G = I or SH + SP = I
hold
...


Investment equals the sum of 3 positions: household saving, government
saving, and the negative trade balance
...

Conclusion: Countries with a high household-saving rate and budget
surplus either have a positive trade balance or invest very much
...

Even this identity is an ex post—identity only and does not describe a
behavioral mechanism
...
The change of ε implies a change in demand and
affects both SH and I
...
6

The IS-LM—model in the open economy

Mundell-Fleming model
...
Besides the
usual (Y, i) diagram, one often uses (not in Blanchard) the representation
in the (Y, E)—world
...
e
...

1 + i∗
t

(38)

Assuming additionally that, at least in the short run, P and P ∗ do not move,
one may substitute this expression for the (nominal) exchange rate instead
of the real exchange rate in the IS equation:
Y = C(Y − T ) + I(Y, i) + G + NX(Y, Y ∗ ,

1 + i ¯e
E )
1 + i∗

and one obtains a negatively sloped IS curve in the (Y, i) diagram
...
The intersection of the LM and IS curve does not only determine an
equilibrium pair (Y, i), but also an equilibrium exchange rate
...
The change in public demand
causes a shift of the IS curve at a rigid LM curve
...
Both Y and i rise
...
e
...
In summary, private consumption increases (depends directly on Y ), while the behavior of investment is
uncertain (higher Y , but also higher i), and net exports fall (MarshallLerner)
...

Monetary policy in the open economy
...
For example, expansionary monetary policy
...
The lower interest rate causes
a depreciation, E falls
...
This apparently ideal case includes, of course, the risk of inflation
...
For diverse reasons, e
...
, to eliminate exchange
rate risk, it may seem attractive to keep the nominal exchange rate E fixed
...

Therefore, at a fixed exchange rate there is no independent monetary policy
any more, this policy instrument is no more available
...
e
...
The advantages of a
fixed exchange rate, such as easing of border-crossing trade with its welfareincreasing effect, must be gauged against the disadvantage of abandoning
monetary policy as an instrument of economic policy
...
While in the
Blanchard variant with flexible exchange rate, the expected exchange rate
E e is exogenous and fixed, which entails certain logical problems, Mundell-

88

Fleming assume in the simplest case E e = Et , which implies i = i∗ , also
for a flexible exchange rate
...

1
...
The
IS curve is negatively sloped, because of the influence of net exports
and the Marshall-Lerner—condition
...
Monetary policy changes output directly
...
With fixed exchange rates, the LM curve disappears, as the money
supply is set endogenously, such that the exchange rate is maintained
The IS curve continues to be negatively sloped and intersects a horizon¯
tal E = E—line
...


89



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