Notesale: Turn your study into money

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ECONOMICS
Gottfries reading notes Chapters 10-18
...


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Contents
GOTTFRIES CHAPTER 10
...
11
GOTTFRIES CHAPTER 12
...
22
GOTTFRIES CHAPTER 14
...
35
GOTTFRIES CHAPTER 17
...
42

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GOTTFRIES CHAPTER 10
Monetary Policy:
The primary goal is to achieve price stability but a secondary goal of keeping production close to its
natural level is also pursued
...

IS: 𝑌 = 𝐶 ( 𝑌, 𝑌 𝑒 , 𝑖 − π𝑒 , 𝐴) + 𝐼(𝑖 − π𝑒 , 𝑌 𝑒 , 𝐾)
LM:

𝑀
𝑃

𝑌

= 𝑉(𝑖)

PC: π = π𝑒 +

𝛽(𝑌−𝑌 𝑛)
𝑌𝑛

+𝑧

An exogenous increase in money demand:
Suppose that there is an increase in money demand for exogenous reasons - that is, an exogenous
decrease in velocity
...
Lenders want their money back and there is an upward pressure on the interest rate
...
If the central bank allows this to happen by holding the money
supply constant there will be an increase in the interest rate and production will fall below the natural
level
...
It does through the
buying and selling government bonds at a particular rate
...
We assume that expected inflation does not change but remains equal to the inflation
target
...
The IS curve shifts out; if the interest rate is kept unchanged, production will increase and
inflation will increase
...
In this way it prevents inflationary
pressure from building up
...
This is consistent with analysis in Chapter 4
...
In this case the central bank's action can
be described as follows: In order to stabilize inflation and production, the central bank should adjust
the nominal interest rate so as to keep the real interest rate equal to the natural rate of interest
...
Let us assume that this shock is perceived as a permanent, one-off occurrence
...
It is less clear
how the IS curve may be affected; if oil is imported, the IS curve may shift inward because an increase
in the world price of oil makes the oil-importing country poorer
...
For simplicity,
we assume that the natural level of production and the IS curve remain unchanged
...
They
must now make a decision; they could increase interest rates, creating a negative output gap and
putting enough downward pressure on wages in order to decrease other prices and return inflation
to target or they must temporarily accept higher inflation
...
In such a scenario, the actions of the central bank
may be determined by the credibility of their inflation target, and therefore its ability to anchor long
term inflation expectations, as well as the importance that the central bank places on keeping
production as close to the natural level as possible
...
From consumption theory we know that
a permanent increase in production should lead to an increase in consumption of similar magnitude,
and the accelerator effect will lead to an increase in investment
...

Depending on the shift in the IS curve and the increase in the natural level of production, either and
increase or a decrease in the interest rate may be required
...
On the other hand,
the unexpected increase in productivity increase has a negative effect on inflation, which calls for a
lower interest rate
...
In the case illustrated below the IS curve shifts more than the natural level of
production and therefore an increase in the interest rate would be called for
...

Effectively, we assumed that the inflation target of the central bank was known and credible
...
In response to an
increase in the expected level of inflation the central bank must raise rates but it faces a dilemma;
increasing the interest rate to 𝑟 𝑛 + 𝜋 𝑒 will bring production back to the natural level but leave
inflation running at π𝑒 which is above target however raising rates to i₁, the level required to return
inflation to target, will create a large negative output gap
...
The likely result is that the central bank will adopt a rate somewhere inbetween these two
levels in order to re-establish the credibility of its inflation target while at the same time preventing
the creation of an excessively large negative output gap
...
This is because an increase in real interest rates is
required to create the negative output gap
...

The Taylor Rule
In 1993, the American economist John Taylor shows that US monetary policy in the period 1982-1991
could be described reasonably well by following the simple decision rule:
𝑖 = 𝑟̅ + 𝜋 + 0
...
5𝑌̂
Here 𝑟̅ is an estimate of the normal real rate of interest and 𝜋 ⊗ is the inflation target of the central
bank
...
5(𝜋 − 𝜋 ⊗ ) + 0
...
Taylor assumed that the normal real interest
rate and the inflation target were both 2%, leading to the decision rule:
𝑖 = 0
...
5 (𝜋 − 0
...
5𝑌̂ = 0
...
5𝜋 + 0
...
It also shows how nominal
rates must rise a level greater than one to one with inflation in order to create the increase in real
interest rates required to bring about a negative output gap and lower aggregate demand
...
This means that expectations will depend on how policy is actually
conducted
...

The macroeconomic implications of rational expectations were formulated in the 1970s
...
The reason is that any predictable monetary
policy will affect inflation expectations and hence it will be incorporated into wage and price setting
...
This may seem like bad news for
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stabilization policy that pursues a specific target but even if wage setters have rational expectations,
monetary policy can still be effective because it can respond to unexpected shocks while wages and
prices may be somewhat rigid
...
In this way, monetary policy can help to stabilize production and employment
and compensate for the lack of flexibility in wages and prices
...
But exactly how does the central bank go about controlling
interest rates?
In short, the central bank controls the short-term interest rate by offering to lend money at an interest
rate which is decided by the decision-making board at a central bank
...

The interbank market for overnight borrowing:
The monetary base includes currency and banks' accounts in the electronic payment system that is
managed by the central bank and used to transfer money between banks
...
Depending on the amount of withdrawals and deposits that
come in, a bank may end up with a deficit or a surplus on its account in the payment system
...

Therefore banks that are in deficit at the end of the day must borrow money overnight to bridge the
gap
...
In the US, this is
known as the Federal funds market
...
This is usually seen as an unattractive option as the central bank will normally charge a
higher interest rate than what is on offer in the interbank market
...
Banks with excess reserves that have been unable to lend during the day can also
deposit money at the central bank and they are paid an interest rate on this money by the central
bank, again below the market level
...
Together the interest rates
on these facilities define an interest rate corridor within which the overnight bank rate must be
...

The central bank can influence the interbank rate further through open market operations, that is the
buying and selling of government securities
...
Repurchase agreements are a more sophisticated form of open
market operation whereby the central bank agrees to purchase a government security off of a bank
on the condition that bank repurchase the security from the central bank at a set date in the future
...
This cost is converted to an annualized rate and
is called the refinancing rate by the ECB and the repo rate by the BoE
...
The decision about the
refinancing/repo rate is the main policy decision of the central bank
...
The main advantage of such an operation is that it reduces the risk taken
by the central bank
...
Since this is an alternative to borrowing in the interbank market
the interbank rate will often track the repo rate and this is how the central bank is able to exercise
further control over this rate in addition to the interest rate corridor it had already created
...

In a situation where there is a general excess of liquidity in the market, where all banks have excess
reserves and will be forced to deposit them in the central bank, the central bank has another option
that it can use
...

Reserve requirements:
Some central banks require banks to hold a certain proportion of their deposits in the form of cash or
deposits with the central bank
...
However if the central bank targets interest rates then the reserve requirement will have little
to no impact on monetary policy, the monetary base will adjust to meet demand
...

The correlation between the interbank rate and other interest rates:
The connection is that expectations about the interbank rate determine other market interest rates
...
If banks expect the interbank rate to
increase in the coming months they will require higher returns from the loans they make to consumers
and to firms
...
The spreads between different interest
rates depend on the credit risk, time to maturity and other differences between assets
...

The key is that the change must be unexpected, if the change was expected the market will have
already priced these changes in to the three and six month interest rates
...
Central banks mainly operate on the short side of the
market however they do also purchase government securities with longer maturities and in this way
they can affect the longer term interest rate by affecting the supply and demand of such products
although the correlation between central bank action and interest rates remains far stronger in the
short term
...
It
is an indicator of perceived credit risk in the general economy since US T-Bills are considered to be
'risk-free' while LIBOR reflects the credit risk of lending to commercial banks
...
Interbank lenders, therefore, demand a higher rate of interest, or accept lower
returns on safe investments such as T-Bills
...
In federal states, there is a distinction between federal and state
governments
...

The difference between gross and net government debt is that gross debt includes intra-departmental
lending and excludes government assets, i
...
government spending on student loans is expected to be
repaid by these students in the future and so net debt is lower than gross debt
...

Note that this does not need to be the case every year but must be the average in order for the debt
to remain sustainable
...
The first term on the RHS represents the primary government deficit while the second term
shows us that if the real interest rate exceeds the real growth rate, an amount is added to the
government debt ratio and this amount depends on the debt ratio at the beginning of the year
...

The numbers we hear in the media usually refer to the total deficit, in nominal terms, including
nominal rather than real interest payments on the debt
...
Note that in this case we have assumed that there is constant growth
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within the economy and where taxes and income are kept at a constant level relative to income
...

Knowing that growth isn't constant we often consider the cyclically adjusted budget balance and the
government's net financial liabilities when evaluating the long-term sustainability of public finances
...
We also have
to modify our model; households pay taxes and receive interest payments from the government which
will alter their disposable income
...
At the moment we will assume that there is no government debt to
simplify the equation
...
In line with our analysis of monetary policy in Chapter 10,
we assume that the central bank sets the interest rate
...
Then, real tax revenue
minus transfers is determined by:
𝑇 = 𝜏𝑌 − 𝑇𝑟
Now we can calculate the short-run effect on production of an increase in government expenditure
on goods and services as:
∆𝑌 =

1
∆𝐺
(1 − 𝑎₁ + 𝑎₁𝜏)

Increased government expenditure on goods and services raises aggregate demand and leads to
higher production
...
This multiplier effect will be smaller than the one found in
Chapter 8 due to a share of it being paid back to the government through taxes
...

Crowding out:
So far we have analysed the effects of fiscal policy in the short run for a given interest rate
...
Consequently there is a good chance that an increase in government
expenditure will be met by an increase in interest rates by the central bank
...
This process is known as crowding out
...
Intuitively, this is because consumers
will realise that a decrease in the tax rate will result in the government receiving less revenue and
therefore government debt is likely to increase and taxes will have to be raised in the future
...
This principle is known as Ricardian
Equivalence
...
e
...

Consumers can borrow/save at the same interest rate as is faced by the government
...

Consumers have a full insight into the government finances
...
Although these
assumptions do not hold fully they do not fail fully either which means that the multiplier will be
neither 0 nor 1
...
Advanced studies have shown that a Ricardian Equivalence does exist that offsets at a
rate of around 40-50%
...
Some households will save the
additional income while others that are credit constrained or myopic may spend the additional income
implying that the multiplier of a tax decrease is somewhere between 0 and 1, keeping i constant
...
Thus, the multiplier of spending on output in greater than 1 when
keeping the interest rate constant
...
5 and the tax & transfer multipliers are around 0
...
7
...
There are four main ones: Information lag, Decision lag, Implementation lag and Effect lag
...
The decision
lag is the delay that occurs due to the decision making process, for example once the prime minister
has decided that he wants to act he must pass legislation through parliament to approve his actions
...
The effect lag is the delay between the
implementation of the policy and it having an effect on the real economy and can often be quite long
for monetary policy while being relatively immediate for fiscal policy
...

• Tax revenue falls and transfer payments increase during recessions
...
5% of GDP (average tax rates
are around 50% of GDP)
...

• The effect of automatic stabilisers is higher in countries with large government sectors that have
high marginal tax rates
...

It is the deficit a country would have had, had its output gap been zero
...
Had GDP been 4%
higher, the deficit would have been 2% smaller (0
...

In practice it is hard to calculate the structural budget deficit when we do not know the natural
production level
...

Provided that we do not have perfect Ricardian Equivalence, governments should have a stabilising
effect on average
...
The overall effect of fiscal policy on output
depends largely on the response of monetary policy
...
However, during recessions, both expansionary fiscal and monetary policy can increase
aggregate demand
...
The central bank decreases the
nominal interest rate until it reaches the zero lower bound
...
Expansionary fiscal policy can fill the void and increase aggregate demand further
and allow interest rates to escape from the ZLB
...
Thus, fiscal policy can close the gap in aggregate demand without
the risk of a rise in the nominal interest rates
...
Since Ricardian equivalence decreases multipliers, the further away
we are from a Ricardian Equivalence the larger the multipliers
...
Also during recessions, the spread between borrowing costs for governments and for
households are larger
...
The high levels of unemployment that accompany a recession also make recruiting new
workers easier without significantly inflated wages
...
Automatic stabilisers are by design less affected by policy lags and thus
are also important instruments for stabilising the economy during economic downturns
...
e
...
This applies not only when the interest
rate is approaching the ZLB but also when interest rates cannot effect the real economy in the desired
way
...
In such a scenario lowering interest rates would not be in the bloc's interests
so the member in recession would be forced to compensate through expansionary fiscal policy
...
However if
15 | P a g e

monetary policy is unconstrained than contractionary fiscal policy can be pursued in order to reduce
the debt burden and be offset by expansionary monetary policy and the lowering of interest rates
...
g
...

Due to the distortion army effects of increased taxation and lower government spending the IMF
concludes that where ample fiscal space remains, governments should follow a policy of gradual debt
reduction
...
e
...
This model is
therefore appropriate for many developed European nations but would not be applicable to the U
...

for example
...

P* represents a price index of the foreign goods in the foreign currency
...
g
...

𝑒𝑃

Then: ε = 𝑃∗
While the nominal exchange rate is the price of the currency of the small open economy in terms of
foreign currency, the real exchange rate is the price of the good produced in the SOE in terms of the
foreign good
...

For further clarification see S2L15 notes
...
A broader measure, the effective real
exchange rate, gives a trade weighted measure of competitiveness – the price of SOE goods relative
to the price of goods from its main trading partners
...
In our simplified model, we have assumed
that domestic goods are sold at the same price at home and abroad, so the relative export price is the
same as the real exchange rate
...
Again, in our model, we have assumed that firms charge the same price home and abroad so
this is homogenous to the real exchange rate
...

As we saw in Chapter 2, the marginal cost is proportional to the unit labour cost, ULC, for the CobbDouglas production function:
𝑊𝑁
𝑊
𝑊
𝑈𝐿𝐶
𝑀𝐶 =
=
= 𝑌 =
𝑌
𝑀𝑃𝐿 (1 − 𝛼) ( ) 1 − 𝛼 1 − 𝛼
𝑁
Thus, if the mark-ups of domestic and foreign firms are the same we have:
𝑒(1 + 𝜇)𝑈𝐿𝐶
] 𝑒𝑈𝐿𝐶
𝑒𝑃 [
1−𝛼
𝜀= ∗=
=
= 𝑅𝑈𝐿𝐶
(1 + 𝜇)𝑈𝐿𝐶 ∗
𝑃
𝑈𝐿𝐶 ∗
[
]
1−𝛼
The real exchange rate is equal to the RULC
...
Previously,
when we assumed that all consumption and investment was domestic, any increase in income would
be wholly encompassed by the IS curve - now that some of that income can leak abroad modifications
are necessary
...
For
government expenditure and private investment, only the domestic good is used
...
In order to derive demand for domestic goods, we start from the balance between
sources and uses in the national accounts in nominal terms:
𝑃𝑌 + (

𝑃∗ 𝑓
𝑃∗
) 𝐶 = 𝑃𝐶 𝑑 + ( ) 𝐶𝑓 + 𝑃𝐼 + 𝑃𝐺 + 𝑃𝑋
𝑒
𝑒

The LHS side is the value of goods and services available: domestic production plus imports
...
The price of the domestically produced good is 𝑃 and the
price of imports expressed in domestic currency is
demand for the domestically produced goods as:
𝑃𝐶 𝑑 + (
𝑌=

𝑝

𝑃∗ 𝑓
)𝐶
𝑒

𝑃∗

...
We will also include the relative price between domestic and foreign goods
- that is, the real exchange rate:
𝐶𝑓 = 𝐼𝑀(𝜀, 𝑌 𝑑 , 𝑌 𝑒 − 𝑇 𝑒 , 𝑟, 𝐴)
A higher real exchange rate leads to an increase in imports, higher disposable income, 𝑌 𝑑 , and higher
expected future income, 𝑌 𝑒 , also increase imports while a higher real interest rate, 𝑟 , reduces
consumption and imports
...
We assume that imports to the ROW are determined
in the same way as imports to the SOE:
𝑋 = 𝑋(𝜀, 𝑌 𝑑∗ , 𝑌 𝑒∗ − 𝑇 ∗𝑒 , 𝑟 ∗ , 𝐴∗ )
We define a net export function:
𝑁𝑋(𝜀, 𝑌 ∗ , 𝑌) = 𝑋(𝜀, 𝑌 𝑑∗ , 𝑌 𝑒∗ − 𝑇 ∗𝑒 , 𝑟 ∗ , 𝐴∗ ) −

𝐼𝑀(𝜀, 𝑌 𝑑 , 𝑌 𝑒 − 𝑇 𝑒 , 𝑟, 𝐴)
𝜀

We now have the IS equation for an SOE:
𝑌 = 𝐶(𝑌 𝑑 , 𝑌 𝑒 − 𝑇 𝑒 , 𝑟, 𝐴) + 𝐼 (𝑟, 𝑌 𝑒 , 𝐾) + 𝐺 + 𝑁𝑋(𝜀, 𝑌 ∗ , 𝑌)
To find real disposable income, 𝑌 𝑑 , note that GDP is paid out to households in the form of wages,
dividends, and interest payments from firms
...
We assume the government
does not borrow abroad so that domestic households must hold all of the government's existing debt
...
Then, domestic households' real disposable income is:
𝑌 𝑑 = 𝑌 − 𝑇 + 𝑟(𝐷 + 𝐹)
We now have two relative prices affecting aggregate demand:
•
•

The real interest rate (the intertemporal relative price) affects choice between consumption
today and consumption tomorrow
...


The effect of the real exchange rate on NX:
Two new factors affect aggregate demand in the SOE: foreign income and the real exchange rate
...
The effect of the real exchange rate is more complicated
...
As domestic goods become more expensive relative to foreign good, foreign consumers buy
more foreign goods and fewer goods produced in the SOE, so the quantity of exports decreases,
i
...
𝑋 tends to be a decreasing function of ε
...
As domestic goods become more expensive relative to foreign goods, domestic consumers buy
more foreign goods and fewer domestically produced goods, so the quantity of imports
increases
...
When imports become cheaper relative to domestic goods, this decreases the value of imports
relative to the value of exports
...
This
effect, known as the valuation effect, is in the opposite direction to the first two and it is
therefore the balance between these effects that will affect the overall outcome on NX
...
The
formal condition for NX to fall with an appreciation of the real exchange rate is known as the MarshallLerner Condition, which says the sum of (the absolute values of) the price elasticities of import and
export demand must be higher than 1
...

Savings, investment and the current account:
A few assumptions:
1
...

2
...

3
...
e
...

The private sector (households and firms) has three assets: real capital, 𝐾, government debt, 𝐷, and
net claims on foreign households, 𝐹:
𝐴 = 𝐾+𝐷+𝐹
Savings of the private sector - disposable income minus private consumption - can be used for real
investments and to accumulate claims on the government and foreign households:
𝑌 𝑑 − 𝐶 = 𝐼 + ∆𝐷 + ∆𝐹
Households' real disposable income is equal to domestic production plus interest on government debt
and on net claims on foreign households, minus tax (as shown above):
𝑌 𝑑 = 𝑌 − 𝑇 + 𝑟(𝐷 + 𝐹)
To simplify, we assume that the real return is the same on government debt as it is on net claims
against foreign households
...
But how is this related to exports and imports? To see this, we use 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
to substitute for 𝑌 in the equation above:
∆𝐹 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋 + 𝑟𝐹 − 𝐶 − 𝐺 − 𝐼 = 𝑁𝑋 + 𝑟𝐹
The change in claims on foreign countries is equal to net exports plus interest income from abroad that is, the current account
...
If there is a deficit, this must be financed by borrowing from foreign countries
...
We can think of it as national
income minus consumption minus real investment:
∆𝐹 = 𝑌 + 𝑟𝐹 − 𝐶(𝑌 𝑑 , 𝑌 𝑒 − 𝑇 𝑒 , 𝑟, 𝐴) − 𝐼(𝑟, 𝑌 𝑒 , 𝐾) − 𝐺
Or we can think of the current account as net exports plus net primary income from abroad:
∆𝐹 = 𝑁𝑋(𝜀, 𝑌 ∗ , 𝑌) + 𝑟𝐹
To complete the construction of our model we must analyse the relation between interest rates and
exchange rates
...

To simplify our analysis we will assume that financial investors always invest where the expected
return is highest
...

Imagine a foreign financial investor who considers lending one unit of their currency in period t, either
in her own currency or in the currency of the SOE
...
In order to lend in the currency of the SOE, the
1
SOE currency must be bought
...
This money is then exchanged back to the ROW currency, giving a final
return of:
1
( ) (1 + 𝑖𝑡 )𝑒𝑡+1
𝑒𝑡
In the ROW currency
...
Thus, the interest rates and the expected exchange rate have to fulfil the
following interest parity condition:
1 + 𝑖𝑡∗ = (1 + 𝑖𝑡 ) (

𝑒
𝑒𝑡+1
)
𝑒𝑡

This equation conveys a simple concept, if the currency of the SOE is expected to depreciate, so that
(

𝑒
𝑒𝑡+1
)
𝑒𝑡

is less than unity, the interest rate in the SOE has to be higher than the foreign interest rate to

compensate for the expected depreciation
...
To do this, we add and
subtract 𝑒𝑡 , in the numerator on the RHS:
𝑒
𝑒 −𝑒
𝑒
𝑒𝑡+1
𝑒𝑡 + 𝑒𝑡+1
∆𝑒𝑡+1
𝑡
1 + 𝑖𝑡∗ = (1 + 𝑖𝑡 ) (
) → = (1 + 𝑖𝑡 ) (
) → = (1 + 𝑖𝑡 ) (1 + (
))
𝑒𝑡
𝑒𝑡
𝑒𝑡

≈ 1 + 𝑖𝑡 +

𝑒
∆𝑒𝑡+1
𝑒𝑡

𝑖𝑡 − 𝑖𝑡∗ ≈ −

𝑒
∆𝑒𝑡+1
𝑒𝑡

The interest differential must be approximately equal to the expected depreciation of the currency in
percent
...

Implications of interest parity under fixed and floating exchange rates:
A fixed exchange rate means that a central bank announces an official level for the exchange rate and
keeps the exchange rate at that level by buying and selling currency
...
e
...
Eventually the central bank will run out of reserves and the currency will depreciate
...
This would require the purchase of
vast sums of foreign currency and would not be sustainable in the long run
...
With a floating exchange rate the central
bank is free to set the interest rate and we can instead think of the interest parity condition as an
equation determining the level of the exchange rate:
𝑒𝑡 =

1 + 𝑖𝑡 𝑒
𝑒
1 + 𝑖𝑡∗ 𝑡+1

This equation shows that the exchange rate is determined by three variables:
1
...

2
...

3
...
Expectations of the future
value of the currency will depend on interest rate expectations and the prospect for economic
growth which would make investments more profitable
...
With perfectly integrated financial markets
the level of the real interest rate is instead tied to the real interest rate in the world financial market
...
Assume also that, in
the long run equilibrium, the real exchange rate is constant
...
If one country were to have
a continuous increase in the price level compared with other countries, exporters in that country
would become unable to compete in world markets
...
A country with high relative inflation will experience a depreciating nominal
exchange rate
...

𝑒

So we can substitute this into the interest parity condition to give:
𝑖 + 𝜋 ∗ − 𝜋 = 𝑖∗
𝑖 − 𝜋 = 𝑖∗ − 𝜋 ∗

The LHS of this equation gives the real interest rate in the SOE and on the RHS we have the real interest
rate in the ROW
...
If savings are less than investment then
the residual is borrowed from abroad
...
As we have just seen, the long run
level of the real interest rate is now determined by the world financial markets and is thus
independent of domestic supply and demand
...
The natural level of production is determined
by the production function and available resources, in the same way as in the closed economy:
𝑌 𝑛 = 𝐹(𝐾, 𝐸(1 − 𝑢𝑛 )𝐿)
Aggregate demand in the open economy is given by the 𝐼𝑆 eqaution derived in Chapter 12:
𝑌 = 𝐶(𝑌 𝑑 , 𝑌 𝑒 − 𝑇 𝑒 , 𝑟, 𝐴) + 𝐼 (𝑟, 𝑌 𝑒 , 𝐾) + 𝐺 + 𝑁𝑋(𝜀, 𝑌 ∗ , 𝑌)
Where 𝑌 𝑑 = 𝑌 𝑛 − 𝑇 + 𝑟 ∗ (𝐷 + 𝐹)
Since the real interest rate cannot adjust to keep production at the natural level, the real exchange
rate must adjust instead
...
For
production to be at the natural level, 𝑌 = 𝑌 𝑛, we must have:
𝑁𝑋(𝜀, 𝑌 ∗ , 𝑌) = 𝑌 𝑛 − 𝐶(𝑌 𝑑 , 𝑌 𝑒 − 𝑇 𝑒 , 𝑟, 𝐴) − 𝐼 (𝑟, 𝑌 𝑒 , 𝐾)
Fig
...
2 illustrates the determination of net exports
...
If the world real interest rate is higher than this, production exceeds
domestic demand and the residual must be exported
...
13
...
In the long run, the real exchange rate
must adjust so that the exporters can sell the required amount of exports in the world market
...


In the closed economy, we defined the natural rate of interest as the real rate that is consistent with
production being at the natural level
...

Fig 13
...
The consequence of an increase in the willingness to invest in the domestic economy is
increased aggregate demand, since production remains at the natural level in the long run, net exports
must decrease in order to meet strong domestic demand
...


24 | P a g e

As illustrated by Fig 13
...
This will lead to inflation in
the SOE and the price level will increase until net exports have declined so much that production
is back at the natural level
...

With a floating exchange rate, the nominal exchange rate will also adjust
...
In this way, some of the adjustment of the real exchange rate may
take place via a change in the nominal exchange rate
...
Expressing the current account in these terms gives:
∆𝐹 = 𝑁𝑋 + 𝑟 ∗ 𝐹 = 𝑌 𝑛 − 𝐶 − 𝐺 − 𝐼 + 𝑟 ∗ 𝐹
=
𝑌 𝑛 + 𝑟 ∗ (𝐹 + 𝐷) − 𝑇 − 𝐶(𝑌 𝑛 − 𝑇 + 𝑟 ∗ (𝐹 + 𝐷), 𝑌 𝑒 − 𝑇 𝑒 , 𝑟 ∗ , 𝐴) − 𝐼(𝑟 ∗ , 𝑌 𝑒 , 𝐾) + [𝑇 − 𝐺 − 𝑟 ∗ 𝐷]
The final term, in square brackets, represents government net lending while the rest of the equation
denotes private sector net lending
...
To determine the effect of this on the
current account we must conisder the effect that this will have on savings and investment
...
This means that it is the effect on private
consumption that is important and for this we must consider Ricardian Equivalence as presented in
Chapter 11
...

As discussed in Chapter 11, there are a plethora of reasons to suspect that there will not be complete

25 | P a g e

Ricardian equivalence and therefore private sector net lending will not increase by as much as
government net lending has fallen and there will be an increase in the current account deficit
...
Consumers will not reduce their consumption by as much as the government has
increased its consumption and therefore there will be an increase in the current account deficit
...

The relation between the two deficits is not as strong as it might first appear
...
This will result in increased government tax revenue which will lower the government's
budget deficit but that will also drive demand for imports that would weaken the current account
deficit
...

Does a current account deficit lead to a depreciation of the currency?
Consider a country where the current account is in balance (𝑁𝑋 = 0) and there is initially no net
foreign debt (𝐹 = 0)
...
After this
period, consumers stop and the spending and start to pay back their loans from foreign countries,
resulting in a current account surplus
...
6 illustrates how this affects net exports and the real
exchange rate
...
However when consumers start to pay back their loans, the
country has to increase its net exports, so the relative price of its goods must decrease
...
We can therefore see that a large current account deficit can be an
indicator of a future depreciation
...


Investment and growth in the open economy:
In the closed economy, all investment must be financed by domestic saving
...
With an international financial market, the possibility of financing investments
through foreign borrowing arises and this has the potential to speed the accumulation of capital
...
Hence firms will invest until the net MRP of capital, minus
depreciation, equals the world real interest rate
...
This condition determines the long run capital stock per effective worker
...

𝐸𝑁 𝑛

The long run adjustment of the capital stock is illustrated in Fig 13
...
If the capital stock is initially
lower than 𝑘 ∗ , the marginal return on capital is high, and firms will invest until the capital stock
reaches this point
...
During this period the country may run a current account deficit
...
However other factors such as human
capital that complement the physical capital may be missing and this slows down the process
...
It is also important to remember that global financial markets are
not totally integrated and that small firms cannot simply borrow from foreign banks
...
This income will therefore depend on the relative size of the stock
of foreign loans that are held and those which are owed
...

Consider an economy that is in equilibrium, the current account is balanced and the nation has some
claim on foreign households', 𝐹
...
Then we know from our analysis of consumption in Chapter 4
that consumption will equal income
...
/ This means that 𝐹 will remain
constant
...
If consumers become more impatient and the subjective discount
rate rises above the interest rate then consumption will increase to be higher than income
...
Here we have a scenario
underwhich domestic production (GDP) has remained constant but under which national income has
decreased
...
This process will
continue until national income reaches zero as a higher and higher proportion of production income
goes on paying back foreign debt
...
Previously, when central banks had to maintain a fixed exchange rate, a large current
account deficit could lead to an exchange rate crisis when the central bank's reserves were run down
to the point where they could no longer support the currency
...

It can often make sense to run a current account deficit - when the capital stock is relatively small and
marginal returns are high everyone benefits from foreign borrowing
...

It is called the Mundell-Fleming model
...
e
...
The model consists of three
equations:
𝑰𝑺 − 𝑌 = 𝐶(𝑌 − 𝑇
...
Production, 𝑌, is endogenous and
determined by aggregate demand according to the first equation
...
With a credibly fixed exchange rate, 𝑒 is fixed by the central bank and then the
𝐼𝑃 equation says that the interest rate in the SOE must be the same as abroad: 𝑖 = 𝑖 ∗
...
This
means we treat 𝑀 as endogenous when the exchange rate is fixed
...

Then production, the interest rate, and the exchange rate are jointly determined
...

Macroeconomic equilibrium with a fixed exchange rate:
Since the central bank cannot control the money supply, we treat the money supply as endogenous
...
We
are therefore not particularly interested in the 𝐿𝑀 equation and can focus on the 𝐼𝑆 equation
...
𝑌 𝑒 − 𝑇 𝑒 , 𝑖 ∗ − 𝜋 𝑒 , 𝐴) + 𝐼 (𝑖 ∗ − 𝜋 𝑒 , 𝑌 𝑒 , 𝐾) + 𝐺 + 𝑁𝑋 ((

𝑒𝑃
) , 𝑌 ∗ , 𝑌)
𝑃∗

𝑒 ⊗𝑃

Where ε = 𝑃 ∗
...
We can use this equation
to examine how the SOE is affected by exogenous shocks
...
For example, the effect of a
change in government spending could be found by differentiating this equation with respect to 𝐺:
∆𝑌 = (

1
) ∆𝐺
1 − (1 − 𝜏)𝑐1 + 𝑞

The increase in government demand leads to higher production and income although the multiplier
effect will be reduced due to the presence of 𝑞 which illustrates the 'leakage' that will occur as a result
of increased domestic demand - some of the increased demand will be for imported goods
...

The effect of the real exchange rate on aggregate demand:
This can be calculated as:
𝑌=(

1
) 𝑑𝜎𝜀 −𝜎−1 𝑌 ∗ ∆𝜀
1 − (1 − 𝜏)𝑐1 + 𝑞

To make this easier to interpret we multiply by ε/𝑌 in order to give us the elasticity of demand with
respect to the real exchange rate:
∆𝑌 𝜀
1
𝑑𝜀 −𝜎 𝑌 ∗
1
𝑋
( ) = −(
)𝜎(
)= −(
)𝜎( )
∆𝜀 𝑌
1 − (1 − 𝜏)𝑐1 + 𝑞
𝑌
1 − (1 − 𝜏)𝑐1 + 𝑞
𝑌
30 | P a g e

Floating Exchange rates:
With floating exchange rate, the central bank sets the interest rate, leaving the exchange rate to be
determined in the currency market, so we rewrite the interest parity condition with the exchange rate
as the dependent variable:
𝑒=

1+𝑖 𝑒
𝑒
1 + 𝑖∗

The central bank controls the domestic interest rate and we take the foreign interest rate as
exogenous
...
To reduce the
Mundell-Fleming model to two equations that we can draw in a diagram, we substitute the interest
parity conditio0n in the goods market equilibrium condition to obtain a modified 𝐼𝑆 equations which
we call 𝐼𝑆 ∗ :
1 + 𝑖 𝑒𝑒𝑃
𝑌 = 𝐶(𝑌 − 𝑇
...

We see that, in the open economy, a higher interest rate affects aggregate demand through two
channels:
•
•

There is a direct effect of the interest rate on domestic consumption and investment, which is
the same as in a closed economy
...
We
can call this the exchange rate channel
...
14
...
The 𝐼𝑆 ∗ curve is flatter than the 𝐼𝑆 curve because
an increase in the interest rate rate has a bigger effect on production when we take account of the
exchange rate channel
...

1
...

2
...
14
...

3
...
This stimulates consumption and investment and the reduction in the interest
rate also makes it less attractive to hold domestic currency
...

4
...


Fiscal policy with a constant money supply:
Consider an increase in government expenditure
...
The 𝐼𝑆 ∗ curve shifts to the right because higher government expenditure increases demand for
a given interest rate
...
As we see in Fig 14
...

3
...
As the volume of transactions increases, demand for money increases, there is a
shortage of liquidity, and the interest rate increases
...
The increasing interest rate increase the
attractiveness of the currency and the appreciation of the exchange rate that follows reduces
net exports
...
The overall effect is ambiguous because monetary policy counteracts expansionary fiscal policy
and while incomes have increased so too have interest rates
...
Expansionary fiscal policy crowds out
private investment and net exports
...
For a given expected future
exchange rate, the slope depends on how consumption and investment are affected by the interest
rate but also on how changes in the exchange rate affect net exports
...
A high interest rate today may generate expectations that future
monetary policy will also be tight, so inflation will be low in the SOE
...
Hence the effect via the exchange rate channel will be higher than if
expectations remained constant
...
In this case the interest rate will
have a bigger effect on aggregate demand and the slope of the 𝐼𝑆 ∗ curve will be flatter
...
Reduced demand and a fall in
production in the short run will reduce inflation and lead to a reduction in the real exchange rate and
this will stimulate the economy and it will return to its natural level of production
...
A floating exchange rate acts as a shock absorber that speeds up the
necessary real exchange rate adjustment thereby dampening the effects of the shocks on aggregate
demand and production
...
The participating central banks had gold reserves
and promised to buy and sell gold at a fixed price
...
If the central bank printed
too much money then the interest rate would be pushed below that which was available abroad and
hence there would be an outflow of capital as investors sold their currency and bought up gold to
convert into other currencies
...
This process was known as sterilization
...
Hence long term monetary policy was strictly controlled by the gold
standard in this period
...
The period can be characterised by its low
average inflation, stable exchange rates and high economic growth
...
Following WWI,
when many countries were forced off the gold standard due to the financial burden of the war, many
countries attempted to re-join the gold standard which meant a prolonged period of deflation and
high unemployment during the 1920s as prices readjusted
...

The Bretton Woods system:
Towards the end of WWII representatives from a number of countries met to discuss free trade
...
In this system, most currencies were fixed relative to the US dollar; each currency had
its own central parity level from which it was allowed to fluctuate by ±1%
...
This system led to the US Dollar becoming the primary
reserve currency as it was 'as good as gold' and other currencies were not directly convertible
...
Consequently it became very hard for countries to finance large
current account deficits
...
The creators of the Bretton Woods system foresaw this
potential problem and created the International Monetary Fund in order to provide an international
lender of last resort
...
Monetary and fiscal policy throughout the 1960s in
the US had generated annual inflation rates of around 4-5% and this made it profitable for private
investors to purchase gold from the Federal Reserve at $35 an ounce and then sell it on in the private
market
...
The 1960s had also seen a series of devaluations and revaluations of major
European currencies that had already brought the viability of the system into question
...
25%
...
The majority of the ERM's members went on to join the European
Monetary Union, or the Euro
...

Some countries have chosen instead to maintain fixed exchange rates relative to a currency basket that is, an index of foreign currencies, where the weights in the index reflect the importance of
different currencies in terms of trade with the domestic currency
...
It is a quick way to improve competitiveness and increase exports and is far less painful than a
recession and deflation as a means to achieve a depreciation
...
However, the possibility of devaluation means that there may be
speculation in the financial markets about a future change in the exchange rate
...
If a
country enters into a deep recession then speculators may feel that a devaluation is imminent and
begin to sell the currency
...

Suppose, for example, that financial investors think that there is a 10% probability that the currency
will be devalued by 20% within the coming year
...
10
...
20) = 0
...
A high interest rate would drive the country further into recession, which will add
to the speculation that the currency will eventually be devalued
...


36 | P a g e

Speculation against a currency creates a serious dilemma for the central bank
...
In several
countries, attempts to maintain a fixed exchange rate have led to devaluation cycles
...
Higher inflation undermines the competitiveness of
the export industry which sooner or later leads to a devaluation
...
The basic reasoning behind a devaluation
cycle is that fiscal policy is too expansionary and stokes inflationary pressures
...
Therefore uncertainty about future monetary policy will translate into uncertainty
and volatility of the exchange rate
...
Consequently many countries today have explicit inflation targets
...
2-0
...
Another
advantage is increased price transparency
...


37 | P a g e

Short-term exchange rate fluctuations:
By eliminating the uncertainty within exchange rate expectations consumer and investor confidence
can be increased
...
By eliminating this uncertainty then trade can be encouraged and the gains fully realised
...

Medium-term exchange rate fluctuations:
If firms are looking to expand production so as to cater to an export market then investment may need
to be made in increasing production capacity
...
However, economic theory does not offer a clear prediction
here
...
Although there is still
good reason to dislike uncertainty; while the average profitability of production may be increased by
price volatility the risk of big losses also increases which may be particularly difficult for small and
medium firms with limited capacity for losses to stomach
...

Macroeconomic aspects: stability:
According to the Mundell-Fleming model, an adjustment of the nominal exchange rate can ease the
adjustment of the real exchange rate
...
How does the economy adjust in this case?
This depends on whether the shock is country is country-specific (asymmetric) or common to most
countries in the monetary union (symmetric)
...
In this case the central bank acts in much the same way as it would if it were a national
central bank
...
One possible way to achieve a real exchange rate adjustment is via wage and price
adjustment
...
As time goes by, competitiveness improves, net exports increase and the
level of production is restored
...

Another method for adjustment is labour mobility
...
In Europe, such movements are limited by cultural and language barriers
...

National fiscal policy can play a role
...
Such a package would consist of reductions in pay-roll
taxes and a simultaneous increase in other taxes such as income tax and VAT
...
An internal
devaluation shifts taxes from firms to consumers and it can be designed in such a way so as to preserve
a balanced budget
...

Federal fiscal policy is the other option available, whereby booming countries face a higher tax rate
which is then used to redistribute income to countries in recession
...
Inflation also increases,
but the evidence suggests that the short run Phillips curve is quite flat, so the short run effect on
inflation is small
...
At the same time we now money is neutral
in the long run, the theory presented in Chapters 7 and 9 suggests that a higher rate of money growth
will have no long term effect on employment
...

If policymakers are short-sighted and attempt to achieve short-term employment gains then we can
analyse this problem with the help of our macroeconomic model
...
If we assume there are
no economic shocks, i
...
𝑧𝑡 = 0, and that the central bank can control aggregate demand and the level
of employment then we can think of monetary policy as choosing a level of unemployment
...

This function is minimized if both inflation and unemployment are at zero
...
From the point of view of the
policymakers we can view this as the probability of them losing the next election
...


39 | P a g e

To find the final policy decision, we combine the Philips curve with the loss function of the policymaker
as in Figure 17
...
Facing the trade-off given by this short-run Philips curve, the policymaker will choose
the point on the short-run Philips curve where the loss is the lowest
...
As we see in the Figure,
this implies positive rate of inflation equal to 𝜋1 , in period 1
...
However this is not a stable equilibrium and the
expected rate of inflation in the second period is higher; now π𝑒 = 𝜋1
...
In the long run
the rate of unemployment will return to its natural level but the level of inflation will be significantly
higher at 𝜋̅
...
This would create a very credible long run inflation target but would eliminate the central bank
to act to stabilize output in the short-run if there are economic shocks
...
Such a rule would prescribe how the
central bank should react to different disturbances, and assure low average inflation while at the same
time allowing the central bank to react in a reasonable way to shocks
...
Again, this eliminates the possibility of the central bank
acting to stabilize employment during crises
...

Long-term contracts: By giving central bankers long-term contracts we can ensure they care about the
long-run effects of their policies
...

Such a contract could punish the leaders of the central bank if inflation is too high and this
...

Deficit Bias:
In a world with full Ricardian Equivalence and non-distortionary taxes, the level of government debt
does not matter
...
As a consequence,
aggregate consumption, saving, and production are unaffected by the level of debt, and so is the utility
of the current and future generations
...

Intergenerational redistribution: Tow main reasons that Ricardian Equivalence does not hold are that
individuals do not fully take into account the utility of future generations and that they are credit
constrained
...
Consequently, aggregate saving will be reduced
by a tax cut and, in a closed economy, this leads to a lower rate of capital accumulation
...
In reality we can expect some combination of the two
...
If we assume that productivity growth continues then this may not necessarily be a bad
thing, future generations will still have higher standards of living and it may therefore be justified to
borrow at their expense
...
Thus, we want to avoid a situation where taxes are very high
and perhaps a stable tax level is the most preferable
...
By running a deficit when
government consumption is temporarily high, i
...
during a recession, and repaying future periods, the
tax level is kept relatively stable and the distortionary effects of taxation are reduced
...
One argument against high levels of government debt is that in order to pay the
41 | P a g e

required interest on the accumulated debt stock taxes will have to be increased in the long run
...

Sustainability and fiscal crisis: When debt is on an unsustainable path the interest rate faced by the
government may continually raise as the potential for default increases
...
For greater
detail on the sustainability of public finances refer to Chapter 11 notes
...
Political fragmentation can occur in power-sharing agreements where
more right-wing and left-wing elements of the coalition fail to agree on a solution to tackle a deficit,
this can lead to a prolonged period of inaction
...

Solutions to deficit bias include:
1
...

2
...

3
...
The issue with this is that such a body might lack democratic accountability, as well as the
fact that the aims of distributional consequences, making fiscal policy inherently political
...
Fiscal Policy Councils: Similar to the above method, this would involve the setting up of an
independent committee to evaluate and give advice on fiscal policy
...
They appoint the board of the company at the
shareholders' meeting and the board appoints the managing director
...

Debt holders are promised a fixed repayment
...
Shareholders have no fixed return and their return on their
investment is dependent on the profits that the firm makes from which it pays dividends
...
This is illustrated below
...
Therefore the amount borrowed is (X-A)
...

Therefore, lenders will typically require that a large part of an investment is financed by equity so that
there is a sufficient buffer that can absorb losses without the company becoming insolvent
...
Companies that are in volatile industries will have lower levels of
debt relative to total assets as the chances of a big loss are greater while firms with a great deal of
collateral and assets that are easy to sell may have higher debt ratios
...
This is because the potential upside for the equity holder is far greater than for the bank, once
the debt holder is repaid there is no remaining upside for them however if a project continues to
perform well the equity holder will enjoy the profits of an increasing share price
...
The limited liability of the equity holder and unlimited potential for profits
creates a divergence in incentives and creates a moral hazard (principal-agent) problem
...
Further, suppose that there are no outside
investors that want to buy shares in the firm at a reasonable price and that the present owners have
all their money invested in the firm
...
When demand and profits are low,
firms may be unable to finance profitable investments
...
As investment
increases, this gives a further boost to aggregate demand and can lead to an accelerator effect within
the economy
...

NB - The key difference between a financial accelerator and a conventional accelerator is time
...
The traditional accelerator effect occurs because GDP growth
increases firms' expectations of future growth in profits and this creates a strong incentive to invest
to increase capacity
...
This means that the value of the share is determined by the expected
present value of future dividends
...
Then 𝑑𝑡+2 = (1 + 𝑔)𝑑, 𝑑𝑡+3 =
(1 + 𝑔)2 𝑑 and so on
...

We see that the value of shares is determined by three factors: expected dividends in the next period;
the relevant real discount rate; the expected growth of dividends
...
Therefore, we expect the stock
market to predict future economic developments
...
In fact, stock
prices vary more than can be explained by changes in expected future dividends - in a sense, there is
excess volatility in the stock market, as shown by the American economist Robert Shiller
...
Therefore, we should expect share prices to be closely
related to investment
...
He argued that investment should be a function of the market value of the
capital stock relative to the replacement value of capital stock, a ratio which is called 'Tobin's q'
...


44 | P a g e

Tobin's theory is broadly consistent with the theory of investment that we presented in Chapter 3
...
Also,
assume that there is perfect competition in the product market
...
We saw in the previous section, that if profits
π
(and dividends) are expected to remain constant, the real value of the shares is 𝑟
...
Thus we get Tobin's q as:
𝜋
𝛼𝑌
−𝛿
𝑆
𝛼𝑌 − 𝛿𝐾
𝑟
𝑞= = =
= 𝐾
𝐾 𝐾
𝐾𝑟
𝑟
With perfect competition in the product market, the theory presented in Chapter 3 implies that, in
the long run, the capital stock is chosen so that the real marginal product of capital minus the
depreciation is equal to the real interest rate
...
The intuition behind the result is that Tobin's q is high when the
expected future total return on capital is high, and then the marginal return on investment is also high
...
In practice, direct lending is associated with
two major problems:
•
•

(1) Lack of information and trust - households do not know if firms are safe to lend to
...


A maturity mismatch (banks lend long but consumers want short-term liquidity) can lead to liquidity
problems for the banks
...
This means that the bank may
be unable to borrow on the market to cover the gap and consequently may have to hold a 'fire sale'
in order to offload assets cheaply and generate liquidity
...

Banks are financial intermediaries which fulfil central roles:
1
...
Providing liquidity
45 | P a g e

Banks convert uncertain and illiquid lending to basically safe and liquid deposits
...

Banks hold buffers of equity and liquid assets to handle unexpected losses and withdrawals
...
e
...

Recent developments in the financial industry:
Wholesale financing: Regular deposits are only one source of funding for banks
...
Banks issue various types of securities that are bought by pension
funds and other institutions
...
When it is time to repay loans, the bank must issue new securities in order to finance
its lending
...

Quasi-banks: In the decades before the financial crisis in 2008, so-called quasi-banks increased in
importance
...
Such institutions are sometimes said to makeup a shadow banking system
...
S
...
These institutions do not take regular deposits and are
involved in the issuing, buying and selling of housing bonds and other securities and when doing so
they hold inventories of securities
...

Securitization: This is where various types of loans held by the banks are packaged together and sold
off as securities to other institutions
...


46 | P a g e



---