Macroeconomics

Lecturer – MATVEEVA Tatiana Yurievna

 "The study of economics does not seem to require any specialized
gifts of an unusually high order. Is it not, intellectually regarded, a
very easy subject compared with the higher branches of philosophy
and pure science? Yet good, or even competent, economists are the
rarest birds. An easy subject, at which very few excel! The paradox
finds its explanation, perhaps, in that the master-economists must
possess a rare combination of gifts. He must reach a high standard in
several different directions and must combine talents not often found
together. He must be mathematician, historian, statesman, philosopher
– in some degree. He must understand symbols and speak words. He
must contemplate the particular in terms of the general, and touch
abstract and concrete in the same flight of thought. He must study the
present in the light of the past for the purposes of the future. No part
of man's nature or his institutions must lie entirely outside his regard.
He must be purposeful and disinterested in a simultaneous mood; as
aloof and incorruptible as an artist, yet sometimes as near the earth as
a politician".
2
John Maynard Keynes 2
 Lecture 1
Introduction to Macroeconomics
• The Subject Matter of Macroeconomics
• The History of Macroeconomics
• Key Macroeconomic Issues
• Principles of Macroeconomic Analysis
• Macroeconomic Agents and Macroeconomic
Markets
• The Model of Circular Flows
• The Macroeconomic System
• Key Objectives of Macroeconomic Policy
3
 What is Macroeconomics?
Macroeconomics is the branch of economics.
Economics is a social science that studies how scarce economic
resources are managed and organized to maximize production in order
to deal with the needs and wants of the society. The term was
introduced in the end of the XIX century by the prominent British
economist Alfred Marshall.
It is a discipline which deals with the economic behavior of individuals
and organizations engaged in the production, distribution and
consumption of goods and services.
The study of economics is subdivided into two general fields:

Economics

Microeconomics Macroeconomics 4
 The History of the Term «Macroeconomics»
The term «ecоnоmics» («oikonomikos») was invented in IV century B.C.
by Xenophon, who was an ancient Greek philosopher, historian,
soldier, mercenary, and student of Socrates.
In translation from Greek that is «housekeeping», while
«micro» means «small», and «macro» means «large».
For the first time the term «macroeconomics» was used in 1933 by
the Norwegian economist-matematician, the first Nobel prize winner in
economics of 1969 Ragnar Frisch, who introduced the concepts of
«microeconomic» and «macroeconomic dynamics».
In 1941 the Dutch economist-matematician Pieter de Wolff divided
economic theory into microeconomics and macroeconomics.

5
 Macroeconomics and Microeconomics
Macroeconomics
analyzes the economy as
a whole;
studies aggregate economic
behavior – the behavior of
aggregate economic agents on
aggregate economic markets;
deals with the economic
issues that affect the entire
economy and most of society;
studies aggregate variables
such as gross domestic
product, national income,
aggregate demand, aggregate
supply, general price level,
rate of unemployment, public
deficit, exchange rate, etc.
Microeconomics
analyzes individual components
of the economy;
studies economic behavior of
individual units (individual firm or
individual household) on markets
for particular goods and services
(wheat, computers, oil, bicycles,
gold, etc.);
deals with the decision-making of a
certain firm (a producer) or a
certain household (a consumer);
studies individual variables such as
the amount of a firm’s output or of
a consumer’s income, quantities
demanded and supplied of particular
goods and their prices, etc.
 Macroeconomics versus Microeconomics

Microeconomics Macroeconomics

Subject Economic behavior

Level of Аnalysis Individual units Entire economy

Aggregate
Agents Individual
(sectors of economy)
Particular goods and
Markets Composite
services
Prices Relative Absolute
Market Only via changes In the short run via
Adjustment in prices changes in quantities
7
 Using Microeconomics in Macroeconomics
Macroeconomics is based on microeconomics
(has microeconomic foundations), because
macroeconomic events are the result of the decisions of millions
of individual agents, who maximize their own welfare and arise from
the interaction of many people;
to understand the behavior of the households and business sectors
of the entire economy we need to know the principles of single
households and firms behavior.
At the same time all the decisions of individual agents are made
taking into account the macroeconomic situation.
Microeconomics Macroeconomics

8
 Macroeconomics as a Special Discipline
But …
despite both disciplines use the same variables, macroeconomic
variables are not just a simple sum of variables that reflect
individual decisions (examples: total output, aggregate
demand, general price level, etc);
not every statement that is true for an individual is always true
for the entire economy (example: the paradox of thrift).
Thus, microeconomics and macroeconomics have specific subjects
and methods of analysis and are based on specific approaches
and theories. They are even taught as separate disciplines.

9
 The Founder of Macroeconomics
The founder of macroeconomics as a special part of economics
was a prominent British economist, lord
John Maynard Keynes,
who in 1936 had published his famous book
«General Theory of Employment, Interest and Money».
He showed that macroeconomics
has a special subject and
some special methods of analysis.
His contribution to economic theory was
so large, that it was called the
«Keynesian revolution».
10
Key Macroeconomic Issues
Overall output
– long-run changes: economic growth
– short run fluctuations: business cycle
Unemployment
Inflation
Interest Rates
Government Budget
Balance of Payments and Exchange Rates
Macroeconomic Policy

11
Questions Macroeconomists Try to Answer
?
?
Why do incomes grow? Would our children live better than we do?

?
Why are some countries richer than others? Why do some
economies grow faster than others?

?
Why do recessions and expansions occur in the economy?
Why is there unemployment? Is it a necessary part of economic

others? ?
life? Why unemployment is low in some countries and high in the

Why do prices grow? What is the cost of inflation for the society?

?
Is it better for an economy to have budget deficit or budget
surplus? trade deficit or trade surplus? to be a lender or a borrower

?
in the world financial markets?

12
Questions Macroeconomists Try to Answer

? ?
Why do interest rates fluctuate? What impact have the changes
in the money and stock markets on the economy?
What are the determinants of the exchange rates? Is it good to

?
have a strong or a weak domestic currency?
Is government policy able to affect long-term economic growth?
Can it eliminate or at least smooth economic fluctuations during
the business cycle?

?
How economic changes in one
country effect the situation in others?
?
?
Macroeconomics
Answer:

13
 Why to Learn Macroeconomics?
Macroeconomists are concerned with issues important:
for economic health of every nation;
for all economic agent as the base of their decision-making;
to estimate proposals made by politicians, and which can have
great impact on national and world economy.
The state of the macroeconomy affects:
everyday life and welfare of everyone;
economic activity of every firm;
political sphere, i.e. government policy;
well-being of the whole society;
the peace and stability within the country and in the world.
It is almost impossible in today’s complex world
to be a responsible citizen without having some grasp
of economic issues and principles. 14
 The Importance of Macroeconomics
Macroeconomic theory
reveals and explores regularities of macroeconomic process and events;
aims to explain macroeconomic phenomena;
helps to understand cause-and-effect relations in aggregate economy;
serves the base for elaboration of principles, tools and measures of
macroeconomic policy that might prevent or improve economic
performance and may in the best way serve to the needs of the society;
provides the framework to make forecasts of future economic
development, to predict future economic problems.

Macroeconomics represents
a fascinating intellectual occupation that has
great practical importance.

15
 The History of Macroeconomics
The ХVIII century – beginning of the ХХ century – classical school
in economic theory.
David Hume «Of the Balance of Trade», 1752 – the analysis of the
relation between the money stock, trade balances and the price level; laid
the foundation of the quantity theory of money.
The main ideas and concepts of the classical approach were
developed in the works of Adam Smith («An Inquiry into the Nature and
Causes of the Wealth of Nations», 1776), David Ricardo («On the
Principles of Political Economy and Taxation», 1817), Jean-Baptiste
Say («Traité d’économie politique ou Simple exposé de la manière dont
se forment, se distribuent et se consomment les richesses», 1803; «Cours
complet d’économie politique pratique», 1828–1830), William Stanley
Jevons («The Theory of Political Economy», 1871), Leon Walras
(«Elements of Pure Economics», 1874), Alfred Marshall («The
Principles of Economics», 1890), John Bates Clark («The Distribution
of Wealth», 1899), Arthur Pigou («The Economics of Welfare», 1920).
 Classical Economists: the Gallery

David Hume Adam Smith Jean-Baptiste

David Ricardo Marie-Ésprit-Léon
Say Walras

William Stanley John Bates

Jevons Alfred Marshall Clark Arthur Cecil
Pigou
 Classical School: Basic Propositions

Economy consists of two separate sectors: the real sector (that

includes the goods market, the capital market (= the loanable funds
market), and the labor market) and the money sector
real variables do not depend from nominal variables = the principle
of «classical dichotomy» and «neutrality of money».
There is perfect competition in all the markets economic agents
cannot influence market prices, they are price-takers.
All the prices are flexible and are set by the relation between
supply and demand the principle of Adam Smith’s «invisible
hand» and «market clearing».
Government has no need to intervene in the regulation of the
economy the principle «laissez faire, laissez passer».

18
 Classical School: Basic Propositions

The main economic problem is the scarcity of resources,

which hence are fully used, and the economy is always at its
potential level of output.
The scarcity of resources poses puts in the forefront the problem
of production the analysis of economy’s behavior from
aggregate supply side («supply-side analysis»).
The «Say’s law» acts in the economy: «supply creates its own
demand», because each economic agent is simultaneously a seller
and a buyer.
The problem of expanding of production possibilities is resolving
slowly, the mutual market adjustment is a long-term process
the description of economy’s behavior in the long run
(«long-run analysis»).
19
 The History of Macroeconomics
But up to the ХХ century macroeconomics didn’t exist as a separate
discipline.
Three events had the fundamental importance for the development of
macroeconomics:
the beginning of the collection of economic information and
systematization of aggregate data (the period of the I World War)
that provided the empirical base for macroeconomic research:
1920-s – the elaboration of the System of National Income and
Product Accounts (NIPA) – Simon Kuznets (Nobel prize, 1971)
and Richard Stone (Nobel prize, 1984);
the substantiation of the fact that the business cycle is a recurring
phenomenon (1920-s – Wesley Clair Mitchell);
the Great Depression (1929–1933) – world economic catastrophe
(the Great Crash) that contradicted to the postulates of classical
economists about the self-correcting economy. 20
 «Keynesian Revolution»

In 1936 a prominent British economist, lord

John Maynard Keynes published a book
«General Theory of Employment, Interest and Money»,
in which he analyzed the Great Depression and
proved that the change in the macroeconomic situation
needs the new methods of analysis,
different from those used by classical economists.
He criticized the main postulates of the classical school and
gave his own explanation of the macroeconomic phenomena.
Macroeconomics became a special discipline, and
a new approach appeared in economic analysis.

21
 Keynes’ Approach: Basic Propositions
The real sector and the money sector are related to each other
money affects real variables, the interest rate is set in the
money market rather than in the capital (or the loanable
funds) market.
There is imperfect competition in the markets.
Prices (nominal variables) are rigid («sticky»).
Equilibrium in the markets is settled, but not on the
full-employment level.

22
 Keynes’ Approach: Basic Propositions
Private sector expenditures are unable to provide the level of
aggregate demand required to obtain the potential (full-
employment) level of output, and, therefore, government
intervention and government regulation are needed.
In conditions of underemployment of economic resources
aggregate demand becomes the major problem of the economy
(«demand-side analysis»).
Government stabilization policy affects economy in the short
run, and price rigidity exists during relatively not long period
the description of the economy’s behavior in the short run
(«short-run analysis»).

23
 Keynesian Economists: the Gallery

John Maynard Alban William

Keynes Arthur Okun James Tobin
Phillips
Nobel Prize,1981

George Akerlof, Ben Bernanke

Nobel Prize,2001 N.Gregory Mankiw
 The History of Macroeconomics
The central point of Keynes’ theory: the market economy does not
guarantee the economy’s stability, and, therefore, to counteract
slumps and recessions and high unemployment government
should intervene in the economic performance and conduct the
stabilization policy.
During 25 years after the II World War – the period of fast
economic growth in most countries – the belief that government
is able to prevent recessions by actively using fiscal and
monetary policy.
But in the middle of 1970-x – stagflation (the combination of high
inflation with stagnation, i.e. low and even negative rates of
economic growth and high unemployment) – the conclusion:
the key source of instability is the stabilization policy itself
«Neoclassical counterrevolution».
25
 Schools Alternative to Keynesian Approach
Monetarism (Milton Friedman, Edmund Phelps)
– the market economy is a self-correcting system and is able to return
to the potential level of output by itself;
– economic fluctuations are the result of the changes in the money
stock, therefore, to provide stability the Central bank should
maintain the constant money growth rate («monetary rule»);
New Classical Macroeconomics (Robert Lucas, Thomas Sargent,
Neil Wallace) (the rational expectations theory)
– if the economic agents’ expectations are rational, government policy
is ineffective;
Real Business Cycle Theory (Finn Kydland, Edward Prescott)
– the source of economic disturbances are technological shocks
rather than government policy.
Supply-side Economics (Arhur Laffer)
– government policy should be aimed to stimulate aggregate supply
rather than aggregate demand. 26
 Schools Alternative to Keynesian Approach:
the Gallery
Monetarism Real Business Cycle Theory

Milton Friedman, Edmund Phelps, Edward Prescott, Finn Kydland,

Nobel prize, 1976 Nobel prize, 2006 Nobel prize, 2004 Nobel prize, 2004

New Classical Macroeconomics Supply-side Economics

Robert Lucas,
Nobel prize, 1995 Thomas Sargent, Neil Wallace Arthur Laffer
Nobel prize, 2011 27
 Development of Macroeconomics
Macroeconomics as a science is permanently developing
changes concern both the sense of issues and problems under
study and of answers and remedies proposed.
These changes are the result of the impact of two groups of factors:

The appearance of new theories, The permanent

while old theories are rejected as development of the
not consistent with economic economy itself,
reality or as outdated in the light that poses new questions
of new concepts. and requires new answers.

28
 Diversity of Macroeconomic Theories

The diversity of approaches to the explanation

of macroeconomic events and especially
problems of macroeconomic policy is caused
by the fact that different groups of
macroeconomists construct their theories by
using different assumptions, may differently
interpret the same events, and therefore, come
to different theoretical and practical
conclusions and give different political
recommendations.
This diversity of ideas is due to the
complexity of macroeconomic problems and
allows to examine them comprehensively,
thoroughly, and from different points of view.
29
 Principles of Macroeconomic Analysis
Macroeconomics is the social science and the controlled experiment
is impossible. Besides, economic phenomena are very complex.
That’s why economists use models.
Economic model is a stylized representation of the economy,
a generalization and abstraction of reality that seeks to isolate
a few of the most important determinants (causes) of an economic
event in order to provide a better understanding of that event.
Economic models are constructed and used
to simplify the analysis of complex economic reality;
to examine the relationship between economic phenomena and
the regularity of their development;
to understand what goes on in the economy and how the
economy works;
to develop policies that might prevent, correct, or alleviate
economic problems and improve the situation in the economy;
to forecast future development of economic processes. 30
 Macroeconomic Models
To study the most important elements that explain how the whole
economy works, economic models are based on assumptions,
which cut off details unnecessary for the analysis of a certain
economic process or phenomenon and reduce the complexity of
economic behavior.
Once modeled, economic behavior may be presented as a relationship
between a dependent (endogenous) variable and a few independent
(exogenous) variables.
Exogenous (independent) variable Endogenous (dependent)
is the one whose value is determined variable is those whose value is
by forces outside the model. determined within the model.
The value of endogenous variable depends and is determined by
the value of exogenous variables.
Exogenous Endogenous
MODEL
31
 The Rules of Model Construction
Frequently, the endogenous variable is presented as depending
upon only one exogenous variable, with the assumption
that all the other exogenous variables are held constant.
This principle is called by the Latin term ceteris paribus,
meaning «other things being equal».
Models should be simple and focused on the examination
of the phenomenon or process under study. They do not need
to be «realistic», but should be consistent with the facts.
There must be the possibility of the transition from one model
to the other depending on the context.
There can be no one grand «true» model that exactly and
completely describes the economic reality.

32
 Types of Relationship between Variables
An economic model specifies whether the dependent and
the independent variables are positively or negatively related.

The relationship between The relationship is negative when

variables is positive when the the value of the dependent variable
dependent variable moves increases (decreases) when the
in the same direction value of the independent variable
as the independent variable. decreases (increases).

Example: positive relation Example: negative relation

of consumption spending of investment spending
from income. from the interest rate.
Models which specify economic reality provide the framework
for organizing data, empirically testing economic hypotheses,
and forecasting economic behavior. 33
 Model Presentations
Modeled behavior may be presented by a function, an equation, a table
and/or a graph. The first three are concise presentations of a relationship
and are essential for the forecasting of economic behavior. Graphs are
useful in that they provide visualization of a relationship between two variables.
For example, a relation between consumption spending (С) and the
disposable (after-tax) income (YD) may be demonstrated as:
a function an equation, which shows that С positively
that reflects a positive depends from YD , but there are other determinants
relation of С from YD : of consumption, i.e. part of consumption is
С С( Y ) autonomous from income С:
D
С С mpcYD
a table a graph
С С(YD)
YD 400 500 600 700
C 360 440 520 600 34

YD
 Types of Macroeconomic Analysis

Economic analysis is the combination of:

functional graphical intuitive

(algebraic) (visual) (substantial verbal)
analysis analysis analysis

35
 The Algebraic Analysis
For simplicity sake, in our analysis we will use the assumption
about linear relationship between variables that can be
represented by the following equations:
y = a + bx or y = a – bx
where:
y – an endogenous (dependent) variable it is a consequence;
x – an exogenous (independent) variable it is a cause or a
determinant;
a – an autonomous variable incorporates all the other variables
that affect an endogenous variable;
signs «+» or «–» characterize the type of the relationship between
an exogenous and an endogenous variable (positive or negative);
b – the sensitivity (the extent of reaction) of an endogenous variable
to the change of an exogenous variable (b y ) .
x 36
 Importance of Using Graphs

«Graphs are plotted by economists

to confuse students».
A student joke
A graph is a way of:
visual presentation of the relationship and links between
economic variables or of the behavior of a variable over time;
visual demonstration of ideas and theories, which are less clear
and even may be misinterpreted or misunderstood, when are only
verbally explained;
visual illustration of models proposed by economists.
In the course of economics graphs are used for the
better perception of theoretical propositions by students.
37
 Types of Visual Data Presentation
Pie Diagram Time Series Graph
Structure of Consumption Spending, Russia, 2018 Unemployment Rate, United States, 1890-2000

Consumption
spending on
food goods
27,9% 35,1% Consumption
37,0% spending on
nonfood goods
Consumption
spending on
services

Bar Diagram Scatter Graph

GDP Growth Rate in Selected Countries Investment Demand Curve
10,0

8,0 Interest
6,0 rate (r)
4,0

2,0

0,0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
-2,0

-4,0
I(r)
-6,0

-8,0 Luxembourg United States Japan

38
Investment Spending (I) 38
-10,0
Algebraic and Graphical Analysis: Correlation
In linear functions y = a + bx or y = a – bx
an endogenous variable y and an exogenous variable x are plotted on
the axes of the scatter graph; changes in these variables are
represented by the movement along the line;
an autonomous variable a shows a point of intersection of the line
with the axis; its changes result in the parallel shift of the line;
relationship between an exogenous and an endogenous variable is
represented by the slope (positive or negative) of the line;
the sensitivity of an endogenous variable to the change of an
exogenous variable b is measured as the tangent of the angle (b y);
its change results in the change of the slope of the line. x

39
 The Graphical Analysis

Consumption Line Investment Line

Interest rate (r)

С С mpcYD I I br
Spending (С)
Consumption

С mpc 1
b
I
Disposable Income (YD) Investment Spending (I)
 The Intuitive Analysis
In our course of macroeconomics the intuitive analysis
(intuition) will be of primary importance, because the main goal
of the economist is not simply to declare relations between
macroeconomic phenomena, but first of all and what is more –
to explain its economic sense.
Intuitive analysis assumes the study and the
explanation of the mechanism of macroeconomic
phenomena, the construction of logical chains of
the sequence of macroeconomic events, i.е. the
examination and substantiation of the effect of one
event (or the change in one variable) on the other,
which in turn leads to further changes.

41
 Positive and Normative Economics
Positive Economic Theory
is the objective or scientific
attempt to describe and explain
the behavior of the economy
and its important variables;
reflects facts and studies
actual economic performance;
is an explanation why the
economy works as it does;
is a basis for predicting how
the economy will respond to
changes in circumstances;
free from subjective value
judgments;
represents an approach of a
scientist.
Normative Economic Theory
involves subjective value judgments
about what economy must be or what
measure is to be undertaken on the
base of a particular economic concept
or theory;
makes prescriptions what should be
done in the economy;
offers recommendations for changes
in economic policy to achieve an
optimal and desirable state of affairs;
is based on personal (subjective)
value judgments;
represents an approach of a
politician. 42
 The Model of Demand and Supply

The key concepts in the market economy are the market

demand (D) and the market supply (S).
Therefore, the basic economic model is the model of
demand and supply. It describes the ubiquitous relationship
between buyers (demanders of goods and services, or
consumers) and sellers (suppliers of production, or producers)
in the market.

43
 Market Demand
The market demand for a good or service is presented as
a schedule, which relates the number of units (quantity) that
will be purchased at alternative prices, holding constant other
variables that influence the purchase decision.
Presented graphically, a demand curve shows an inverse
relationship between the price of an item and the quantity
demanded: more units are demanded at lower prices than at
higher prices. Hence, a demand curve has a negative slope.
Price (P)

Demand (D)
44
Quantity (Q)
 Change in the Quantity Demanded versus
Change in the Demand
A change in the commodity’s price results in a change in quantity
demanded and graphically is represented by a movement along an
existing demand curve.
A change in any other variable that affects the willingness to buy
a commodity other than the price of this commodity is classified as a
change in demand and graphically is represented by a shift of the
demand curve, because it implies the change in quantities demanded
at each level of the price.
Change in the Quantity Change in the Demand
Price (P)
Demanded Price (P)

P1 A A A
P1
P2 B P2 B B
D1 D2
Demand (D)
Q 1 Q2 Quantity (Q) Q 1 Q2Q 1 Q 2 Quantity (Q)
 Change in Market Demand
The key factors that can change the market demand and
result in the shifts of the demand curve are:
in microeconomics (= a market demand for a particular commodity):
a change in the number of consumers in the market;
consumer preferences;
consumer money income;
the price of a substitute commodity;
the price of a complementary commodity.
in macroeconomics (= a market demand for aggregate output):
a change in aggregate consumption spending;
a change in aggregate investment spending ;
a change in government purchases of goods and services;
a change in net exports. 46
 Market Supply
The market supply of a good or service is presented as a
schedule which relates the quantity that producers are willing
and able to supply at alternative prices.
Presented graphically, a supply curve shows a direct
relationship between the price of the item and the quantity
supplied, i.e. more units are supplied at higher prices than at
lower prices. Hence, a supply curve has a positive slope.

Price (P) Supply (S)

47
Quantity (Q)
 Change in the Quantity Supplied versus
Change in the Supply
A change in the commodity’s price results in a change in quantity
supplied and graphically is represented by a movement along an
existing supply curve.
A change in any other variable that affects the willingness to supply
a commodity other than the price of this commodity is classified as a
change in supply and graphically is represented by a shift of the supply
curve, because it implies the change in quantities supplied at each level
of the price.
Change in the Quantity
Supplied Change in the Supply
Price (P) Supply (S) Price (P) S1 S2

P2 B B
P2 B
P1 A A
P1 A

Q1 Q2 Quantity (Q) Q1 Q2 Q 1 Q 2 Quantity (Q)

 Change in Market Supply
The key factors that can change the market supply and
result in the shifts of the supply curve are:
in microeconomics (= a market supply of a particular commodity):
a change in the number and/or size of producers;
a change in technology;
a change in the price of a factor of production;
a change in the price of other commodities used in production;
the price of a complementary commodity.
in macroeconomics (= a market supply of aggregate output):
a change in the quantity of economic resources;
a change in the quality of economic resources;
a change in the level of technology;
a change in the prices of economic resources;
49
government regulation.
 Market Equilibrium
Equilibrium is the state in the market when
the quantity that consumers wish to purchase
exactly equals the quantity producers wish
to supply, and there is no pressure for change.
Geometrically it is the point of intersection
of the market demand curve (D) with the market supply curve (S).
The price and the quantity at which equilibrium exists, i.e. that equate the
quantity demanded with the quantity supplied, are known, respectively,
as the equilibrium price and the equilibrium quantity.
Price (P) Supply (S)
E Equilibrium:
Equilibrium Quantity Demanded =
price (PE)
Quantity Supplied
Demand (D)
Equilibrium Quantity (Q) 50
quantity (QE)
 How Market Equilibrium is Reached
When there is the disequilibrium, and the price is equal either to P1
that is higher than PE, or to P2 that is lower than PE, the price will start
to change in order to equate the quantity demanded by the buyers with
the quantity supplied by the producers.
Under the price P1, the quantity Under the price P2, the quantity
supplied exceeds the quantity
Demand demanded exceeds the quantity
demanded = excess supply supplied = excess demand
(= AB) the price will fall to the (= CD)Supplythe price will rise to the
equilibrium price PE equilibrium price PE
Price (P) Excess supply Supply (S)
P1
A E B The process is called
PE
market clearing
P2 C D
Excess demand Demand (D)
QE Quantity (Q) 51
 Market Clearing
Market clearing is an alignment process whereby decisions between
suppliers and demanders reach an equilibrium.
When there is the change either in the market demand,
or in the market supply, the new equilibrium in the market
will be attained via price adjustment.
Suppose a sudden increase in
Demand Suppose a sudden increase in
demand excess demand supply excess supply, on the
places a upward pressure on the contrary,Supply
places a downward
price from point A to point B pressure on the price and the new
since the original price Р1 equilibrium price will be Р2.
no longer clears the market. In both cases market clears by itself
Price (P) S Price (P) S1
P В Excess supply S2
2
P1 А P1 А
D2 P2
В
Excess demand D1 D
Q1 Q2 Quantity (Q) Q1 Q2 Quantity (Q)
 Prices: Flexible versus Sticky

Economists typically assume that the market will go into an

equilibrium of supply and demand.
But, assuming that markets clear continuously is not
realistic. For markets to clear continuously, prices would
have to adjust instantly to changes in supply and
demand, i.e. must be fully flexible.
But, evidence suggests that prices and wages often adjust
slowly and in actuality, some of them are sticky.
The difference between macroeconomic theories is
primarily based on the assumption of how quickly the
prices change and thus how quickly all the markets clear.
.

53
 Long-run and Short-run Analysis

MACROECONOMICS
Time factor is of great importance in macroeconomics.
Macroeconomists usually distinguish
the long-run and the short-run
behavior of aggregate economy.
Issues are analyzed under the assumption of
flexible prices rigid (or sticky) prices
The level of output is determined
by production possibilities by aggregate expenditures in
of the economy the economy (the willingness
(by the production function), to buy goods and services),
that is by aggregate supply that is by aggregate demand
Such level is called
potential output actual output
Its changes are associated with the
economic growth business cycle
 Long-run Growth versus Business Cycle

Aggregate
Output Economic Growth
(potential output)

Business Cycle
(actual output)

Time (years)

55
 Types of Economic Resources
The amount of output that can be produced in the economy is
determined by the quantity, quality and productivity of economic
resources, or factors of production, that are commonly separated
into four groups:
Labor: the physical and mental effort of people. This can be
increased by education, training and experience (human capital);
Physical capital: the stock of manmade equipment (like machinery,
tools, vehicles, computers) and structures (buildings, constructions,
real estate) that are used to produce goods and services;
Land or Natural resources: inputs provided by nature, such as
land, rivers, mineral deposits, oil and gas reserves. They come in
two forms: renewable and non-renewable.
Entrepreneurial ability: the ability to identify opportunities and
organize production (that is the effort and know-how to put the
other resources together in a productive venture), and the
willingness to accept risk in the pursuit of rewards. 56
 The Production Function
In the long run aggregate output is determined by the production
function, which reflects the production possibilities of the economy
and shows the quantity of goods and services that can be produced
with all available quantity and quality of economic resources and the
existing technology (that determines the productivity of resources)

Y = AF (L, K, H, N)

output technological physical human natural

knowledge labor capital capital resources

57
 The Production Possibility Frontier
A production possibility frontier shows the maximum amount of
alternative combinations of goods and services that a society can produce
at a given time when there is full utilization of economic resources and
technology. In macroeconomy (as opposed to micro) all goods are divided
into: capital (or investment) goods that are used in the production process,
and consumption goods that are consumed by individuals.
Example
Alternative Capital Goods Consumption Goods Cost of Additional Unit
Outputs (thousand unions) (million unions) of Capital Goods
A 0 8
0.5
B 1 7.5
C 2 6.5 1
D 3 5 1.5
E 4 3 2
F 5 0 3 58
 The Production Possibility Frontier:
A Review from Micro
The PPF demonstrates the problems of:
- limited productive capacity and therefore the problem of scarcity;
- increasing opportunity costs: investment goods production can be
increased only by decreasing consumption goods output, and with each
additional unit of investment goods this sacrifice grows.
The reason: imperfect substitutability
F of resources due to differences in the
5
E skills of labor and to the specialized
Investment Goods

4
D
function of most machinery and many
3 buildings. It implies that resources are
not equally efficient in the production
2
of different types of goods, i.e. they
1 B are not equally productive when used
to produce an alternative good.
1 2 3 4 5 6 7 8 The increasing opportunity costs
Consumption Goods explain the concave shape of the59PPF.
The Production Possibility Frontier & Effectiveness
The other problem demonstrated by the PPF is efficiency and inefficiency:
points on a PPF (such as B, C, D and E) are efficient because all
available resources are utilized, and there is full use of existing
technology,
points within the frontier (such as G) are inefficient because some
resources are either unemployed or underemployed in
macroeconomy it corresponds to a recession (= recessionary gap).
points outside the frontier (such as F
H) are unattainable with the 5
E

Investment Goods
existing quantity and quality of 4
economic resources and the level D
H
of technology from the micro 3
approach and in macroeconomy 2 G
in the long run, but are attainable in 1 B
macroeconomy in the short run due
to the rise in goods prices
1 2 3 4 5 6 760 8
(= inflationary gap). Consumption Goods
 Movement to and Shifts of the PPF

Investment Goods D
Movement from a recession to
PPF full employment = movement
G from the point inside the PPF
(point G) to the point on the
Consumption Goods
PPF (point D).
The long-run economic growth = increase in the production possibilities
due to the increase in the quantity and/or quality of economic resources
and/or in the level of technology = rightward shift of the PPF = movement
from a point on one PPF (point D) to a point on the higher PPF (point H).
Investment Goods

Investment Goods

Investment Goods
H H
H
PPF2 PPF2 PPF2
D D D
PPF1 PPF1 PPF1
61
Consumption Goods Consumption Goods Consumption Goods
 Time Intervals in Macroeconomics
Olivier Blanchard in his textbook distinguishes
three time periods:

Short-run Medium-run Long-run

the analysis of what the analysis of what the analysis of what
happens in the happens in the economy happens in the economy
economy during approximately during 50 years and
from year to year one decade more

According to these time intervals the accent is put

on the study of different macroeconomic problems, and
the analysis is based on different models.

62
 Lecture 1
Introduction to Macroeconomics
• The Subject Matter of Macroeconomics
• The History of Macroeconomics
• Key Macroeconomic Issues
• Principles of Macroeconomic Analysis
• Macroeconomic Agents and Macroeconomic
Markets
• The Model of Circular Flows
• The Macroeconomic System
• Key Objectives of Macroeconomic Policy
1
 Aggregation
The main principle of macroeconomic analysis is aggregation.
Aggregation means putting all the units together.

The subject matter of macroeconomics is to study

aggregate economic behavior, i.e. behavior of
aggregate (macroeconomic) agents on
aggregate (macroeconomic) markets.
There are four macroeconomic agents and
four macroeconomic markets. 2
 Macroeconomic Agents
Households
the owners of economic resources
(suppliers of factors of production);
the earners of national income;
the main consumers of goods and services
(demanders for aggregate output);
the main savers (lenders).
Firms
the main producers of goods and services
(suppliers of aggregate output);
the main demanders for economic resources;
the consumers of the part of aggregate output
(demanders for investment goods);
the main borrowers.
Households and firms form the private sector of the economy. 3
 Macroeconomic Agents
Government
the producer of public goods;
the consumer of the part of aggregate output
(purchaser of goods and services);
the redistributor of national income (through collecting taxes and
making transfer payments);
lender or borrower in the financial markets (depending on the state
of government budget);
the regulator of economic activity:
- establishes and supports institutional basis for the economic
performance (“rules of the game”);
- conducts macroeconomic policy.
Private and government sectors form
the closed economy
(or the mixed closed economy), that is
the economy not interacting with other economies.
4
 Macroeconomic Agents

Foreign sector
interacts with the national economy through two channels:

international trade capital flows

exchange of goods and exchange of assets,
services primarily financial (bonds and shares)

OIL

Economy that interacts with other economies

(with the rest of the world) is called
the open economy
5
 Macroeconomic Markets
Goods (or product) market
Resource (or factor) market

labour market loanable funds market

Financial market
which consists of two segments:

money market bonds market

Foreign exchange market
Price (P) Supply (S)
E Equilibrium:
Equilibrium Quantity Demanded =
price (PE)
Quantity Supplied
Demand (D)
Equilibrium Quantity (Q)
quantity (QE) 6
 Model of Circular Flows

In order to understand how the aggregate

economy works and to analyze the aggregate
economic behavior economists use
the model of circular flows, that represents
the interaction between macroeconomic
agents through macroeconomic markets.
We begin with the simple or private or two-sector model,
consisting of two macroeconomic agents
(households and firms)
and two macroeconomic markets
(goods market and resource market).

7
 Simple (Private Sector)
Diagram of Circular Flows

Expenditures Revenues
Goods
Goods and Market Goods and
Services Purchased Services Sold
Households Firms

Land, Labor, Capital, Inputs

Entrepreneurship Resource (Factor Services)
Market Factor Payments
Incomes
(Wages, Rents,
Flow of money Interest, Profits)
Flow of goods and services and of
economic resources
8
 Private Sector Model
of Circular Flows
Goods flow from firms to households through the goods (product)
market and economic resources flow from households to firms
through the resource (factor) market.
Firms pay factor incomes (wages, rent, interest and profits) to
households - the owners of economic resources and households spend
their incomes buying goods and services. Hence,
• aggregate income is identically equal to aggregate expenditures
(all income is spent, all expenditures translate in somebody’s income);
• aggregate expenditures are identically equal to aggregate product;
• aggregate product is identically equal to aggregate income.
Movement of income, expenditures and product form a circle.
Thus, we have circular flows.
9
 Private Sector Diagram of Circular Flows
with Financial Market

Consumption
Spending (C) Revenues
Goods
Market (Y) Investment
Spending (I)

Households Firms

Saving (S)
Financial Market
Loanable
Funds (F)
Resource
Incomes (Y) Market Factor Payments
(Wages, Rents,
Interest, Profits)

10
 The Role of Financial Markets
Being rational, households spend only part of their
income, the rest they save, because saving can bring
extra income, if money is used in the financial
markets in the form of:
a deposit in a bank, or
a purchase of a security (an equity or a bond), issued by firms.
Saving of households are used by firms to buy investment (or
capital) goods (equipment and structures), necessary to maintain and
to expand the level of output.
Spending, made by firms for the purchase of
investment goods, are called investment
spending. To obtain funds, firms take loans
from the banks or issue and sell securities to
households.
Financial markets connect saving and investment. 11
Expenditures and Income in the
Private Sector Model

Expenditures are now divided into two parts:

- consumption spending of households (C);
- investment spending of firms (I).
AE = C + I
Income is also divided into two parts:
- consumption spending (C);
- saving (S).
Y=C+S

12
 Private Sector Model of Circular Flows
with Financial Market
The equalities between aggregate expenditures (AE) and
aggregate income (Y), and between aggregate income and
aggregate product are still held:
AE Y
or
C+I C+S
thus
I S
It means that injections are equal to leakages.

Injection is something Leakage is something

that increases the flow of that withdraws from the flow
spending and leads to the of spending and can cause the
increase in output and income decrease in output and income
Investment is an injection, saving is a leakage. 13
 The Role of the Government
Adding government to our analysis, we get a three-sector model.
The influence of the government sector is executed through:

Purchases of goods Government payments Taxes (Tx)

& services (G) that involve no direct which are imposed
which include: service by the recipient: upon property and
goods purchased to transfer payments to income (direct taxes);
households (Tr) such upon goods and
run government and services (indirect
as unemployment
the military; insurance payments, taxes, such as VAT,
payments to govern- sales and excise
welfare payments
taxes)
ment employees and subsidies to firms (Sb) in order to pay for
the military for their interest payments on all the expenditures
personal services. public debt (i × BG). of the government.
14
 Diagram of Circular Flows with Government
(Mixed Closed Economy)
Revenues
Consumption Goods
Spending (C) Investment
Market (Y) Spending (I)
Government
Taxes (Tx) Purchases (G) Taxes (Tx)
Transfers (Tr)
Government Subsidies (Sb)
Households Loan to the Public Firms
Government Saving (SG)
Loanable
Financial Market Funds (F)
Saving (S)

Resource
Incomes (Y) Market Factor Payments
(Wages, Rents,
Interest, Profits)
15
 The Three-Sector Model of the Economy
Now the sum of aggregate expenditures consists of three elements:
AE = C + I + G
and aggregate income
Y = C + S + Tx – Tr
We get two injections – G and Tr and a leakage – Tx:
AE Y C+I+G C + S + Tx – Tr
I + G + Tr S + Tx or I + G S + T
where T is net taxes (T = Tx – Tr)
With the appearance of the government sector aggregate income,
earned by households, (national income Y) differs from the
income that they can use for consumption and saving
(disposable income YD):
YD = Y – Tx + Tr
YD = C + S 16
 Government Budget
Taxes represent the revenues of the government. Government purchases
of goods and services, transfers, subsidies and interest payments on
government debt are its expenditures.
The balance between the government revenues and expenditures is called
government (or public) budget.
If revenues exceed expenditures (Tx > G + Tr + Sb + i × BG), there is
budget surplus (BS).
If they are equal (Tx = G + Tr + Sb + i × BG), the budget is balanced (BB)
If expenditures exceed revenues (Tx < G + Tr + Sb + i × BG),
government runs budget deficit (BD).
To finance budget deficit government either takes a loan (borrows funds)
from financial market, issuing and selling government bonds to the
public or prints money.
If there is budget surplus, government is a saver. The excess of
government revenues over government expenditures is called
public (or government) saving (SG):
17
SG = Tx – (G + Tr + Sb + i × BG)
 National Saving
The sum of private sector saving and government sector (public)
saving is called national saving (SNAT):
SNAT = S + SG
They form the amount of loanable funds in the financial market
available to private firms to finance investment spending
in the three-sector economy investment spending is financed by
national saving.
Private sector saving (S)
Public sector saving (=BS)

18
 Diagram of Circular Flows with Government
and with Foreign Sector (open economy)
Exports (Ex)
Foreign Sector
Imports (Im) Revenues
Capital Outflow (SNAT)

Consumption
Goods
Spending (C) Investment
Market (Y) Spending (I)
Government
Taxes (Tx) Purchases (G) Taxes (Tx)
Transfers (Tr) Government Subsidies (Sb)
Households Loan to the Public Firms
Government Saving (SG)
Saving (S)
Loanable
Financial Market Funds (F)
Capital Inflow (SF)
Resource
Incomes (Y) Market Factor Payments
(Wages, Rents,
Interest, Profits) 19
 The Role of the Foreign Sector
Adding foreign sector, we get new flows.
A country exports domestic goods and services (Ex)
and imports foreign-made goods and services (Im).
Now aggregate product Y ≡ C + I + G + (Ex – Im)
This equation is known as the national accounts identity
The difference between exports and imports is called net exports (NX)
NX = Ex – Im
and represents country’s trade balance.
The country can have ▪ trade surplus (Ex > Im) or
▪ trade deficit (Im > Ex)
In the case of trade surplus the country is a saver (a lender) and there is
net capital outflow: part of national saving (SNAT) moves to the
foreign sector.
In the case of trade deficit the country is a borrower and there is
net capital inflow: foreign sector saving (SF) moves to the country’s
20
economy. S = Im – Ex
 Net Foreign Investment
Net foreign investment = the purchase of foreign assets by
domestic residents – the purchase of domestic assets by foreigners
= capital outflow – capital inflow = net capital outflow
When a domestic resident
buys and controls capital in a foreign country, it is known as
foreign direct investment;
buys stock in a foreign corporation, but has no direct control of
the company, it is known as foreign portfolio investment.
Net foreign investment (NFI) by size and sign always equals
net exports (NX):
NFI = NX or –NFI = –NX
When net exports is positive (Ex – Im > 0),
net foreign investment is positive (= net capital outflow).
When net exports is negative (Ex – Im < 0),
net foreign investment is negative as well (= net capital inflow). 21
The Four-Sector Model: Important Identities
In the open economy the expenditure-income identity is
C + I + G + (Ex – Im) C + S + (Tх – Tr)
As now we get an extra injection (Ex) and an extra leakage (Im),
then the injections-leakages identity will be
I + G + Tr + Ex S + Tх + Im
Total investment are identically equal to the sum of total saving:
I S + (Tx – G – Tr) + (Im – Ex)

Private Government Foreign Sector

Saving (Public) Saving Saving

National Saving

Aggregate Saving
This last equation is called the capital formation equation. 22
 The Four-Sector Model: Important Identities
From the injections-leakages identity we can also get
uses-of-private-saving identity:
S I + (G + Tr – Tx) + (Ex – Im)

Financing of Financing of Loan to the

Domestic Investment Budget Deficit Foreign Sector
budget deficit financing identity:
(G + Tr – Tx) S – I + (Im – Ex)

Government Private Sector Fall in Domestic Loan from the

Budget Deficit Saving Investment Foreign Sector

23
Injections and Leakages within the Circular Flow

When the level of injections = the level of leakages

(i.e. I + G + Tr + Ex = S + Tх + Im)
the circular flow is in balance
Equilibrium

If the level of injections > the level of leakages

(I + G + Tr + Ex > S + Tх + Im),
national income will rise
If the level of injections < the level of leakages
(I + G + Tr + Ex < S + Tх + Im),
Disequilibrium national income will contract

24
 Stock and Flow Variables

Macroeconomic variables can be divided into stocks and flows.

A flow is an economic magnitude A stock is an economic

measured per a given period of
time (a year, a week, an hour).
All the variables in the model of
circular flows (output, income,
consumption, saving, investment,
taxes, budget deficit, trade
surplus and others) are flows.
magnitude measured at a
particular point of time (on
January 15th, 2021).
Examples: wealth, savings,
government debt, capital
stock, money supply, number
of unemployed, etc.

Flows add to or diminish stocks.

For example, the flow of investment changes the stock of capital;
the flow of budget deficit increases the stock of government debt;
the flow of saving affects the stock of wealth. 25
Stocks and Flows

FLOW

STOCK
STOCK

26
 The Image of the Macroeconomic System

Objectives
External Instruments
Factors

P LRAS
SRAS
SRAS
AD
Y

Market Economy

27
 The Macroeconomic System
It is a market economy which
is influenced by has objectives uses instruments
external (induced variables): (policy variables):
(exogenous) factors: economic growth; fiscal policy;
natural (weather, high employment; monetary policy;
earthquakes, spots income policy;
stable prices;
on the sun, tsunami, foreign trade
eruptions, etc); balance of payments policy;
social (revolutions, equilibrium. exchange rate
wars, overturns, etc) policy.

Macroeconomic Policy

28
 Market Economy: the Key Concepts

Aggregate Demand and Aggregate Supply

LRAS
P P SRAS
Consumption SRAS Cost of Human
Spending AD Resources
Y Y* Y
Investment Cost of Capital
Aggregate Aggregate
Spending Resources
Demand Supply
Government Cost of Natural
Purchases Resources

Equilibrium Equilibrium
Net Exports Technology
Aggregate General Price
Output Level

29
 Macroeconomic Policy

Economic Growth Policy Stabilization Policy

• is aimed to stimulate economic • is aimed to smooth out business

growth in the long run and to
affect productive possibilities
of the economy;
• suggests changes primarily
in aggregate supply.
cycle in the short run and to
diminish the depth of recessions
and the height of booms;
• suggests changes primarily
in aggregate demand.

30
 Key Objectives of Macroeconomic Policy in UK

Growth of Real GDP Price Stability Falling Unemployment/

(National Output) (CPI Inflation of 2%) Raising Employment

Higher Average Living Stable Balance of A more Equitable

Standard (National Payments on the Distribution
income per capita) Current Account of Income and Wealth
31
Additional Objectives of UK Macroeconomic Policy

Balancing the Budget & Improving Economic Better Regional

Reducing National Debt Well-being Balance

Improved Access Improved Environmental

32
to Public Services Competitiveness Sustainability
 Lecture 2
National Accounts
Measuring Aggregate Output and Income
• Gross Domestic Product
• Approaches for Calculating GDP
• Other Variables of National Accounts
• Nominal and Real GDP
• Price Indexes
• Potential and Actual GDP. GDP Gaps
• GDP and Economic Well-being

1
 Major Variables of National Accounts
The main indicators of aggregate output and aggregate income
in the economy can be found in the
National Income and Product Accounts (NIPA) System,
proposed in the late 1920s by the group of U.S. economists
from NBER, headed by Simon Kuznets (Nobel prize, 1971).

The major measures of The major measures of

aggregate output are:
• Gross Domestic Product
• Gross National Product
• Net Domestic Product
• Net National Product
aggregate income are:
• National Income
• Personal Income
• Disposable Personal
Income

Nobel Prize
 Gross Domestic Product
The main measure of aggregate output is gross domestic product.

Gross Domestic Product (GDP) is the total market value of

all final goods and services produced within the country
(by domestic economy) during a one-year period.

• total measures aggregate output;

• market only official market transactions are included
(self-made goods and shadow economy are excluded);
• value measured in money (blns of pounds, dollars, rubles);
• all final goods and services transfer payments & subsidies,
and financial transactions (purchases of bonds and shares) are
excluded (because income is not created, but redistributed and
nothing new is produced);
3
 Gross Domestic Product
• final goods and services in order to avoid double
counting, intermediate goods (that form inputs for final
product such as steel in car production or flour in baking
bread) are excluded;
• produced not redistributed or resold;
• within the country i.e. in the domestic economy, no
matter by what factors of production, either owned by the
citizens of the country or by foreigners (goods and services
produced by national factors abroad are excluded);
• during a year only newly (currently) produced goods.

4
 Items Excluded from Calculating GDP

Production
Goods
Self-made of previous years
produced Transfer
production
abroad payments

Purchases
Non-market of bonds
activity and shares
Subsidies

Self-made goods

Resold Intermediate
goods goods Shadow
economy 5
 How to Calculate GDP
Production

The theoretical base for measuring GDP

is the model of circular flows, from which
we learn that aggregate output is equal:
Incomes - to the sum of expenditures; Expenditures
- to the amount of aggregate income;
- to the value of aggregate product.

6
 Methods for Calculating GDP

Thus there are three methods for calculating GDP:

Production (or Value

Added) Approach Income
Approach

Expenditure
Approach

7
 The Value Added

By definition GDP is the total value of final goods and

services. But by appearance it is often impossible to judge
if a good is final or intermediate (for example, apples
bought by a person or apples bought by a firm producing
juice).
Thus, to calculate the value of final product economists use
the concept of value added.
To learn what does value added mean and why it can be used
to measure the value of final product, let’s examine the
production process (for example, of bread).

8
 Receipts on Each Stage of Production
Receipts of farmer
from miller
$.18
Receipts of miller
from baker
$.18 $.24 = $.42
Receipts of baker = $.80
from grocer
$.18 $.24 $.38
Total
Receipts of grocer consumer
from consumer
$.18 $.24 $.38 $.20 = $1.00
expenditure
Value added (= income created) at each stage of production
$.18 Value added by farmer

$.24 Value added by miller

$.38 Value added by baker

$.20 Value added by grocer

9
Total value added =Total income created =Total consumer expenditure
 The Value Added Approach

Thus, the value added of a particular firm can be calculated as:

Firm’s value added = Revenue – Value of intermediate goods
purchased from the other firms
while the total value added in the economy as a whole is:
Total value added = Value of total output (total sales) –
– Value of total intermediate product
As the value of final goods is always equal to the sum of values
added on all stages of production process, GDP can be measured
as the sum of values, added by all the firms in the economy or in
all the branches or large sectors of the economy (such as industry,
agriculture, construction, etc).
GDP = values added
10
 Distribution of US GDP
(Value Added by Industry), 2019
• Agriculture, forestry, fishing, and hunting 0.8%
• Mining 1.4%
• Utilities 1.6%
• Construction 4.1%
• Manufacturing 11%
• Wholesale trade 6%
• Retail trade 5.5%
• Transportation and warehousing 3.2%
• Information 5.2%
• Finance, insurance, real estate, rental, and leasing 20.9%
• Professional and business services 12.9%
• Educational services, health care, and social assistance 8.8%
• Arts, entertainment, recreation, accommodation, and food services 4.2%
• Other services, except government 2.1%
• Government 12.3% 11
Source: U.S. Bureau of Economic Analysis
 Russian GDP Structure
(Gross Value Added by Industry), 2019
• Сельское, лесное хозяйство (3,6%)
• Добыча полезных ископаемых (13,2%)
• Обрабатывающие производства (14,3%)
• Обеспечение электроэнергией (2,7%)
• Строительство (5,7%)
• Торговля оптовая и розничная (13,9%)
• Водоснабжение и утилизация отходов (0,5%)
• Транспортировка и хранение (6,5%)
• Деятельность гостиниц и общепита (0,9%) Source: Goscomstat
• Деятельность в области информации и связи (2,5%)
• Деятельность финансовая и страховая (4,3%)
• Операции с недвижимым имуществом (9,4)%
• Деятельность профессиональная, научная и техническая (4,2%)
• Деятельность административная (2,3%)
• Государственное управление и соцобеспечение (7,4%)
• Образование (3,1%)
• Деятельность в области здравоохранения (3,3%)
• Деятельность в области культуры и спорта (1%)
• Предоставление прочих видов услуг (0,6%) 12
• Деятельность домашних хозяйств как работодателей (0,6%)
 The Circular Flow of Income
and Expenditure

Exports (Ex)
Investment
Spending (I)
Government
Purchases (G)

Factor Consumption Financial Government Foreign

Spending (C) Market Sector Sector
Payments

Saving (S)
Net Taxes (T) Imports (Im)

13
 The Expenditure Approach

The expenditure approach sums up spending of

all macroeconomic agents:
• households – consumption spending C ;
• firms – investment spending I ;
• the government – government purchases of goods
and services G ;
• the foreign sector – net exports NX :

GDP = C + I + G + (Ex – Im)

NX

14
 Consumption Spending
Consumption spending include expenditures made by households for:
• current consumption – purchases of non-durable goods
(food, clothes, shoes, etc);

• consumption of durable goods (furniture, cars, TV-sets,

refrigerators, etc.) (except houses);

• payments for services (hair-cuts, medical care, entertainments,

tourism, etc.).
 Investment Spending
Investment spending represent expenditures
made by private business firms and households
to buy capital goods. It is the sum of expenditures for:
• purchases of new equipment and machinery ;
• new nonresidential construction (buildings, offices,
hotels, factories, other commercial real estate);
• new residential construction (houses, cottages, flats);
• inventory investment.
Purchase of securities (bonds and shares) is not considered as
investment spending, because represents redistribution, not
creation of output).

16
 Inventory Investment
Three first components of investment spending form domestic private
fixed investment.
Inventory investment (Iinv) represent the annual net changes in the
stock of inventories.
Inventories, held by firms, include:
• raw materials; Inventory investment =
• parts (or semi-finished goods); = Production – Sales
• unsold finished goods.
If the changes in inventories are positive I GDP .
If the changes in inventories are negative I GDP .
Example
Beginning End
of the year of the year
$100 $120 Iinv = + $20 increase in GDP by $20
$100 $70 Iinv = – $30 decrease in GDP by $30
 Composition of Investment Spending

Purchases of
new durable equipment

New non-residential Fixed private

construction domestic
investment
New residential
construction

Private domestic
Inventory investment
investment
18
 Gross and Net Investment

Fixed investment spending are divided into:

• gross investment (Igross);
• replacement investment (= depreciation = capital
consumption allowances A): during production process
capital wears out and must be replaced or repaired;
• net investment (Inet).
Igross = A + Inet
Net investment is the base for increase in stock of physical
capital and thus in the productive possibilities of the economy.

19
 The Role of Net Investment

6
Gross Investment

4 2
Replacement Investment Net Investment

Change in Capital Stock = + 2 20

 Government Purchases
Government purchases are the government sector’s spending
on goods and services. They include expenditures on:
• goods purchased to run government and the military (including
purchase of investment goods for public enterprise and infrastructure
and in order to produce public goods);
• payments to government employees (civil servants, teachers,
firemen) and the military for their personal services;
and exclude transfer payments (welfare social benefits) and subsidies,
since they result from redistribution of previously received funds).
Government purchases can be divided into:
• government consumption – the purchase of consumer goods and
payments to government employees;
• government investment – the purchase of investment goods.

21
 Imputed Value
It is a national accounting rule to calculate GDP by adding the
market prices of all final goods and services, produced within
the economy…
but there are some final goods and services, that are parts of total
output, but are not sold and bought in the market.
The value of items that have no market value and are not traded
in the market, but must be included in total output and income
is called the imputed value.
Examples:
some government services that enter GDP at their costs;
rental payments that are paid by house owners to themselves.

22
 Net Exports

All the countries in our days are open economies, i.e. economies
transacting with other countries (with the rest of the world).
One of the major links between economies is international
trade. Countries sell (export) domestically produced goods and
services to the foreign countries and buy (import) goods and
services produced abroad.
The value of domestic production that is sold to other countries is
called gross exports (Ex).
The value of foreign production that is purchased by the domestic
economy is the country’s gross imports (Im).
The balance between gross exports and gross imports is called
net exports (NX).
23
 The Diagram of Net Exports
Payments for Domestic Goods and Services (Ex)

Domestic Goods and Services

Domestic Economy Foreign Economy

Foreign Goods and Services

Payments for Foreign Goods and Services (Im)

Flows of Money
Flows of Goods and Services
24
 How Imported Goods Are Registered
Goods and services produced abroad are bought by all domestic
macroeconomic agents (households, firms and government), thus
they are parts of correspondingly consumption spending C,
investment spending I and government purchases of goods and
services G). Hence:
C = CD + CF; I = ID + IF and G = GD + GF.
Because gross domestic product includes the value of only
domestically produced goods and services, then in order to
calculate GDP, we must subtract the value of all imported goods
and services, and add the value of all domestically produced
production bought by foreigners:
GDP = (CD + CF ) + (ID + IF) + (GD + GF) + Ex – Im

Im
Therefore, imported production is excluded from the value of GDP,
but in national accounts is registered twice. 25
 The Expenditure Approach

Structure of US GDP, 2019

68.1% 17.4% 17.5% –3.0%
Structure of UK GDP, 2019
65.8% 16.1% 18.8% –0.7%
Net
Consumption Spending Investment Government Exports
(C) Spending (I) Spending (G) (NX)

51.2% 22.8% 18.4% 7.7%

Structure of Russian GDP, 2019

Sources: U.S. Bureau of Economic Analysis, OECD Economic Outlook, Goscomstat

26
 The Income Approach
The income approach makes use of the fact that expenditures on
GDP ultimately become income.
Thus, GDP represents the total sum of factor incomes, earned by the
owners of economic resources, i.e. households. It consists of:
• wages and salaries, earned by workers of private firms;
• rental payments, earned by land and estate owners (including
imputed rental payments for housing services, enjoyed by house
owners);
• interest payments, earned by capital owners;
• profits, earned by entrepreneurs and firms’ owners.
The sum of income earned by the factors of production owned by a
country's citizens is called National Income (NI) or National
Income at factor costs:
NI = Wages + Rents + Interest + Profits 27
 Interest Payments

According to U.S. national accounts

interest payments is called «net interest».
Net interest = interest paid by firms – interest received by
firms + interest received from the rest of the world –
– interest paid to the rest of the world

%%
28
 The Types of Profits
In accordance with the existing forms of business organization,
national accounts distinguish two types of profits:
proprietors’ income, i.e. profits of firms, possessed by one
owner (single proprietorship) or several joint owners (partnership),
who themselves manage the firm make all the decisions and are
personally responsible for all of the firm’s actions and debts;
corporate profits, i.e. profits of firms in which ownership and
financial responsibility are divided, limited, and shared among any
number of shareholders. Such type of firms is called corporations.
One part of corporate profits is paid to government in the form of
corporate taxes, and the rest sum is divided into two parts:
distributed profits – the part which is distributed to shareholders as
dividends;
undistributed profits – the part not distributed to shareholders and
29
retained by the firm (also called retained earnings).
 The Structure of Profits

Profits

Proprietors’ Corporate
Income Profits

Corporate Distributed Profits Undistributed Profits

Profit Taxes (dividends) (retained earnings)

30
 The Structure of Factor Payments
The dominant factor of production is labor. The share of labor
income in National Income in industrialized countries occupies
more than 2/3 of all factor payments (≈ 70% in the U.S.). Most
of the remainder goes to pay capital. Only a small amount goes
for other factors of production or true profits.

Payments to Capital
and Other Factors

Payments to Labor
 From National Income to GDP

National Income must be modified slightly to arrive at GDP.

We must add components that are necessary for calculating
aggregate output, but not included in National Income as they
do not become income for suppliers of productive resources:
• depreciation (= capital consumption allowances), because
these expenses capture the value of output needed to replace or
repair worn out buildings and machinery;
• indirect taxes (sales taxes, value-added taxes, customs duties,
license fees, and so on), because they are part of the expenditure
on goods and services and are included in prices;
• factor income of foreigners received for the use of their
economic resources in the country, whose GDP is calculated.
32
 From National Income to GDP

At the same time we must subtract from NI elements that are

not part of GDP:
• subsidy payments made by the government to firms
(farmers, for example) that are part of the farmers' income
but are not made in exchange for goods or services;
• factor income of the citizens of the country
abroad, because NI includes the income of all citizens
everywhere whereas GDP includes the value of goods
produced domestically by anyone.

33
 Net Factor Income from Abroad

Factor income includes:

labor income (= compensation of employees);
property and entrepreneurial income (= investment income
from the ownership of financial assets, i.e. interest on short-
and long-term capital, dividends, rent, etc.)

Net Factor Income of the citizens Income of

Income from = of the country – foreigners received
Abroad abroad within the country

34
 The Income Approach: A Summary

In summary,

GDP = NI + Depreciation + Indirect taxes – Subsidies –

– Net factor income from abroad

All the approaches for calculating GDP

(expenditure, income and value added)
must give the same result.

35
 GDP Across the Countries, 2019 (IMF)
Rank Country $ bln Rank Country by PPP,$ bln
1 United States 21 345 1 China 27 331
2 China 14 217 2 United States 21 345
3 Japan 5 176 3 India 11 468
4 Germany 3 964 4 Japan 5 750
5 United Kingdom 2 972 5 Germany 4 467
6 France 2 829 6 Russia 3 358
7 India 2 762 7 Indonesia 3 743
8 Italy 2 026 8 Brazil 3 496
9 Brazil 1 960 9 United Kingdom 3 128
10 South Korea 1 739 10 France 3 055
11 Canada 1 657 11 Mexica 2 658
12 Russia 1 610 12 Italy 2 442
13 Spain 1 429 13 Turkey 2 274
14 Australia 1 417 14 South Korea 2 230
15 Mexica 1 241 15 Spain 1 938
16 Indonesia 1 022 16 Saudi Arabia 1 862
17 Netherland 915 17 Canada 1 838 36
 Gross National Product

Gross National Product (GNP)

is the total market value of all final goods and services
produced within a year by factors of production
owned by the citizens of that country.

It doesn't matter where the output is actually produced:

in the domestic economy or abroad.

37
 GNP versus GDP

Italian worker
works in Germany
He adds to:
Gross Domestic Product of Germany
Gross National Product of Italy
Thus,
GNP = GDP + Net factor income from abroad

Hence, GNP may be greater or smaller than GDP, depending on

whether the citizens of the country earn more or less abroad than
foreigners earn in this country.
38
 GNP versus GDP
When the British receive more income from other countries than
foreigners receive in the United Kingdom, British GNP will be
somewhat larger than GDP in that year. If the British receive less income
from other countries than foreigners receive in the United Kingdom, on
the other hand, British GNP will be somewhat smaller than GDP.

39
 Net Domestic and Net National Product

Net Domestic Product (NDP) = GDP – Depreciation

Net National Product (NNP) = GNP – Depreciation
or
Net National Product = National Income + Net Indirect Taxes
that is why NNP is often called national income at market prices.
NNP characterizes productive potential of the economy
for the next year because it is free from depreciation and
includes only net investment.

40
 National Income

National Income = NNP – Net Indirect Taxes =

= NNP – Indirect taxes + Subsidies
National Income (NI) (or national income at factor costs) is
the money income earned by households for the factor
services. It is the sum of factor payments, made to
households by private firms.

NI = Wages + Rents + Interest + Profits

41
 Personal Income
Personal income (PI) is the money income received by households
before personal income taxes are subtracted.
PI = NI – Contributions for social insurance –
– Corporate profits + Personal dividend income +
+ Government and business transfers – Net interest +
+ Personal interest income
(Not all national income is distributed to persons. Some of the corporate
profits are retained by firms. Similarly, not all interest payments paid by
firms go to persons: some go to banks, some go abroad.)

42
 Disposable Income

Disposable income (DI) is the money income which is

at the disposal of households and which they can use as they
like. It is an after-tax personal income.
DI = PI – Personal income taxes
Disposable income is used by households for consumption
spending (C) and saving (S):
DI = C + S
Part of the disposable income that is not spent for consumption
is called personal (or household) saving:
S = DI – C
 National Income Accounting: A Summary
Net Factor Net Factor
Income from Income from
Depreciation
Abroad Abroad

NX
Net Indirect
G Taxes
Rental
GNP Income
I Profits
at market GDP National
NNP Interest
prices at market Income = Income
at market NNP
prices prices at factor Wages
C costs and
Salaries

44
 GDP as an Indicator of the
True Level of National Output
Being the major measure of aggregate output, GDP can’t serve
the exact indicator of the actual level of production in the
economy.
Official GDP statistics do not provide a complete accounting
of economic activity, because do not include the value of:
underground or illegal economic activities;
household work and production;
bartered goods.

45
 GDP as the Indicator of the
Welfare and the Well-being
GDP and GNP can’t serve the exact indicators of societal well-being.
An increase in these measures might reflect an increase in the
standard of living, but GDP and GNP:
also increase with expenditures on natural disasters, deadly
epidemics, war, crime, and other detriments to society;
do not include non-market activity and self-made production;
do not reflect the impact of externalities, either
positive («goods») or negative («bads»), such as
deterioration of environment, changes in leisure
time, the level of medical care and education,
the length of life, the crime situation, noise, etc;
do not capture the change in product quality.
46
 Lecture 2 (continued)
National Accounts
Measuring Aggregate Output and Income
• Gross Domestic Product
• Approaches for Calculating GDP
• Other Variables of National Accounts
• Nominal and Real GDP
• Price Indexes
• Potential and Actual GDP. GDP Gaps
• GDP and Economic Well-being
 Nominal GDP versus Real GDP

Nominal GDP is GDP measured at current prices.

The size of nominal GDP is influenced by two factors:
changes in the size of physical volume of production;
changes in prices (level of inflation).
In order to measure the true change in output economists use
real GDP (measured in terms of goods).
Real GDP is GDP measured at constant prices.
Real GDP is nominal GDP corrected for inflation.
Nom inal GDP
Real GDP = P rice Level
 Example

Imagine, that the economy producers only bananas.

Quantity Price Nominal GDP Real GDP

(in tons) (in dollars) (in current prices) (in prices of the
Q P base 2019 year)
Year
100 150 150 × 100=15000 150 × 100= 15000
2019
Year
2020 80 200 200 × 80 = 16000 150 × 80 = 12000

In 2020 the real GDP decreased

while the nominal GDP increased due to the increase in prices.
 Nominal GDP versus Real GDP
If economy produces a great number of goods
(n goods, for example), then the value of
Nominal GDP = current year prices × current year quantities
n
Pi t Qit
i 1
the value of
Real GDP = base year prices × current year quantities =
n
Pi 0Qit
i 1

where Pi t and Pi 0 are the prices for good i correspondingly in the

current (t) year and in the base (0) year;
Qit and Qi0 are the quantities of good i produced correspondingly
in the current (t) year and in the base (0) year.
 Nominal and Real GDP in Russia, 1995-2019
bln.rubles
110000
100000
90000
80000
70000
60000
50000
40000
30000
20000
10000
0

Nominal GDP Real GDP (in 2008 year prices) 5

Source: Goscomstat
 Price Indexes

The measures of general price level are:

Consumer Price Index – CPI
Producer Price Index – PPI
GDP Deflator

Price indices are used to measure inflation and the cost of living,
they adjust nominal values for inflation in order to find real values.
 The Consumer Price Index
• is based on the prices of items in a fixed representative «market
basket» of hundreds of final goods and services used by typical
urban consumers in a base year, i.e. measures the average price
of consumption;
• is the government's gauge of inflation used to make comparisons
across the countries;
• is considered to be the best measure of the cost of living;
• is used, for example, to adjust tax brackets and social security
payments and wages for inflation (i.e. indexation);
• is calculated as Laspeyres index, that is fixed basket (base year)
quantities index:
Current year prices Base year quantities
CPI = 100
Base year prices Base year quantities
n
Pi t Qi0
i 1
n
100
Pi0Qi0
i 1
 The Producer Price Index
is based on the prices of items in a fixed «market basket» of
hundreds of intermediate (or wholesale) goods (such as lumber and
steel) used by producers during a production process in a base year;
is calculated as Laspeyres index, that is fixed basket (base year)
quantities index, so the PPI is similar in calculation to the CPI;
differs from CPI, because:
- includes raw materials and semi-finished goods;
- is designed to measure prices at an early stage of
a distribution system;
- is constructed from prices at the level of the first
(not final) significant commercial transaction;
is sometimes a good predictor of future inflation (since producers
often pass their cost increases on to consumers).
 The GDP Deflator

The Gross Domestic Product Deflator is an alternative general price

index that reflects the importance of products
in current market baskets (current year quantities),
rather than in base year market baskets (base year quantities),
which become less relevant over time.

Current year prices current year quantities

GDP Deflator = 100
Base year prices current year quantities

n
Pi t Qit
i 1
n
100
0 t
Pi Q i
i 1

GDP deflator is calculated as Paasche index.

From Nominal GDP to Real GDP

In order to convert any year's nominal GDP

(or any other nominal figure)
into real GDP
(or any other corresponding real figure),
one must use the formula
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷
𝑹𝒆𝒂𝒍 𝑮𝑫𝑷 =
𝑮𝑫𝑷 𝑫𝒆𝒇𝒍𝒂𝒕𝒐𝒓
 CPI versus GDP Deflator
The Consumer The GDP
Price Index Deflator
Only Consumer All the Final Goods
Type of Goods
Goods Included in GDP
Imported Goods Includes Excludes
Market Basket Fixed Changing
(Quantities) (of the base year) (of the current year)
Price Index Laspeyres Paasche
Changes in Price Level Overestimates Underestimates
Substitution Effect Doesn’t reflect Reflects
Quality Improvements Excludes Includes
Price Changes in New
Excludes Includes
Products
 How to Measure Inflation
Inflation is a sustained increase in the overall price level.
An increase in the price of one good or several goods is not
necessarily inflation. There must be an increase in the
general price level (P) between two years: the current year
(t) and the previous year (t – 1).
The key measure is the rate of inflation (π):
Pt Pt 1 Pt
The rate of inflation ( ) = 100% ( 1) 100%
Pt 1 Pt 1
The most frequently used measures of price level
are the CPI and the GDP deflator.
CPI t CPI t 1
100%
CPI t 1
GDP deflatort GDP deflatort 1
100%
GDP deflatort 1
 Nominal GDP, Real GDP and Inflation
The GDP deflator implies a simple relation between nominal GDP
(YN) and real GDP (YR) for each year (year t):
Nominal GDPt Yt N
GDP Deflatort or Pt
Real GDPt Yt R

Nominal GDP in year t = Price Level in year t × Real GDP in year t

YNt = Pt × YRt
If inflation is low (< 10%), the relationship between
nominal GDP, real GDP, and the inflation rate (π) is:
Changes in Nominal GDP (in %) = Changes in Real
GDP (in %) + Changes in the Overall Price Level (in %)
ΔYNt (in %) = ΔYRt (in %) + πt
Example. Suppose during a year nominal GDP increased by 7%, while
the rate of inflation by the end of the year appeared to be 4%.
It means that the growth of real GDP was only 3% (7% – 4% = 3%).
 Actual versus Potential Real GDP

To measure changes in quantities, that is the physical

amount of output, only real GDP can be used,
since it uses constant price.
But annual (short-run) output can deviate from output that can be
produced if all the economic resources are fully employed
(long-run output).
The first one is called actual real GDP and is used to measure the
changes in real from year-to-year output (= business cycle
fluctuations).
The second one is called potential (or natural) real GDP and is
used to estimate the changes in productive possibilities of the
economy (= the trend of economic growth).
 Actual versus Potential Real GDP
Actual Real GDP (Y)
• Short run period.
• Measures changes in the
annual (year-to-year) output.
• Is a characteristic of the
business cycle.
• The level is determined by
the desire of economic
agents to buy produced
goods and services, i.e.
by aggregate demand.
Real
GDP
Peak
Trough
Potential Real GDP (Y*)
• Long run period.
• Measures changes in the production
possibilities.
• Is a characteristic of the long-run
economic growth.
• The level is determined by the
quantity, quality and productivity of
economic resources and the existing
technology, i.e. by aggregate supply
(that is by the production function).
Peak TREND
Y* (potential GDP)
Y (actual GDP)
Trough
Time (years)
 Actual and Potential Real GDP in US, 1960-2019
$ bln
20000
18000
16000
14000
12000
10000
8000
6000
4000
2000
0

Actual Real GDP Potential Real GDP

Source: US Bureau of Economic Analysis
 The Business Cycle

The business cycle is the fluctuations in the economic activity,

the periodic rise and fall in real output.
In general, there are two phases of the business cycle and two
extreme points.
Expansion – a period where real GDP is growing.
Peak – the top of the cycle where an expansion has run its course
and is about to turn down.
Contraction (or recession) – a period where real GDP is falling.
A prolonged and deep recession is called a depression.
Trough – the bottom of the cycle where a contraction has
stopped and is about to turn up.
 US Business Cycle, 1930-2019
%
18

14

10

-2

-6

-10

-14

Source: US Bureau of Economic Analysis

 The GDP Gap
The deviation of actual real GDP (Y) from its potential level (Y*) is
known as the GDP (or output) gap.
GDP gap = Actual GDP – Potential GDP = Y – Y*
The GDP gap may be:
negative, when actual real GDP is below its potential level;
it is the period of recession; this type of gap is called
the recessionary GDP gap;
positive, when actual real GDP exceeds its potential level;
it is the period of expansion (or boom); this type of gap is called
the inflationary GDP gap the economy in this case is named
an overheated economy.
 Recessionary versus Inflationary GDP Gap

Recessionary GDP gap Inflationary GDP gap

Level of output Y < Y* Y > Y*
Level of Underemployment Overemployment
employment (less than full) (higher than full)
Major problem Unemployment Inflation
Situation Crisis (slump) Boom (overheating)
Behavior of Key Variables During the Business Cycle
Recession Expansion
Real GDP (real output)
Incomes
Investment Spending
Inventories of Unsold Production
Firms’ Profits
Unemployment Rate
Price Level (according to the cause) or or
Tax Revenues
Transfers
Imports
Exports Independent from the phase
Variables that
change in the same direction as GDP are called procyclical
move in the opposite direction are named countercyclical
change irrespective of the business cycle – acyclical
 The Rate of Growth
The rate of growth (g) is an important macroeconomic variable that
is used to measure the annual percentage changes in the level of
economy’s output, i.e. in actual real GDP (Y) in a given year (year
2 or more generally year t) relative to the previous year (year 1 or
more generally year t – 1), that allows to estimate if economic
activity is declining or expanding.
Real GDP of year2 Real GDP of year1
g 100%
Real GDP of year1
or more generally
Yt Yt 1
g 100%
Yt 1

Periods of positive GDP growth (g > 0) imply expansions.

Periods of negative GDP growth (g < 0) imply recessions.
 Growth Rates of Real GDP Across the Countries,
2007-2019 (%)
Country 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Russia 8,5 5,2 -7,8 4,5 5,3 3,7 1,8 0,7 -2,8 -0,2 1,5 2,3 1,3
Germany 3,4 1,1 -5,6 4,1 3,7 0,5 0,5 1,9 1,7 1,9 2,2 1,3 0,6
Italy 1,5 -1,1 -5,5 1,7 0,6 -2,8 -1,7 0,1 1,0 0,9 1,5 0,8 0,3
Canada 2,1 1 -2,9 3,1 3,1 1,7 2,5 2,6 0,9 1,5 2,1 2,0 1,7
Great
Britain 2,6 -0,5 -4,2 1,7 1,5 1,5 2,1 3,1 2,3 1,9 1,8 1,3 1,5
United
States 1,8 -0,3 -2,8 2,5 1,6 2,2 1,7 2,6 2,9 1,5 2,3 3,0 1,7
France 2,4 0,2 -2,9 2 2,1 0,2 0,6 0,9 1,1 1,2 1,8 1,8 1,5
Japan 1,7 -1,1 -5,4 4,2 -0,1 1,5 2,0 0,4 1,4 0,9 1,7 0,3 0,7
China 14,2 9,7 9,4 10,6 9,5 7,9 7,8 7,3 6,9 6,7 6,9 6,7 6,1
Singapore 9,1 1,8 -0,6 15,2 6,4 4,1 5,1 3,9 2,2 2,4 3,6 3,4 0,7
Zimbabwe -3,4 -17,7 12,0 12,6 15,4 14,8 5,5 2,1 1,7 0,6 3,4 3,5 -6,5
Venezuela 8,8 5,3 -3,2 -1,5 4,2 5,6 1,3 -3,9 -6,2 -16,5 -16,6 -19,6 -35,0
Sources:. International Monetary Fund, World Bank, Goscomstat
 2
7

-13
-8
-3

-18
12 %
-14,5
-8,7
-12,6
-4,1
-3,6

Source: Goscomstat
1,4
-5,3
6,4
10
5,1
4,7
7,3
7,2
6,4
8,2
8,5
5,2
-7,8
4,5
4,3
3,4
1,3
0,7
-2,8
-0,2
1,5
Real GDP Growth Rates in Russia, 1992-2019

2,3
1,3
 How to Measure the Standard of Living
The best measure for the productive potential of the economy is
real GDP.
But it is not the exact variable to estimate the living standard and
the well-being of each citizen, because the population growth
rate may be higher than that of real GDP.
So the best measure for the standard of living is thought to be
real GDP per capita.
Real GDP
Real GDP per Capita
Size of Population
But real GDP per capita is not the ideal measure of personal
economic well-being, because it doesn’t include the changes:
in the distribution of income;
in the amount of household production;
in leisure time enjoyed by the typical person;
in the impact of externalities;
in product quality, etc.
GDP per Capita Worldwide (PPP Int.$), 2020 (IMF)
1 Luxembourg 112 875 30 Japan 41 637
2 Singapore 95 603 36 Lithuania 38 605
3 Qatar 91897 50 Greece 29 045
4 Ireland 89 383 51 Turkey 28 294
5 Switzerland 68 340 53 Russia 27 394
6 Norway 64 856 56 Kazakhstan 26 589
7 United States 63 051 76 China 17 206
8 Brunei 61 816 86 Brazil 14 563
9 United Arab Emirates 58 466 96 Ukraine 12 710
10 Hong Kong 58 165 110 Vietnam 10 755
11 Denmark 57 781 128 India 6 284
12 Netherland 57 101 140 Bangladesh 5 139
16 Taiwan 54 020 143 Kenia 4 993
17 Germany 53 571 167 Zimbabwe 2 583
18 Sweden 52 477 176 Afghanistan 2 073
19 Australia 50 845 185 Mozambique 1 279
25 France 45 454 188 Congo, Dem. Republic 978
26 South Korea 44 292 189 Central African Republic 972
27 United Kingdom 44 288 191 Burundi 783
 Human Development Index, 2019 (UN)
Life Expected

Rank
HDI Mean Years GNI per Capita
Country Expectancy at Years of
Values of Schooling (PPP $)
Birth (years) Schooling
Norway 1 0.954 82.3 18.1 12.6 68 059
Switzerland 2 0.946 83.6 16.2 13.4 59 375
Ireland 3 0.942 82.1 18.8 12.5 55 660
Germany 4 0.939 81.2 17.1 14.1 46 946
Hong Kong 4 0.939 84.7 16.5 12.0 60 221
Australia 6 0.938 83.3 22.1 12.7 44 097
Iceland 6 0.938 82.9 19.2 12.5 47 566
Sweden 8 0.937 82.7 18.8 12.4 47 955
Singapore 9 0.935 83.5 16.3 11.5 83 793
Netherlands 10 0.933 82.1 18.0 12.2 50 013
United Kingdom 15 0.920 81.2 17.4 13.0 39 507
United States 15 0.920 78.9 16.3 13.4 56 140
Japan 19 0.915 84.5 15.2 12.8 40 799
France 26 0.891 82.5 15.5 11.4 40 511
Estonia 30 0.882 78.6 16.1 13.0 30 379
Portugal 40 0.850 81.9 16.3 9.2 27 935
Russia 49 0.824 72.4 15.5 12.0 25 036
Brazil 79 0.762 75.7 15.4 7.8 14 068
China 85 0.758 76.7 13.9 7.9 16 127
Zimbabwe 150 0.563 61.2 10.5 8.3 2 661
Burundi 185 0.423 61.2 11.3 3.1 660
Central African Rep. 188 0.381 52.8 7.6 4.3 777
Niger 189 0.377 62.0 6.5 2.0 912
 Happiness Index Across the Countries, 2020
1 Finland 17 Germany 78 Hong Kong
2 Denmark 18 United States 82 Malaysia
3 Switzerland 19 Czechia 83 Vietnam
4 Iceland 20 Belgium 93 Turkey
5 Norway 21 United Arab Emirates 94 China
6 Netherland 23 France 100 Algeria
7 Sweden 25 Taiwan 105 Albania
8 New Zealand 30 Italy 109 South African Rep.
9 Austria 31 Singapore 115 Nigeria
10 Luxembourg 45 Cyprus 123 Ukraine
11 Canada 50 Kazakhstan 144 India
12 Australia 61 South Korea 148 Tanzania
13 United Kingdom 62 Japan 150 Ruanda
14 Israel 73 Russia 151 Zimbabwe
15 Costa Rica 75 Belarus 152 South Sudan
16 Ireland 77 Greece 153 Afghanistan
Source: United Nations Organization
 Lecture 3
The Goods Market Equilibrium
in the Private Closed Economy

• The Components of Aggregate Demand

• Consumption Function
• Investment Demand
• Equilibrium Output
• The Multiplier
• The «Paradox of Thrift»
• The Expenditure and Output Gaps
 Equilibrium Condition in the Goods Market
Quantity of goods demanded (AD) = Quantity of goods supplied (AS)
In the long run output In the short run output
is determined by the quantity is determined by the willingness of
and quality of economic resources all the consumers (households,
(labor L, physical capital K, human firms, government and foreigners)
capital H, natural resources N) and to buy goods and services
the level of technology A, that is produced by the domestic firms,
by the production function
Y* = AF (L, K, H, N), that is by aggregate demand, and
and is always at its potential may deviate from its potential level
(full-employment) level Y* (Y ≠ Y*)
Long-run Equilibrium Short-run Equilibrium
P P
LRAS

E
E SRAS
AD AD
Y* Y Y Y
Determination of Equilibrium Output in the Short run

Thus the problem is:

How can we find the short-run equilibrium output (Y)?

The answer:
We need to analyse the goods market, where aggregate output is
determined, and to examine components of aggregate demand
 Components of Aggregate Demand
Aggregate demand (AD) is the sum of demands
(= desired or planned expenditures)
of all macroeconomic agents for goods and services:
consumption demand of households (C);
investment demand of firms (I);
government sector demand (G);
foreign sector demand (NX).
AD = C + I + G + NX

Planned Consumption Planned Government

Expenditures Purchases
Planned
of Households
Planned Investment Net Exports
Expenditures of Firms
 Production, Income, and Demand for Goods

Year-to-year movements in economic activity can be represented as

the interaction between production, income and demand.
Changes in the demand for goods and services
lead to changes in production
Changes in production lead to changes in income
Changes in income lead to changes in the demand for goods.

Production Income

Demand
 Demand-Side Analysis

The first economist, who tried to analyze

the behavior of the economy in the short
run and to show how actual (short run)
equilibrium output can be determined, was

John Maynard Keynes

In his book «General Theory of Employment, Interest and Money»
(1936) he examined the causes and the results of the
Great Depression (1929-1933) and made an attempt to elaborate
the receipts how to prevent such economic catastrophes in future,
and primarily how to fight high unemployment.
He developed a theory that was called
Keynesian (or demand-side) approach in macroeconomics.
 Assumptions of Keynes’ Theory

Output is below its full-employment level (Y < Y*);

Goods prices are rigid (P = const), hence changes in aggregate
demand have no effect upon the price level;
Aggregate supply is absolutely elastic (AS curve is horizontal),
that implies firms can produce as many goods and services as
they know the buyers will want to buy (under the condition of
high unemployment, firms have no problem to hire additional
workers and to increase output);
Money (nominal) wages are rigid (sticky) (W = const); when
unemployment is high, workers cannot claim the increase in
wages, thus the costs of inputs do not change;
 Assumptions of Keynes’ Theory

Interest rate is rigid, and nominal interest rate coincides with

real interest rate (r = i = const);
National output = national income (it means that depreciation
and indirect taxes are not concerned);
Taxes are only direct and are paid only by households;
Economy is closed (NX = 0), but the methodology of analysis
allows to apply it to the conditions of the open economy.
Aggregate Demand and Aggregate Supply
in the Keynes’ Model

P AD1 AD2
Increase in AD leads only to
the increase in output (from
P A AS Y1 to Y2), while price level
B
stays unchanged (P ).

Y1 Y2 Y

In the closed economy aggregate demand:

AD = C + I + G
 Consumption Demand and its Determinants
Consumption spending constitute the largest part (approximately 2/3)
of aggregate expenditures. The determinants of consumption spending are:
national income (Y ) – income,
earned by households;
income taxes (Tx); disposable income (YD)
transfers (Tr);
consumers expectations (consumer confidence), such as:
- price expectations – Pe;
- income expectations – Ye;
- job loss (unemployment) expectations – Ue;
- quantity of goods expectations (abundance or lack) – Qe;
consumer indebtedness (D);
interest rate (r);
borrowing conditions ( ); Thus, consumption function looks as:
wealth (W);
C f (Y , Tx , Tr , P e , Y e , U e , Q e , D , r , , W, P )
price level (P ).
 The Consumption Function
In the short run the major determinant of the level of consumption
spending is the disposable income YD – the income that remains once
consumers have paid taxes and received government transfer payments
YD = Y – Tx + Tr = Y – T
However, other (non-income) variables, though less important, also
effect consumer spending in the short run.
The part of consumption spending that depends on the disposable
income is called induced consumption. The rest part that depends on
non-income factors is called autonomous consumption (parameter C )
The function C(YD) is called the consumption function. It represents
a behavioral equation, because it captures the behavior of consumers.
Thus, the consumption function is
C C mpc YD

Autonomous Induced
Consumption Consumption
 The Marginal Propensity to Consume
Consumption spending increases with the rise in the disposable income,
but less than one for one – the tendency that J.M.Keynes named
«the main psychological law».
The behavioral parameter, that shows the dependence
of consumption spending from the disposable income,
J.M.Keynes named the marginal propensity to consume (mpc).
The marginal propensity to consume depicts the change
in consumption spending due to the change in the disposable income:
C
mpc 0 < mpc < 1
C YD
C C mpc YD

Induced
Consumption
C Autonomous
Consumption
YD
Movement Along the Consumption Line
Changes in the disposable income YD
lead to changes in the level of consumption C and
correspond to the movement along the consumption line:
up with the increase in the disposable income
(for example, from point A to point B), and
down with the decrease in the disposable income

C
C C mpc YD
B
C2
A
C1

C mpc

YD1 YD2 YD
 The Slope of the Consumption Line
The slope of the consumption line is determined
by the marginal propensity to consume.
The greater is the value of the mpc, the steeper is the consumption line.
–
– C C mpc2×YD
C C C mpc ×Y C
1 D

C'
C
mpc1 YD mpc2 YD
C C

YD YD
 The Shifts of the Consumption Line
The changes in any determinant of the autonomous consumption
cause the parallel shifts of the consumption line
upward (if it increases) and downward (if it decreases).
The key factor of autonomous consumption spending
J.M.Keynes considered the consumer confidence.

C C2 C2 mpc×YD
C1 C1 mpc×YD

C2
C1 mpc

YD
Saving Function and Marginal Propensity to Save
Households spend on the purchase of consumption goods
only part of their disposable income, the rest part they save:
YD = C + S
Thus, saving in the Keynes’ model also depends
on the disposable income.
The behavioral parameter, that shows the dependence of saving
from the disposable income, Keynes named
the marginal propensity to save (mps).
The marginal propensity to save depicts the change in saving
due to the change in the disposable income:
S
mps
YD 0 < mps < 1
The sum of the marginal propensity to consume and
of the marginal propensity to save equals to 1.
C S C S YD
mpc mps 1
YD YD YD YD
 The Saving Function
The saving function may be derived in the following way:
S YD C YD ( C mpc YD ) C (1 mpc ) YD
Since (1 – mpc) = mps,
we get: S C mps YD

Autonomous Induced
saving saving
S S C mps YD

Saving
S>0
0
S<0 YD
Dissaving S=0
mps
C
sale of assets or
borrowing money
 Movement Along the Saving Line
Changes in the disposable income YD lead
to changes in the level of saving S, and
correspond to the movement along the saving line:
up with the increase in the disposable income
(for example, from point A to point B), and
down with the increase in the disposable income.

S
B S C mps YD
S2
S1 A
0
mps YD1 YD2 YD
C

18
 The Slope and the Shifts of the Saving Line
The slope of the saving line is The shifts of the saving line are
determined by the value of the caused by the changes in the
marginal propensity to save. autonomous consumption.
The greater is mps, If the autonomous consumption
decreases, it corresponds to the
the steeper is the saving line increase in the autonomous saving
( mps2 > mps1 ) ( С2 C1 ), the saving line shifts up

S S
S2 C mps2 YD
S C mps1 YD S2 C2 mps×YD
S1 C1 mps×YD
0 0
YD C2 YD
mps2
mps1
C C1
 Consumption and Saving Lines
C C mpc YD
C, S

C mpc
S C mps YD
0 YD
C mps
C = YD
C, S Saving
In point A: S>0 C C mpc YD
A
C = YD C
C S<0 S=0
Dissaving 450
𝑌𝐶=𝑌𝐷 YD
 The Average Propensity to Consume and
the Average Propensity to Save
The average propensity to consume is the relation of consumption
spending to income (the share of consumption spending in income):
C
apc
YD
The average propensity to save is the relation of saving to income
(the share of saving in income):
S
aps
YD
The sum of the average propensity to consume and
of the average propensity to save equals to 1.
C S C S YD
apc aps 1
YD YD YD YD
 Changes in the Average Propensity to Consume
and in the Average Propensity to Save
The Keynes’ theory of consumption implies that the increase in the
disposable income leads to the decrease in the average propensity
to consume and to the increase in the average propensity to save.
The proof:

С (C mpc YD ) C YD C
apc mpc mpc
YD YD YD YD YD
C
because mpc = const, then when YD increases, falls,
thus apc decreases, while aps rises. YD

The conclusion: the richer becomes the person, i.e. the higher is his/her
income, the smaller is the portion of income, which he/she spends,
and the larger is the portion of income, which he/she saves.
 Average and Marginal Average and Marginal
Propensity to Consume Propensity to Save

C C C mpc YD S S C mps YD

aps1 aps2
mpc YD1 YD2 YD
С С mps
apc2
apc1
YD1 YD2 YD
mpc,
apc mps,
YD2 > YD1 apc2 < apc1 aps YD2 > YD1 aps2 > aps1

mps
aps2
apc1 aps1 aps
apc2 аpc
mpc
YD1 YD2 YD
23
YD1 YD2 YD
 The Consumption Puzzle
The idea of the fall in apc with the rise in income means, that while
economy grows and becomes richer, consumption spending (the largest
part of aggregate demand) should fall, causing recession in the economy.
Thus, using Keynes’ consumption function, economists predicted a
secular stagnation (a long depression of infinite duration) in the U.S.
economy in the early 1940-s. The forecast didn’t prove to be true and
seemed to deny the Keynes’ conjecture about the behavior of apc.
At the same time Simon Kuznets (a future Nobel Prize winner), while
analyzing the U.S. consumption statistics for more than 70 years (from
1869 to 1940), discovered that the ratio of consumption to income was
almost constant over time, despite large increases in income.
These two circumstances imply a puzzle,
known as «consumption puzzle» or «Kuznets’ puzzle».
Why do cross-section (short-run) studies of household spending
support Keynes’ hypothesis, but his conjectures
fail in the time-series (long-run) consumption analysis?
 The Consumption Puzzle: the Clue
The solution of the puzzle is that there are two consumption functions:
the short-run consumption function
(the relationship of consumption and C
CLR
disposable income is nonproportional):
C SR C mpc YD CSR
• the long-run consumption function
(the relationship of consumption and mpc
C
disposable income is proportional):
apc
C LR apc YD 0 YD
The puzzle was solved in the consumption theories developed by
Franco Modigliani (life-cycle hypothesis) and by
Milton Friedman (permanent income hypothesis).
Both theories explain consumption by relating consumption
spending to expected rather than current income.
 Investment Demand and its Determinants
The second component of aggregate demand is the
investment demand of firms. Investment spending
is the most volatile part of aggregate spending.
Determinants of investment spending are:
interest rate (r), because firms usually use loanable funds to buy
investment goods;
expectations (E), i.e. business confidence;
income (Y), part of which (profits) firms can use for investment
spending;
taxes (Tx);
subsidies (Sb);
technological advances (A);
The investment function may be written:
existing stock of capital (K0);
I f ( r , E , Y , Tx , Sb, А, K 0, Pk )
price of the unit of capital (Pk).
 Decision to Invest
The major determinant of investment demand is the interest rate.
The decision of a firm to spend money on new machinery or construction
is simply a decision based upon marginal benefits and marginal costs.
The marginal benefit of an investment is the expected real
internal rate of return (IRR) the firm anticipates receiving on its expenditure:
Annual Earnings from Project
IRR
Total Cost of Project
The marginal cost of the investment is the real rate of interest (r),
or the cost of borrowing (the price for loanable funds).
The higher is r, the lower is the desire of business to take loans and to
buy investment goods.
Thus, the common rule is:
if IRR r, the firm will make investment spending and buy
investment goods;
if IRR < r, the firm will not make investment spending.
 Investment Demand
Example. Suppose, an airline company makes a decision about the
number of airplanes that is reasonable to buy, if the price for each
airplane equals $40 mln, but the profit is different.

Number of the Project Profit Internal Rate of Return

First plane $8 mln. [8/40] × 100% = 20%
Second plane $6 mln. [6/40] × 100% = 15%
Third plane $4 mln. [4/40] × 100% = 10%
Fourth plane $2 mln. [2/40] × 100% = 5%

If the market interest rate r = 15%, the company would buy only two
planes (N = 2), if r = 10% it would buy three planes (N = 3) and so on.
It means the rational firm invests in all projects up to the point where
the real rate of interest equals the expected rate of return (r = IRR).
 Investment Demand
Very few investment projects are available at extremely high rates of
return and so those opportunities are taken first. As the internal rate of
return (IRR) falls, those very profitable opportunities are gone, but
many less profitable investments remain, i.e. when the expected IRR
falls, the cumulative amount of investment spending rises. Likewise,
when the cost of borrowing falls (to r'), more and more projects
become worth, hence total investment spending rises (from I1 to I2).
And vice-versa, with the
IRR, r rise of the interest rate IRR, r
(to r"), fewer investment
20% projects will have the IRR IRR
higher or at least equal to
15% C
this high interest rate and r"
10% A
thus would be not financed r r
B
5% total amount of r'
investment spending
1 2 3 4 N would fall (to I3). I3 I1 I2 I
 Interest Rate and Investment Demand
The alternative way to prove the inverse relation of the investment
demand from the interest rate is to use discounting. For example, if an
investor expects the annual earnings from the project equal to
Х dollars and the market interest rate (rate of discounting) equals to r,
then the present value of this project, computed for Т years is:
X X X X X
PV ...
1 r (1 r ) 2 (1 r )3 (1 r )4 (1 r )T
The investor will finance this project (make
investment spending), only if the sum of money r
invested now is not higher than the discounted to
present total sum of future earnings from the
project (I ≤ PV). Otherwise, it is more reasonable
to put this sum of money in the bank.
Since the relation of investment spending to the I(r)
interest rate is negative, the investment demand
curve has a negative slope. I
 Investment Function and its Properties
The investment function is:
I I br

autonomous interest sensitivity of interest rate

investment I (in percentage points)
investment demand(b )
r
Changes in I Changes in b Changes in r
cause parallel shifts of result in the change provoke movement
the investment line of the slope of the line along investment line
r r r

r1 A′ A r1
A A′ r1 A
r2 B′ B r2
B B′ r2 B
1 1
b b
I1 I2 I I′1 I1I′2 I2 I I I1 I2 I
 Investment Demand in the Keynes’ Model
Keynes believed that the key factor of In his model of the goods
investment decisions was business market equilibrium Keynes
confidence, which he called the supposed that investment
«animal spirit» of the investor, that is spending do not depend on
pessimism or optimism in his income and hence is
appraisal of the future situation in the autonomous:
economy and hence are not very I I
sensitive to the interest rate. It means It means that in the (I – Y)
that in the (I – r) space the investment space the investment demand
demand curve is very steep. curve is horizontal.
r I
r1 A

r2 B I I(Y)
I(r)
I1 I2 I Y
 Aggregate Demand in the Private Economy
Aggregate demand in a simple two-sector model is a sum
of the consumption demand of households (C) and
of the investment demand of firms (I):
AD = C + I
Thus, the addition of the investment demand can be graphically
represented as the parallel upward shift of the consumption
demand line.
C, I
С I
C

C I
C mpc

Y
Aggregate Expenditures in the Private Economy

The sum of aggregate expenditures (AE) in the simple economy:

AE = C + I
But it is important to distinguish:

Actual expenditures (AE) Planned expenditures (AEP)

in fact made by households
and firms;
that are always identically equal
to aggregate output/income:
AE Y
that households and firms
wished to do;
may differ from the size
of aggregate output/income:
either AEP = Y or AEP Y

The difference between AEP and AE equals to

unintended inventory investment
(unintended changes in inventories of unsold production)
 Keynesian Cross
Because actual expenditures are always equal to aggregate output
(AE Y), the graph is the 45-degree line starting at the origin.
Planned expenditure line has a slope equal to mpc, since
induced consumption spending is the only component of
aggregate expenditures, that changes with real income.
The model is often called the Keynesian Cross model.
AE=Y
AE
AEP

C I mpc Equilibrium point: Y = AEP

Autonomous Output (AS) = Aggregate Demand (AD)
Spending 450
0
YE Y
 Reaching the Goods Market Equilibrium
in the Private Economy
There is only one level of output where actual and planned expenditures
are equal (point A): Y = AEP: all output produced by firms will be sold
unintended inventory investment IUN = 0
If economy is in point B, output exceeds aggregate planned
expenditures (Y > AEP), firms will not be able to sell all their production
AE AE=Y (= excess supply of goods) and
D there will be an unintended
AE1=Y1 Iun > 0 increase in inventory
AEP
AEP1 investment (Iun > 0), equal to
B
A BD, and firms will decrease
AE=YE
output (from Y1 to YE).
Iun= 0

450
YE Y1 Y
 Reaching the Goods Market Equilibrium
in the Private Economy
If economy is in point C, output is too low (Y < AEP) to satisfy
aggregate demand, i.e. there is excess demand for goods: firms will start
to sell their production of previous years, held in stocks, and inventories
will unintentionally decrease (Iun < 0), equal to CF, and firms will
increase output (from Y2 to YE).
AE AE=Y
D
AE1=Y1 Iun > 0
AEP In both cases economy
AEP1
B will by itself return
A
AE=YE to the equilibrium
AEP2 C
(to point A).
Iun= 0
Iun< 0
AE2=Y2 F
450
Y2 YE Y1 Y
 The Mechanism of Adjustment
AE AE=Y The equilibrium condition in the
goods market: aggregate output
Y>AEP AEP is equal to aggregate demand
B
A Y = AEP
C The mechanism of adjustment
Y<AEP
(movement to the equilibrium in the
goods market) in the short run is the
change in inventories of unsold
Y2 YE Y1 Y
production (= inventory investment),
Iun i.e. the change in quantities
Iun (amount of aggregate expenditures),
B
not in the price level as in the long run.
0 Iun> 0 When inventories rise (Iun > 0),
Iun< 0 A Y firms decrease output (from Y1 to YE),
C while when inventories fall (Iun < 0),
firms increase output (from Y2 to YE).
Goods Market Equilibrium in the Private Economy:
Alternative Approach
In a simple two-sector economy without government and foreign sectors,
all income is either spent on consumption or saved:
Y=C+S
while planned aggregate expenditure are equal planned consumption spending
plus planned investment spending:
AEP = C + IP
Thus, to obtain Y = AEP, it must be that S = IP.
If the amount of saving is greater than planned investment
(S > IP), aggregate planned expenditures fall short of real output
(AEP < Y), and excess supply appears firms accumulate
inventories of unsold goods they did not intend to hold (Iun > 0), and
decrease output.
If the amount of saving is smaller than planned investment (S < IP),
aggregate planned expenditures exceed real output (AEP > Y) = excess
demand, and firms end up with lower inventories than they had
planned (I < 0), that stimulates higher output.
 Reaching Goods Market Equilibrium
in the Private Economy: Alternative Approach
The equilibrium condition in the goods market
according to this approach is:
S = IP
If saving (leakages) equals planned investment (injections),
real output equals planned aggregate expenditures (point A).
If they are not equal (points B and C), the unintended
inventory change will bring economy to the equilibrium.
I, S S Increase
B in inventories
S1 (Iun> 0)
F A S > IP
I IP
D
Decrease S2 S < IP C
in inventories
(Iun< 0) Y2 YE Y1 Y
S = IP
(Iun= 0)
 Equilibrium and Disequilibrium in the
Keynesian Cross Model

Equilibrium Case of Case of

Conditions Excess Demand Excess Supply
AS = AD AS < AD AS > AD
Y = AEP Y < AEP Y > AEP
S = IP S < IP S > IP
Leakages = Injections Leakages < Injections Leakages > Injections

41
 The Multiplier Effect

Keynes showed that the increase in spending leads to the increase

in output/income, but much more greater than the initial change
in spending. This effect was called the multiplier effect.

Change in Output
Multiplier
Change in Spending

It is based on the fact that all the expenditures become somebody’s income
which in turn is partly spent, insuring income to the next agent, who
in his turn spends the part of it for consumption, etc.
The larger is the part of income which goes for consumption spending
and the smaller the part, that is saved, the larger is the multiplier effect.
 The Multiplier Process
Imagine a firm buys additional equipment for $1000, and pays the
sum to its producer, who spends a part for consumption, etc.
We get a kind of pyramid, where the total income is much more
greater than $1000.
Y1 I = $1000
Suppose mpс = 0,8
Y2 С S
800 200
The multiplier process
Y3 С S will last until it reaches zero
640 160

Y4 С S
512 128 Mechanism of investment multiplier:
I Y1 С1 Y2 С2 Y3 …
Y5 С S
409.6 102.4
Y = Y 1 + Y2 + Y3 + Y 4 + Y5 + … =
= 1000 + 800 + 640 + 512 + 409.6 + …
 The Value of the Spending Multiplier
The change in total income is the sum of changes in income of all
the economic agents involved in the process:
Y = Y1 + Y2 + Y3 + Y4 + Y5 + ...
I I mpc ( I mpc ) mpc
( I mpc 2 ) mpc ( I mpc 3 ) mpc ...
I (1 mpc mpc 2 mpc 3 mpc 4 ...)
1
Y I
1 mpc
1
where 1 mpc is an autonomous spending multiplier (multĀ), that
shows the change in total income/output, caused by the change in
autonomous investment spending.
In our case, the autonomous spending multiplier is 1/(1 – 0.8) = 5.
It means that the increase in investment spending by $1000 ends in the
increase in total income/output by $5000:
ΔY = ΔI × [1/(1‒ mpc)] = $1000 × 5 = $5000.
 The Multiplier on the Graph
AE AE=Y
N AE P C I2
J
H AE P C I1
F I
D G
E
В AB = BC; CD = DE; EF = FG; …..
С

C I2 Y = BC + DE + FG + …..
I
А The multiplier is the sum
C I1 of successive increases in
450 1000 800 640 512
production resulting from
Y1 Y Y2 Y an increase in demand.
In our example mpc = 0.8 = 4/5 The multiplier arises
it means that of 5000 increase in output
because of the dual role
1000 was generated by the rise in
investment spending and 4000 (that is 4/5) of Y in the model –
by the increase in consumption spending. as production and income.
 The Multiplier Effect under Different
Marginal Propensities to Consume
AE=Y
AE AE=Y AE B AEP2
AEP1
AEP2 A
B
AEP1 –
– A I
I
mpc1 mpc2

450 450
Y Y Y' Y
mpc2 > mpc1 Y' > Y
The greater is the marginal propensity to consume,
i.e. the higher is the portion of income spent on consumption
(graphically it corresponds to the steeper AEP curve),
the larger is the multiplier effect of the change
46
in autonomous spending on the change in output.
 Deriving the Spending Multiplier
To derive the multiplier algebraically we need to equate the sum of
aggregate planned expenditures to total income (output):
Y = AEP
Y = C + IP
and to replace C by the consumption function: C C mpc YD .
Since in the simple model with no government (hence no taxes and
transfers) the disposable income equals to the national income (YD = Y),
Y C mpc Y I
Y mpc Y C I
1
Y (С I )
1 mpc
It means that any change in any kind of autonomous spending Ā
(either consumption or investment in this simple model)
leads to a multiplied change in total income/output.
 Deriving the Spending Multiplier:
Alternative Approach
Alternative condition of the goods market equilibrium is the equity
of saving to planned investment:
S = IP
Since the saving function is: S C mps YD and with the absence
of government sector (and thus of taxes and transfers) the disposable
income equals to the national income (YD = Y), we get the same
formula for the spending multiplier and for the equilibrium output:
C mps Y I
mps Y C I
1 1
Y (С I) (C I)
mps 1 mpc
 The Paradox of Thrift
The «paradox of thrift» is the economic phenomena, which can occur
only in the short-run period and only in the case,
when the increase in saving does not transform to the increase in
investment spending, that is possible only if saving and investment are
determined by different factors (saving – by the disposable income,
while investment spending – by business confidence).

The paradox: when people begin to save more (become more

thrifty), the level of saving remains unchanged the increase
in saving does not result in the rise of the level of saving.

The explanation. The rise in saving means the increase in leakages

from the flow of spending (from aggregate demand) that results in
the decrease of the equilibrium level of output, which in turn leads
to the fall in the disposable income and consequently in saving,
hence the level of saving doesn’t change.
 The Paradox of Thrift on the Graph
The saving function consists of two parts:
𝑺 = −𝑪 + 𝒎𝒑𝒔 × 𝒀𝑫

Autonomous Induced
Saving Saving
The increase in saving can occur if there is:
a rise in autonomous saving a rise in the marginal propensity
(= the fall in autonomous to save (= the fall in mpc)
consumption) S(mps2)
I,S C
S( 2 ) I,S
A
S( C1 ) S(mps1)
I B B A
I I I

Y2 Y1 Y Y2 Y1 Y
C2
mps2
S ( C ) mps ( YD ) mps1 S C mps ( YD )
C1 S const C S const
 The Paradox of Thrift: the Intuition
In both cases the increase in saving (from S1 to S2) causes
the decrease in output (from Y1 to Y2) and thus in saving,
hence the level of saving remained unchanged
(it is the same in points A and B)
and equals to the level of planned investment (S1 = S2 = IP).
The equilibrium condition of the goods market holds:
▪ saving equals to planned investment, hence
▪ aggregate output (aggregate supply) equals aggregate planned
expenditures (aggregate demand): Y = AEP, and
▪ leakages are equal to injections.
 Expenditure and Output Gaps:
A Recessionary Gap
The short-run equilibrium in the goods market may not
(and usually doesn’t) coincide with the level of full-employment
(potential) output: YSR ≠ YLR. Keynes analyzed the situation (Great
Depression), when actual equilibrium output was essentially lower
than potential (i.e. observed the recessionary output gap: YSR < Y*).
He concluded that it was a result of the insufficient aggregate demand
(or the recessionary expenditure gap).
The way to overcome the
AE AE=Y recessionary output gap and
B AEP2 to approach economy to the
AEP1 full-employment output Y*
A
is to increase aggregate
А2 autonomous expenditures
А1 (from А1 to А2 ).
recessionary expenditure gap
YSR Y* Y recessionary output gap
 Expenditure and Output Gaps:
An Inflationary Gap
The opposite situation may be observed in our days, when the
equilibrium actual output may be higher than potential
(YSR >Y*). It is the case of inflation, i.e. of the inflationary output
gap, that may be the result of the excess aggregate demand
(inflationary expenditure gap).
To cure this type of gap in order
AE=Y to approach economy to the full-
AE
AEP1 employment output Y*, according
A to the logic of the Keynesian
AEP2
analysis, a decrease in aggregate
B expenditures (from А1 to А2 )
А1
is usually proclaimed.
А2
inflationary expenditure gap
Y* YSR Y inflationary output gap
 Expenditure and Output Gaps:
the Relationship
Under the assumptions of the Keynesian model this relation is:
Output gap ( Y) = Expenditure gap × Spending multiplier =

1
= A
1 mpc

That is why, by opinion of J.M.Keynes and his followers,

the best way to cure the recession and to reach the full-employment
level of output is to increase aggregate expenditures;
in the case, when consumer confidence and business confidence are
low, the government should intervene in the economic performance
and influence the level of aggregate demand.
 Lecture 4
The Goods Market Equilibrium
in the Closed Mixed Economy and
in the Open Economy
• The Government Sector and Aggregate Demand
• The Effect of Government Purchases
• The Effect of the Lump-Sum Taxes
• The Effect of Transfer Payments
• The Balanced Budget Multiplier
• The Effect of the Proportional Income Tax
• The Foreign Sector and Aggregate Demand
• The Aggregate Demand Curve
 The Government Sector and its Impact
on Aggregate Demand
Adding government sector to our analysis, we
get a mixed closed (or three-sector) economy.
The influence of the government sector on
aggregate demand and therefore the situation in
the goods market is possible through the changes in:
• government purchases of goods and services (a direct effect on
aggregate demand);
• taxes (imposed on households and firms, and thus having an indirect
effect on aggregate demand via the change in consumption and
investment demands);
• transfer payments and subsidies (that also have an indirect effect on
aggregate demand through the impact on consumption and
investment demands);
• money supply (that influences the interest rates and thus the
investment and consumption demands);
• issue of government bonds (that affects the demand for loanable
funds and the interest rate, and hence has an impact on primarily the
investment demand).
Government in the Planned Aggregate
Circular Flows Expenditure
(AEР = C + IР + G)

Aggregate
Output (Y) Financial
Markets

Households
Firms
Government
 The Role of Government Purchases
The government purchases is assumed to be autonomous, because it is
a political variable:
G G
Now (in the three-sector model) the sum of aggregate planned
expenditures (aggregate demand) is:
AD C I G
while the sum of injections is:
I G
and capital formation equation that in the three-sector model reflects
the equity of domestic investment to the amount of national saving
SNAT (the sum of private saving S and government saving SG) with
the absence of taxes is:
I S G
 The Effect of AE AE=Y
Government Purchases B С IP G
С IP
on the Graphs
The appearance of government A
purchases in the model can be C I G G
graphically represented as the mpc
C I
parallel shifts: 450
of the aggregate planned Injections, Y1 Y2 Y
expenditure line AEP and of Leakages S
the injections line upward; B
I G IP+G
A
of the aggregate saving line I G IP
SAGG downward 0 mps Y
C Y2 Y
by the amount of government 1

purchases G. S
I,SAGG
The result is the increase in S G
A B
output (from Y1 to Y2) due to I IP
the increase in aggregate 0 mps Y
C G 1 Y2 Y
demand (aggregate spending).
C G 5
 The Multiplier Effect of Government Purchases
The addition of government spending to the sum of private expenditures
leads to an increase in output (from Y1 to Y2) with the multiplier effect.
Since government purchases are autonomous, the value of the government
spending multiplier is the same as the value of the multiplier for any
type of autonomous spending: multG mult A
To derive the government spending multiplier, we need to use the
equation for the equilibrium condition in the goods market: Y = AEP
Y = C + IP + G
Y C mpc Y I G
Y mpc Y C I G
1
Y (С I G )
1 1 mpc
where is the government spending multiplier multḠ. It shows that,
1 mpc
if we add government purchases G, output will rise by: Y 1
G
1 mpc
6
 The Government Spending Multiplier
The government spending multiplier (multG ) shows, that the change
in demand for output will be larger than the initial amount of
government purchases.
The reason: With an insertion of government purchases (G ) in our
model, aggregate planned expenditures (that is aggregate
demand) and thus income increase by G . The increase in income
raises consumption by mpc G . The rise in consumption raises
aggregate planned expenditures and income again. The second
round increase in income by mpc G again raises consumption,
this time by mpc (mpc G ), which again raises income and so
on. As a result, the overall increase in income ( Y) will be much
more greater, than G .
¯
Appearance of G
AEP Y C AEP Y C AEP Y 7...
 The Role of Lump-Sum Taxes
Under the assumptions of the Keynesian model taxes are imposed only
on households, hence introduction of taxes (Tx) leads to the change
in the disposable income and hence in the consumption function:
C C mpc (Y Tх )
and to the increase in the sum of leakages: Leakages S Tх
Capital formation equation changes for: I S (Tх G )

government saving
Let’s suppose taxes do not depend on income, i.e. taxes are
autonomous. Autonomous taxes are called lump-sum taxes (Tх T х).
The appearance of taxes in the economy causes the decrease of the
disposable income, that lowers consumption and thus aggregate
planned expenditures (that is aggregate demand), that in turn results
in the fall of aggregate income (output).
¯
8
Appearance of Tx YD C AEP Y
 The Lump-Sum Tax Multiplier
Taxes also influence equilibrium output with a multiplier effect.
Let us include lump-sum taxes into the equation for aggregate
planned expenditures and thus into the equation for the
equilibrium condition in the goods market:
Y = AEP
Y = C + IP + G
Y C mpc (Y T х ) I G
Y mpc Y C mpc T х I G
1
Y (С mpc T х I G )
1 mpc
mpc
The lump-sum tax multiplier is: multT x
1 mpc
That is: when lump-sum taxes T х appear in the economy, output falls by:
mpc
Y Tх
1 mpc 9
The Effect of Lump-Sum AE AE=Y AEP1
A AEP2
Taxes on the Graphs
The insertion of lump-sum taxes B
in our model may be graphically A1 C mpc T x
represented as the parallel shifts:
A2 mpc
of the aggregate planned
expenditure line downward 450
by mpc T х, i.e. by the amount Y Y Y
2 1
of the change in consumption Injections,
Leakages
S Tx
spending ΔС; S
of the leakages line and of B A
I G IP+G
the aggregate saving line
both upward by mpc T х. 0
C mpc T x mpc
mps
Tx Y
2 Y1 Y
The result is the fall in output C
(from Y1 to Y2) because of the I,SAGG S (T x G )
decrease in consumption spen-
ding due to the reduction of B A S–G
I IP
the disposable income, caused
0
by the appearance of taxes C G mpc T x mpc T x Y2 Y1 Y
mps
C G 10
 The Government Budget
The government budget is the balance between government
revenues (primarily net taxes T, that are the difference between
lump-sum taxes and government transfer payments: T = Tx – Tr)
and government spending (purchases of goods and services G):
if T > G, government runs the budget surplus (BS);
if T < G, government runs the budget deficit (BD);
if T = G, government has the balanced budget (BB).
Government
G,T Revenues (T)
Budget
T>G Surplus
T<G Government
Budget Spending (G)
Deficit Balanced Budget
(T = G)
11
 The Balanced Budget Multiplier
If government wants to finance government spending by
taxation in order to keep the balanced budget, then taxes must
be equal to government spending (G T х).
In this case the effect on output (Y) will be the combined one
and will be equal to the sum of multiplier effects of
government purchases G and taxes T х :
1 mpc
Y YG YT х G Tх
1 mpc 1 mpc
Because G T х :
1 mpc
Y G ( ) G 1 G
1 mpc 1 mpc
Thus, the balanced budget multiplier (multBB ) equals to 1.
The change in Y is exactly equal to the amount of G (and T х ).
12
 The Role of Transfer Payments
Transfer payments is also a political variable, hence are considered
autonomous Tr T r
They increase the sum of injections Injections I G T r
or, viewed as a part of net taxes (T=Tx –Tr), decrease the size of leakages
Leakages S (T x T r )
Being type of government expenditures, transfer payments decrease the
amount of government saving to
SG T x (G Tr)
and capital formation equation becomes:
I S (T x G Tr)
Since transfer payments increase the disposable
income to YD = Y – Tx + Tr, the consumption
function now is: C C mpc (Y T x T r ) 13
 The Effect of Transfer Payments
Transfer payments may be viewed as anti-lump-sum-taxes.
They also affect output with a multiplier effect and by the same
size as lump sum taxes, but in the opposite direction.
The appearance of transfer payments leads to the rise in personal and
hence, all things being equal, in the disposable income, that causes
the increase in consumption spending and therefore in aggregate
demand and thus in aggregate output.
¯
Appearance of Tr YD C AEP Y

mpc
The transfer payments multiplier is: multT r
1 mpc
It implies, that when we insert transfer payments in our analysis,
the increase in aggregate income/output will be:
mpc
Y Tr
1 mpc 14
 The Role of the Proportional Income Tax
Besides lump-sum taxes that are autonomous, there are proportional
income taxes in the economy. Tax revenues from the proportional
income tax depend on income:
Tx t Y

a tax rate (0 < t < 1).

The tax function now is mixed: Tx Tx t Y

lump-sum proportional
taxes income taxes

the sum of leakages: Leakages S (T x t Y )

and capital formation equation is:
I S [(T x t Y ) (G T r )] 15
 The Spending Multiplier
with the Proportional Income Tax
To derive the spending multiplier we again need to use the equation
for the equilibrium condition in the goods market, taking into account
that the equation for the consumption function under the mixed tax
system is:
C C mpc (Y T x t Y T r )
We get:
Y = AEP
Y = C + IP + G
Y C mpc (Y T x t Y T r ) I G
Y mpc t Y mpc Y C mpc T x mpc T r I G
1
Y (С mpc Tx mpc Tr I G)
1 mpc (1 t )

mult A 16
 The Spending Multiplier
with the Proportional Income Tax
The value of the spending multiplier in the presence of the
proportional income tax is smaller than in its absence:
1 1
1 mpc (1 t ) 1 mpc

It is so, because we get an extra leakage, and consumers have to

pay a part of their income in the form of a tax, that reduces
disposable income and in turn consumption spending. In the
absence of the proportional income tax consumers spend for the
purchase of consumption goods part of their income, equal to
mpc, while in the presence of the income tax they can spend for
consumption only part of income, equal to mpc×(1– t), that
weakens the multiplier effect of the increase in spending.
17
 The Effect of the AE AE=YAE (t =0)
A P
Income Tax on the Graphs AEP (t 0)

Graphically the addition of С mpc T I G B

the proportional income tax mpc
is reflected by the change mpc×(1–t)
in the slope of the aggregate
planned expenditure curve 450
AEP: it becomes flatter, Injections, Y
Y2 Y1 S+T–
because instead of mpc its leakages S+T
I G B A
slope decreases from mpc IP+G
to [mpc × (1 – t)].
0 Y
At the same time the slope C mpc T mps+(1–mps)× t
mps
of the leakages curve and
of the aggregate saving I,SAGG SNAT2
curve SAGG increases from B A SNAT1
I IP
mps to [mps + (1 – mps) × t]
0 Y2 Y1 Y
and they both become
steeper. mps+(1–mps)× t 18
C G mpc T mps
 Government Budget Multipliers
Under the Mixed Tax System
To derive the lump-sum tax multiplier, we need to use the goods
market equilibrium condition:
Y = AEP Y = C + IP + G,
Y C mpc (Y T x t Y T r ) I G
1
Y (C mpc T x mpc T r I G)
1 mpc (1 t )
We get:
Lump-sum tax Y mpc
mult T x
multiplier Tx 1 mpc (1 t )

Transfer payments Y mpc

multT r
multiplier Tr 1 mpc (1 t )

Balanced budget 1 mpc

mult BB
multiplier 1 mpc (1 t )
Under the mixed tax system the balanced budget multiplier 19
does not equal to 1.
 The Foreign Sector and Aggregate Demand

Adding the foreign sector, we get the open economy and an extra
component of aggregate demand in the form of net exports:
NX = Ex – Im
Exports is an injection, because it increases the demand for the
domestic output.
Imports is a leakage that decreases the demand for the
domestically produced goods and services, moving it to the
purchase of foreign production.
Imports (Im)
Ex,Im
Trade Deficit
NX < 0
(Ex < Im)
NX > 0 Exports (Ex)
Trade Surplus
(Ex > Im) NX = 0
20
 Exports and its Determinants
Exports is autonomous, because
it doesn’t depend on domestic income (Y):
Ex Ex
Export is influenced by the willingness of foreigners to buy goods and
services from the given economy.
The determinants of exports are:
the income of foreigners (YF);
the tastes & preferences of foreigners to buy goods from this country;
the exchange rate of national currency (e);
the relation between domestic and foreign prices (P/PF).
The higher is the income of foreigners; the higher are their preferences to
buy goods from this economy; the weaker is national currency; the
cheaper are domestic goods and/or the more expensive are foreign
goods the more goods and services foreigners would desire 21to buy
from the given economy and thus the higher would be exports.
 Imports and its Determinants
Imports is greatly affected by:
the domestic income (Y): the wealthier are the citizens, the more
foreign goods and services they are eager to buy. It means that
part of imports is induced (i.e. depends on income).
But imports is also influenced by non-income factors also important,
while making a decision either to buy or not to buy foreign goods.
They are:
the exchange rate of national currency (e);
the tastes for foreign goods;
the relation between domestic and foreign prices (P/PF).
Hence part of imports is autonomous. Ex,Im
The formula for imports is: Im
Im = Īm + mpm × Y NX < 0
NX > 0
Ex
Autonomous Induced mpm
Imports Imports
YNX =0 Y
22
 The Marginal Propensity to Imports

The marginal propensity to imports (mpm) is a behavioral

parameter, which shows the change in imports caused by
the change in national income:
Im (0 < mpm < 1).
mpm
Y
Hence, the net exports equation is:
NX Ex Im E x ( I m mpm Y ) ( E x I m ) mpm Y
–
where Ex Im NX is the autonomous net exports.

23
 The Effect of Net Exports
Insertion of net exports in our analysis implies that
• due to autonomous net exports the aggregate planned expenditure
curve AEP shifts up, and the aggregate saving curve SAGGREGATE
shifts down, while the injections curve shifts up due to exports
and the leakages curve also shifts up due to autonomous imports,
but simultaneously
• due to induced imports the aggregate planned expenditure curve
AEP changes the slope and becomes flatter: now its slope under
the lump-sum tax system equals to (mpc – mpm) instead of mpc,
or under a proportional tax system [mpc× (1 – t) – mpm] instead
of [mpc× (1 – t)], while both the leakages curve and the aggregate
saving curve SAGGREGATE become steeper: their slopes under the
lump-sum tax system equal to (mps + mpm) instead of mps, or
under a proportional tax system [mps + (1 – mps)× t + mpm]
instead of [mps + (1 – mps)× t]. 24
 The Effect of AE AE=Y
B С I P G NX
Net Exports С IP G
on the Graphs A
С mpc T I G NX mpc–mpm
NX mpc
С mpc T I G

450
Y
Injections, Y1 Y2
leakages
S T Im
B S T
I G Ex I P G Ex
Ex A
I G IP G
С mpc T I m
0 mps+mpm Y
mps Y1 Y2
С mpc T Im SNAT
I, SAGG S AGG S NAT S F
A B
I IP
0
mps Y1 Y2 Y
С G mpc T 25
NX mps+mpm
С G mpc T NX
 Goods Market Equilibrium Condition
in the Open Economy
Output (income) equals to
aggregate planned expenditures:
Y = AEP
Y = C + IP + G + NX
AE,I,SAGG АE=Y Planned investment equals to
А АEP
aggregate saving:
IP = SAGG
IP = Sprivate+ Sgovernment + Sforeign

A YD – C T–G Im – Ex

А' S AGG S (T G ) ( I m E x)
IP
450
0
S AGG YE Y
S AGG C mps (Y T x t Y T r ) (T x t Y G T r ) ( I m mpm Y E x)
S AGG C mpc T x mpc T r G I m E x
 The Spending Multiplier in the Open Economy
When adding the equation of net exports to the sum of aggregate
expenditures (under the lump-sum tax system), we get
the new equation for the equilibrium condition in the goods market:
Y = AEP
Y = C + IP + G + NX
Y C mpc (Y T x T r ) I G E x I m mpm Y
Y mpc Y mpm Y C mpc T x mpc T r I G Ex I m
1
Y (C mpc T x mpc T r I G E x I m )
1 mpc mpm
autonomous spending Ā in the open economy

1
MultiplierA OPEN ECONOMY mult A
1 mpc mpm
27
The Multiplier in the Open Economy versus
the Multiplier in the Closed Economy

The multiplier effect in the open economy is weaker than in

the closed economy because of the extra leakage from the
flow of spending in the form of imports.
The value of the spending multiplier in the open economy
is smaller due to an additional leakage rate –
marginal propensity to imports (mpm).

1 1
1 mpc mpm 1 mpc

28
 Other Multipliers in the Open Economy

1 1 1
mult A 1 mpc (1 t ) mpm 1 mpc (1 t ) mpi mpm
1 mpc mpm

mpc mpc mpc

multT x 1 mpc mpm 1 mpc (1 t ) mpm 1 mpc (1 t ) mpi mpm

mpc mpc mpc

multT r 1 mpc mpm 1 mpc (1 t ) mpm 1 mpc (1 t ) mpi mpm
1 mpc 1 mpc 1 mpc
mult BB 1 mpc mpm 1 mpc (1 t ) mpm 1 mpc (1 t ) mpi mpm

29
 Keynesian Cross Model as
the Model of Aggregate Demand
Keynesian Cross is the model of aggregate demand.
With its help we can derive the aggregate demand (AD) curve,
which shows the quantity of goods and services demanded at
each price level, i.e. the relationship between real GDP (Y) and
the price level (P).
When prices go up, the willingness of macroeconomic agents
(households, firms, government and foreigners) to buy goods
and services produced in the domestic economy decreases, and
they reduce spending (aggregate planned expenditure curve
shifts down). On the contrary, when prices are low, agents wish
to buy more (aggregate planned expenditure curve shifts up).
Thus, the relationship between aggregate demand and
the level of prices is negative. 30
Keynesian Cross and the Aggregate Demand Curve
AE=Y
AE AEP(P3) When prices rise from P1 to P2,
C aggregate planned expenditures fall
AEP(P1) from AEP1 to AEP2 (the curve shifts
Ā3 A AEP(P2) down) and the level of output
decreases from Y1 to Y2 (the graph at
Ā1 the top). It means, that when prices
B
Ā2 are P2, output will be Y2 (movement
along the curve from point A to point
Y2 Y1 Y3 Y B in the bottom graph).
P When prices fall from P1 to P3,
aggregate planned expenditures
B
increase from AEP1 to AEP3 (the
P2 upward shift in the upper graph), and
P1 A the level of output rises from Y1 to
Y3. It means that at the price level of
P3 C
AD P3 output becomes Y3 (movement
along the curve in the bottom graph
Y2 Y1 Y3 Y from point A to point C). 31
 The Aggregate Demand Curve and its Slope
Since aggregate demand curve reflects the total demand in the
economy, it is not a simple aggregation of individual demand curves
for particular goods, and it is not a market demand curve.
The difference is that the AD curve reflects changes in demand, when
the price level for all goods increases or decreases, but not when the
price of one good changes relative to the price of another. When the
general price level increases, we do not substitute one good for
another, rather we as a nation buy fewer goods and services.
The negative slope thus cannot be explained by the substitution effect
or by the income effect, as the negative slope of the individual or
marker demand curve is explained in microeconomics.
Three effects explain why the AD curve has a negative slope:

Real Wealth Effect Interest Rate Effect Foreign Trade 32

Effect
 Effects Explaining the Negative Slope of
the Aggregate Demand Curve: the Pigou Effect
The Real Wealth Effect (the Real Balances Effect or
the Pigou Effect):
When the price level (P) increases, the value (the purchasing
power) of money, such as cash and checking account balances, and
of non-money assets falls. For a given sum of money (M), if
prices become higher, people can buy fewer goods. They feel
themselves less wealthy and decrease consumption spending (C),
that reduces the quantity of goods demanded in the economy and
ends in the decrease in real GDP (Y).
P (M/P) C ADQUANTITY Y
where (M/P) is real money balances (real purchasing
power of money), or the real financial wealth.
Likewise, when the price level falls, the purchasing
power of peoples' assets increases, and people buy more. 33
 Effects Explaining the Negative Slope of
the Aggregate Demand Curve: the Keynes’ Effect
The Interest Rate Effect (or the Keynes’ Effect):
When the price level (P) increases, the real quantity of money (its
purchasing power) decreases. People need more money even to
continue their current consumption levels. This increases the
demand for money (MD) in the form of loans, and decreases the
supply of loanable funds. The interest rate (r) (which is effectively
the «price» of money) goes up. The higher interest rate (the higher
price of loanable funds) leads to a decrease in primarily investment
demand of firms (I) that decreases the quantity of goods
demanded in the economy and forces firms to decrease
real output.
P MD r I ADQUANTITY Y
Likewise, a decrease in the price level decreases
34
interest rates, and increases real GDP.
Effects Explaining the Negative Slope of Aggregate
Demand Curve: the Mundell-Fleming Effect
The Foreign Trade Effect (or the Mundell-Fleming Effect):
When the price level (P) in one country increases, the price of
imports from other countries becomes relatively less expensive for
its macroeconomic agents, but exports from this country becomes
relatively more expensive for foreigners. Thus, more imported
goods and services (Im) are purchased and fewer exports (Ex) are
sold. Domestic firms will also find it relatively more profitable to
invest abroad. The decrease in exports and the increase in imports
(that is a decrease in the quantity of net exports demanded),
resulting from a higher price level, lead to a decrease
in real GDP (and vice versa).
P Im ; Ex NX ADQUANTITY Y
35
Movements Along the Aggregate Demand Curve

These three effects explain the influence of the change in the

price level on real GDP through the changes in quantities of
goods and services demanded at each price level, and
correspond to the movement along the AD curve (from one
point to another – for example, from point A to point B).

P P

B
(M/P) C ; P2
r I ; AD
P1 A
Im ; Ex NX
Y AD

Y2 Y1 36 Y
 The Shifts of the Aggregate Demand Curve

The reasons for the AD curve to shift are all the changes in the
components of aggregate demand, but other than caused by a
change in the price level. If these changes lead to the increase
in aggregate demand, the AD curve shifts to the right.
Otherwise, the AD curve shifts to the left.
P P

AD2 AD1
AD1 AD2

Increase Y Decrease Y
in Aggregate Demand in Aggregate Demand 37
 The Shifts of the Aggregate Demand Curve
Among non-price factors that
influence consumption demand: demand by conducting fiscal and
expectations (consumer
confidence):
- of the change in prices;
- of the change in income;
- of shortages or abundance
in the future;
- about jobs and employment;
changes in disposable income
due to the changes
- in personal income taxes;
- in transfer payments;
interest rate on consumer loans
the level of wealth, etc.
Major factors that influence
investment demand:
interest rates;
business confidence.
Government can affect aggregate
monetary policy, i.e. by changing:
government spending;
taxes;
transfer payments;
money supply.
Demand for net exports is affected
by the changes in:
exchange rate of national currency
foreign income;
tastes & preferences;
relationship between
domestic and foreign
prices.
 Inflation and the Size of the Multiplier Effect
The increase in the price level decreases the multiplier effect.
The value of the multiplier is the highest, when all prices are sticky
(or rigid), and the aggregate supply curve is horizontal.
Increase in aggregate demand leads to the increase in real output to Y1.
When prices for goods are flexible and
P LRAS for resources (nominal wages) are
SRAS rigid, aggregate supply curve has a
P3 D positive slope, and the multiplier effect
C is smaller: output increases only to Y2.
P2
B SRAS When all prices are fully flexible, and
P1 A
aggregate supply curve is vertical at
the potential level Y*, the multiplier
AD2 effect disappears: despite of increase in
AD1 AD, output does not change; the only
Y* Y Y
2 1 Y effect is the rise in the price level P. 39
Inflation and the Size of the Multiplier Effect
AE AE = Y AEP' (P1)
B
AEP (P2)
C AEP (P1) = AEP (P3)
Ā A=D

450
Y* Y2 Y1 Y
P LRAS SRAS
P3 D

P2 C

P1 A B
SRAS
AD1 AD2
40
Y* Y2 Y1 Y
 Lecture 5
The Fiscal Policy
• Targets and Instruments of the Fiscal Policy
• Fiscal Policy and Aggregate Demand
• Expansionary and Contractionary Fiscal Policy
• Discretionary (Active) and Automatic Fiscal Policy.
Automatic Stabilizers
• The Crowding-out Effect
• Budget Deficit and National Debt
• Fiscal Policy: Different Approaches
• Fiscal Policy and Aggregate Supply
 Fiscal Policy and its Targets
Fiscal policy
is a type of stabilization policy aimed to smooth the business cycle
(recessions and booms in the economy) and to counter fluctuations
in aggregate output by changes in aggregate spending;
is concerned with the effects of changes in government
expenditures and/or in taxes;
deals with the government's attempts to use budget policy
instruments to meet a set of macroeconomic policy targets such as:
stable (non-inflationary) growth of real output (real GDP);
full employment of economic resources, that is natural rate of
unemployment;
stable general price level.
influences both aggregate demand and aggregate supply.
2
 The Fiscal Policy Instruments

Government Transfer Taxes – Tx

spending – G payments – Tr (direct and indirect,
(government (unemployment insurance, lump-sum and
purchases of goods welfare benefits) proportional
and services) and subsidies – Sb income)

Government Major government

(or government budget) (or government budget)
expenditures revenues

3
 Fiscal Policy and Aggregate Demand

The influence of fiscal policy instruments

on aggregate demand was first analyzed by
John Maynard Keynes.
Under the assumption of rigid prices and wages changes
in all these instruments have a multiplier effect on
aggregate output and the highest belongs to the changes
in government purchases.

1
Y G
G
1 mpc
mpc
mpc Y Tx Tx
Y Tr 1 mpc
Tr
1 mpc
No multiplier effect, but
Y G‾ = Tx
‾ = G ¯
¯ = Tx
nevertheless the rise in output
 Fiscal Policy and Aggregate Demand:
the Effect of Government Purchases

G2 G1
Increase in AE AE=Y
Government B AE P 2 С I G2
Purchases AE P1 С I G1

А2 С mpc (T x T r ) I G2 A
G¯
А1 С mpc (T x T r ) I G1 –
Y=multG¯× G
450
Y1 Y2 Y
1
mult G
1 mpc Y = [1/(1– mpc)]× G¯

Government G AE P ( AD ) Y
Spending Multiplier 5
5
 Fiscal Policy and Aggregate Demand:
the Effect of Lump-Sum Taxes
Taxes have an inverse impact on aggregate demand, and thus
aggregate output. An increase in taxes reduces disposable income,
that lowers consumption demand and decreases aggregate output.

T x2 T x1 AE AE=Y
Increase in A АЕР1 C (T х1 ) I G
Lump-Sum Taxes АЕР 2 C (T х2 ) I G
B
А2 С mpc (T x1 T r ) I –
G ΔC=–mpc× Tx
А1 С mpc (T x2 T r ) I G
–
Y= multTx
¯ × Tx
mpc 450
mult T х Y2 Y1 Y
1 mpc
¯
Y = [–mpc/(1–mpc)]× Tx
Lump-Sum Tax
Multiplier Tх YD С AЕ Р ( AD ) Y
6
 Fiscal Policy and Aggregate Demand:
the Effect of Transfer Payments
Transfer payments have a positive impact on aggregate demand and hence
aggregate output. An increase in transfer payments increases disposable
income, that raises consumption demand and increases aggregate output.

T r2 T r1 AE=Y
AE
Increase in B
АЕ Р 2 C (T r2 ) I G
Transfer Payments АЕ Р1 C (T r1 ) I G
A
А2 C mpc T x mpc T r2 I G ΔC=mpc
¯
Tr
А1 C mpc T x mpc T r1 I G –
Y=multTr
¯ × Tr
mpc 450
mult T r Y1 Y Y2
1 mpc
¯
Y = [mpc/(1–mpc)]× Tr
Transfer Payments Tr YD С AЕ Р ( AD ) 7 Y
Multiplier
 Fiscal Policy and Aggregate Demand:
the Effect of the Balanced Budget
¯ ¯ Effect on aggregate output:
ΔG = ΔTx 1 mpc
Y YG Y Tх G Tх
Balanced Budget 1 mpc 1 mpc
(in the closed economy with 1 mpc
the lump-sum tax system) Y G ( ) G 1 G
1 mpc 1 mpc
AE AE=Y
B AE P (G2 , T x1 )
ΔC= –mpc ¯
Tx AE P (G2 , T x2 )
C AEP (G1 , T x1 )
A (G2 , T x1 ) Balanced Budget
A (G2 , T x2 )
G¯ A Y = G¯ = Tx
¯
Multiplier = 1
A (G1 , T x1 )
Y
450 No multiplier effect, but
Y1 Y2 Y nevertheless the rise in output
8
 The Balanced Budget Multiplier: the Example

Suppose, government increases its purchases by $100 and fully

finances them by taxation, i.e. raising taxes by $100. This policy will
have a double effect on aggregate demand:

AD = C + I + G

ΔAD = $20 = ΔC = ̶ $80 + ΔG = $100

mpc = 0.8
ΔY = ΔAD × multĀ mps = 0.2
= $20 × 5 = $100 ΔYD = ̶ $100 ΔS = ̶ $20

ΔY = ΔG = ΔTx ΔTx = $100

10
 Fiscal Policy and Aggregate Demand:
the Effect of the Income Tax Rate
t2 t1
Decrease in the AE AE=Y
Income Tax Rate АЕ Р 2 C (t 2 ) I G
B
АЕ Р1 C (t1 ) I G
A
mpc×(1– t2)
mpc×(1– t1)
A C mpc (T x T r ) I G
Y
450
Y1 Y2 Y
1
mult А
1 mpc (1 t ) 1 1
Y= Ā×[ – ]
1–mpc×(1–t2) 1–mpc×(1–t1)
Spending Multiplier t YD С AЕ Р ( AD ) Y
11
 Types of Fiscal Policy
Fiscal policy is used to cure a recessionary or an inflationary gap and
to keep output close to its potential level. Fiscal policy thus can be:
Expansionary: Contractionary:
conducted during recessions; conducted during booms, when
held in order to stimulate economy is overheated;
economic activity; held in order to decrease
aimed to boost real GDP and excessive demand;
aimed to lower the price level
to decrease unemployment;
and fight inflation;
involves: involves:
increase in government decreasing government
purchases (G ), purchases (G ),
increase in transfers (Tr ), decreasing transfers (Tr ),
decrease in taxes (Tx ), increasing taxes (Tx ),
equal increase in G and in Tx equal decrease in G and in Tx
(expansionary balanced budget) (contractionary balanced budget)
 Fiscal Policy in the AD-AS Model
Expansionary Contractionary
Fiscal Policy Fiscal Policy
LRAS LRAS
P SRAS P
SRAS
P2 B
A
P1 A
P1
AD2 P2 B
AD1 AD1
AD2
YSR Y* Y Y* YSR Y
Recessionary gap (Y < Y*) Inflationary gap (Y > Y*)
G (or Tx , or Tr , or G = Tx ) G (or Tx , or Tr , or G = Tx )
AD Y AD Y
unemployment price level (P2 < P1 )
13
Discretionary versus Automatic Fiscal Policy
Discretionary (Active) Fiscal
Policy
involves intentional changes
in government spending
and/or net tax revenues, that
are the result of deliberate
changes in government
policy, in order to alter the
level of aggregate spending
and to eliminate
a recessionary or
an inflationary gap.
Automatic Fiscal Policy
is based on the work of
automatic (built-in) stabilizers
in the economy – instruments
that automatically lessen
economic fluctuations and
help stabilize output,
automatically changing the
level of net tax revenues,
when the economy moves
away from (or toward) the full-
employment level of output.
14
 Automatic (Built-in) Stabilizers
Automatic stabilizers are government budget revenue and expenditure
items, that automatically change with the state of the economy in
such a way as to stabilize GDP.
They include:
• government transfer payments (unemployment insurance benefits,
food stamps, and other government assistance programs);
• personal income taxes;
• corporate profit taxes;
• value added taxes;
• subsidies to the farmers (in U.S.), etc.
Example: When output falls, government collects smaller revenues
from taxes and increases transfer payments. Hence, consumer
disposable income falls less, consumer spending is more stable over
the business cycle, and the amplitude of economic fluctuations
is lessened. 15
 The Role of Built-in Stabilizers

Built-in stabilizers smooth the business cycle fluctuations and

make economy more stable to the exogenous shocks.

Real GDP Y' (actual GDP in the

presence of the built-in
stabilizers)
TREND
Y*(potential GDP)

Y (actual GDP in the

absence of the built-in
stabilizers)

Time (years)
16
 Limitations of the Active Fiscal Policy

Time lags:
Economists distinguish:
the inside lag – the period of time needed to discuss the state of
affairs in the economy (recognition lag), to adopt the decision
about what to do in order to improve economic performance
(decision lag) and to introduce this decision in the economy
(implementation lag) – this lag is typical for fiscal policy;
the outside lag – the period of time between the moment, when
the change in economic policy is undertaken, and the moment,
when the result of the policy is achieved (effectiveness lag) –
this lag is typical for monetary policy.

17
Limitations of the Active Fiscal Policy
Uncertainty: it is often very difficult
to estimate exactly the real situation existing in the
economy;
to choose the best policy instrument to cure the problem;
to define the exact amount of the change in the political
variable.
Crowding-out effect that is the result of the
expansionary fiscal policy. It occurs when increased
government expenditures and/or decreased taxes cause
aggregate output and hence the interest rate to rise, which
reduces (crowds out) interest-sensitive private sector
(primarily investment) spending.
Budget deficit. 18
 Crowding-out Effect: the Concept
From the national accounts identity for the closed economy
AE Y C+I+G C+S+T
and from the capital formation equation
I = S + (T – G)
where T is net taxes (T = Tx – Tr), we see, that if there is the increase
in G or in Tr or the decrease in Tx, part of private saving is going to
finance additional government expenditures (if taxes are unchanged)
or to compensate the fall in tax revenues (if government expenditures
are constant).
It results in the reduction of loanable funds available for private firms,
and therefore leads to the decrease in their investment spending.
Hence, part of private investment is crowded out:
I = S + (T – G ) I = S + (T – G)
 Crowding-out Effect: the Mechanism
The increase in government purchases (G) or in transfers (Tr) or the
decrease in taxes (Tx) leads to the increase in aggregate demand (AD)
and therefore in output (Y) with a multiplier effect, that in turn causes
the increase in the demand for money (MD) needed to buy additional
goods and services, which raises the nominal interest rate (i) and the
real interest rate (r). With the higher interest rate (=higher price of
borrowing) fewer investment projects will have the internal rate of
return that exceeds this high interest rate and thus will be financed, that
corresponds to the fall in aggregate investment demand (I) part of
private investment spending will be crowded out:
G (or Tr or Tx ) AD Y MD i and r I AD Y
Usually the decrease in Y due to the fall in I is assumed to be smaller
than the initial increase in Y as a result of the fiscal expansion
crowding out is partial.
Crowding out would be complete, if the initial increase in Y is fully
eliminated by the fall in Y caused by the decrease in I. 20
 Crowding-out Effect on the Graph
Keynesian Cross Money Market Investment Demand
AE AE=Y i MS r
B AEP(G2,I1)
I AEP(G2,I2)
C AEP(G1,I1) B
i2 B r2
A Output
G i1 r1 A
Effect A
MD(Y1') I(r)
450 MD(Y1)
Y – M I2 I1 I
Y 1 Y 2 Y 1' M

Multiplier Crowding-out
Effect Effect
Because of the crowding out (decrease) of private investment spending
resulting from the rise in the interest rate, output increases
from Y1 not to Y1' (point B is hypothetical), but to Y2 (point C). 21
Contractionary Fiscal Policy & Crowding-in Effect
Keynesian Cross Money Market Investment Demand
AE AE=Y i M S r
A AE P (G ,I
1 1 )
AEP(G2,I2)
C I AEP(G2,I1)
A A
i1 r1
B Output
G B
Effect i2 r 2
B MD(Y1) I(r)
450 MD(Y1')
– I1 I2
Y 1' Y 2 Y 1 Y M M I

Multiplier Crowding-in
Effect Effect
The mechanism of the contractionary fiscal policy:
G (or Tr or Tx ) AD Y MD i and r I AD Y
Crowding-out Effect: Alternative Explanation

The rise in the interest rate as a result of the expansionary

fiscal policy, that leads to the crowding out of private
investment spending, can be equivalently explained
through the changes in the loanable funds market

23
 Loanable Funds Market
The loanable funds market is the market which connects
supply of demand for
with
loanable funds FS loanable funds FD

demand of demand of
national saving firms government
to increase to finance
investment increase in
private + government spending I G or in Tr
sector saving sector saving
r FS
Tx – G > 0
S = YD – C = budget surplus E
rE
Equilibrium in the loanable funds market gives
the equilibrium quantity of loanable funds FE FD
and the equilibrium real interest rate rE
(that is the price for the use of loanable funds) FE F
 Crowding-out Effect: Alternative Explanation
To finance increased budget expenditures The decrease in taxes Tx (that
(G or Tr) government can borrow are budget revenues) causes the
funds in the loanable funds market by fall in public saving (which is
issuing and selling government bonds, the part of the supply of loanable
(= expands the demand for loans FD), funds FS), that under the constant
that under the constant supply of demand for loanable funds FD
loanable funds FS causes the rise in puts the upward pressure on the
the interest rate, that restores the interest rate and provides the
equilibrium in this market restoration of the equilibrium
G (or Tr ) FD r I Tx FS r I
r FS r FS2
FS1
B r2 B
r2
r1 r1
A FD2 A
FD
FD1
F F
 Crowding-out Effect on the Graph:
Alternative Explanation
Keynesian Cross Loanable Funds Investment Demand
AE AE=Y Market
r r
B AE P (G ,I
2 1 )
I AEP(G2,I2) FS
C AEP(G1,I1)
B
r2 r2 B
A Output
G r1 r1
Effect A
A
FD(G2) I(r)
D
F (G1)
450
Y 1 Y 2 Y 1' Y F I2 I1 I
Crowding-out
Multiplier Effect
Effect
but to finance increase in G
G AD Y FD r I AD Y
26
 Fiscal Policy and Budget Deficit
Expansionary active fiscal policy

the increase the decrease

in government expenditures, and/or in taxes collected,
that are budget expenditures that are budget revenues

leads to the budget deficit

27
 Ways to Finance Budget Deficit
Borrowing
from the central bank
(= printing money):
it is an inflationary way,
called the monetizing of
the budget deficit, which leads
to the increase in the supply of
money (the “helicopter effect”)
Borrowing
from the public
by selling government bonds:
it is the debt way,
called the deficit financing,
which leads
to the increase in
the national debt
28
 National Debt
The national debt (or the government debt) is
an accumulation of all past annual deficits,
the total amount that the government owes at a given time.

National debt generates Annual Deficit (2020)

the necessity to pay Annual Deficit (2019)
interest on government Annual Deficit (2018)
Annual Deficit (2017)
bonds. The higher is the Annual Deficit (2016)
Annual Deficit (2015)
debt, the larger are the Annual Deficit (2014)
Annual Deficit (2013)
sums for debt service, i.e.
budget expenditures.
Therefore, in the attempt
to finance budget deficit
in present, government
provokes budget deficit
in future.
 Government Debt in Russia

On January 1st, 2021 government internal debt of Russian Federation,

expressed in government securities, amounted to 14 751.438 mln. rubles,
while government external debt was 56 702.9 mln. US dollars
(from which 38 257.7 mln. on government securities),
including on state guarantees of the Russian Federation
in foreign currency 17 596.6 mln. US dollars.

30
 Types of Budget Deficits
The size of the budget deficit is not a good measure
of the government’s fiscal stance. Economists distinguish:
structural, cyclical and actual budget deficits.
Structural budget deficit Cyclical budget deficit
shows what the budget occurs because of a down-turn in
would have been under the the business cycle and equals to the
existing tax system, difference between actual budget deficit
if output had been at the and structural budget deficit:
full-employment level: BDcyclical = BDactual – BDstructural =
BDstructural = (G– + Tr
– – Tx
– – t ×Y) – (G– + Tr
– – Tx
– – t ×Y*)
=G – + Tr – – t × Y*
– – Tx = t × (Y* – Y)

The result of discretionary The result of the built-in

fiscal policy stabilizers
31
 Types of Budget Deficits
Actual budget deficit is the difference between actual government
expenditures and tax revenues, actually received in the existing
economic situation under the existing tax system:
BDactual G
– – Tx
– + Tr – –t×Y

During recessions actual budget deficit exceeds structural deficit

by the value of cyclical deficit, because Y < Y*.
During expansions actual budget deficit is lower than structural
deficit by the absolute value of cyclical deficit, because Y > Y*.
GB Net Tax Revenues
Government
Spending
Structural Deficit

t Actual Deficit
Cyclical Deficit 32
Y Y* Y
UK Public Sector Spending 2020-21
Total ₤928 billion
UK Public Sector Current Receipts 2020-21
Total ₤873 billion

In 2020 fiscal deficit planned to be ₤55 billion (2.6% GDP),

but because of COVID-19 pandemic reached 16.2% (!) GDP.
 Russian Government Spending, 2019

Russian federal budget receipts were: oil revenues – 41.6%, value

added tax – 34.6%, excise taxes – 5.3%, profit taxes – 4.8%, other
revenues – 13.7%. Budget surplus in 2019 amounted to 1.8% of GDP.
Russian Government Spending, 2020

13,9% 15,3%

9,8%

30,6% 6,6%

6,1%
3,4%
5,8% 4,2%
4,1%

Oil budget revenues decreased to 28%.

Budget surplus was replaced by budget deficit,
equal to 3,8% of GDP (4.1 trillion rubles)
 Fiscal Policy:
Classical Approach
Fiscal policy is absolutely ineffective
because of the complete crowding-out effect:
Jean-Baptiste Say the increase in prices provokes such a large rise Adam Smith
of the interest rate (because of the higher demand for money needed to
buy becoming more and more expensive goods and services), that causes
the full replacement of private investment spending by government
purchases (= the change for the worse in the composition of output that
reduces the effectiveness of the economy), while leaving the level of real
output unchanged fiscal policy is not only useless, but harmful).
P AS
G P MD r
I ( I = G) Y* P2 B

(unchanged in level, but changed P1

for worse in composition) A AD(G2)
AD(G1)
Y* Y
 Classical Economists: Overcoming the Slump
According to the Say’s law, protracted crises are impossible in the
economy, because aggregate demand is determined by aggregate supply
and hence they are always equal (AD = AS).
If, however, there occasionally occurs a temporary disproportion,
economy is able to overcome it itself (without government intervention),
and market forces will bring output back to its potential level.
Suppose, a decrease in aggregate demand brings economy to point B,
where output falls to Y2. Because output is low, unemployment (u) is
high, and workers agree to take jobs at a lower P AS
nominal wage (W). It implies the fall in firms’
costs of production and gives them an incentive P1 A
to expand the supply of output economy B
moves to point C. Output returns to its potential P2 C
level, and there is again full employment. The AD1
AD2
fall in prices returns real wage to its initial size. Y2 Y* Y
Y low u high W costs AS (movement along AD2 curve)
Y to Y*, u to u*, P to P2 , and (W2/P2) = (W1/P1)
 Fiscal Policy: Neoclassical Approach
Ricardian Equivalence
Tax cuts financed by borrowing from the public (that is, by the
increase in government debt) have no effect on the economy,
because private citizens recognize their future tax obligation (they
are sure that government would raise taxes by the size of the
current cut (equivalently) in future in order to be able to repay the
increased public debt), save the sum of the increase in their
disposable income resulting from the tax cut, and do not increase
consumption spending.

Tx YD S (= Tx) C unchanged AD unchanged

Y unchanged
Conclusion:
Lower income taxes is not a remedy
for the falling economy.
 Fiscal Policy: Neoclassical Approach
Ricardian Equivalence
The idea, that temporary tax cuts may have no impact on the economy,
was first proposed in the early 19th century by the prominent British
economist David Ricardo and regenerated by Robert Barro in 1974 in
his article “Are Government Bonds Net Wealth?”, and is known as
Ricardian or Barro-Ricardian equivalence. Because foreseeing the
future rise in taxes households save the sum resulting from the current
tax cut and do not raise their consumption demand, aggregate demand
will not increase to AD2, and therefore output Y will stay unchanged.
The real interest rate on the debt r will also stay unchanged.
To have an effect on the economy the tax cut must be permanent.
P SRAS r FS1
FS2
B
r2
A r1 A C
P 1
AD2 FD2
AD1 FD1
David Ricardo
Robert Barro
Y1 Y F
 Fiscal Policy and Aggregate Supply

The influence of the fiscal policy on aggregate supply was

analyzed in early 1980s by the American economist, the
economic adviser of the U.S. President Ronald Reagan,
Arthur Laffer,
who showed the relation between the change in tax rates
and the level of economic activity.

41
 The Laffer Curve
Laffer supposed that the decrease in tax rates (t) could stimulate
the supply of output (AS), and could help to solve two major problems,
which faced the US government in that period:
budget deficit stagflation
(budget revenues are less than (simultaneous fall in
budget expenditures) output and rise in prices)

because Y T (= t ×Y) BD t AS Y and P

The Laffer Curve AD-AS Model
Tx P LRAS SRAS
B 1
Txmax
A
SRAS2
Tx1 P1 A
P2 B
AD

topt t1 t Y1 Y* Y 42
 Fiscal Policy and Aggregate Supply

Instruments of fiscal policy that can influence aggregate supply:

profit taxes subsidies investment tax credit personal taxes

decrease increase decrease

in the tax rate in the amount paid implementation in the tax rate

increase in net investment rise in the disposable income

increase in the stock of physical capital increase in the supply of labor

increase in the production possibilities of the economy

= increase in the potential level of output
 Fiscal Policy and Aggregate Supply
Conclusion: fiscal policy can affect aggregate output
not only in the short run (Y), but also in the long run (Y*).

P LRAS1 LRAS2
SRAS1
SRAS2
A
P1
P2 B

AD
Y*1 Y*2 Y

Result: an increase in the potential output Y* accompanied

by the fall in the price level Р
 Lecture 6
Money and Banking.
Money Market Equilibrium
• Money and its Functions.
• Money Supply and its Aggregates ₽
• The Banking System $
• Money Creation Process
• Deposit and Loan Multipliers
¢
• Money Multiplier ¥
• Motives for Holding Money
• Liquidity Preference Theory€
• Money Market Equilibrium £
 Money Market as a Segment of
Financial Market
Financial Market

Market of Money Market of Non-money

Financial Assets Financial Assets
(liquid assets) (income bearing assets)
Types of Financial Assets
in Macroeconomics:
Money that can be used for Bonds that pay a positive
transactions, but pays interest income i,
no interest income and includes: but cannot be used for
currency and demand deposits. transactions.
Equilibrium Condition:
Demand for Money = Supply of Money: Demand for Bonds = Supply of Bonds:
MD = MS or (M/P) D = MS/P ВD = ВS or ВD/P = ВS/P
 Money and its Functions

Money is anything that is commonly accepted as a means of

payment for goods and services or the settlement of debts.
Money serves four major functions:
a medium of exchange, which allows to purchase goods and
services and is the key feature of money;
a unit of account – a measure of value, which provides a
common denominator for measuring prices, costs, revenues,
and income;
a store of value, which allows to postpone the spending
of current money income and thereby save in order to
make purchases in future;
a standard of deferred payment – a unit of account over
time that can be used to repay debts and thus enables lending
and borrowing.
 Kinds of Money

Commodity Money Token Money

Fiat Money IOU Money

Bills Bank-notes Cheques

 Kinds of Money

Commodity money are ordinary goods, which also serve as a

medium of exchange. Thus they have intrinsic value.
Token money is a means of payment whose value as money greatly
exceeds its cost of production or value in uses other than money.
They must be legal tender and are accepted as a means of
payment by law. Currency made of paper and inexpensive
metals has value as money only because it is deemed to have
such value by government order. So they are fiat money.
IOU (I owe you) money is a medium of exchange based on the
debt of a private agent (a firm or an individual).
Plastic cards are not considered as money in macroeconomics,
because represent the short-run bank’s loan to its holder
and are already included in money stock as the amount
of money, deposited in commercial banks while issuing
these cards.
 Money Supply Aggregates

In the United States they are:

M1 = currency outside banks (coin and paper money) +
PROFITABILITY

+ checking (or transaction) deposits + travelers checks.

LIQUIDITY

M2 = M1 + savings deposits + small time deposits (less

than $100,000) + money market mutual funds +
+ Eurodollar deposits.
M3 = M2 + large time deposits + Eurodollar time deposits.
L = M3 + Treasury bills + other less liquid assets.

Liquidity is a feature of an asset

to be quickly converted into a
money balance with a minimal M1 M2 M3 L
loss of nominal capital value or
into any other asset. The most
liquid asset is currency.
 Money Supply Aggregates in Russia
М0 = наличные деньги в обращении вне банковской системы
(12 523,9 млрд.руб на 1 января 2021 г.);
М1 = М0 + остатки средств в национальной валюте на расчетных,
текущих и иных счетах до востребования населения (10 348,7
млрд.руб), нефинансовых и финансовых (кроме кредитных)
организаций (8 913,0 млрд.руб), являющихся резидентами РФ
(итого 31 785,6 млрд.руб);
М2 = М1 + остатки средств в национальной валюте на счетах
срочных депозитов и иных привлеченных на срок средств
населения (16 685,6 млрд.руб), нефинансовых и финансовых
(кроме кредитных) организаций (10 179,9 млрд.руб), являющихся
резидентами РФ (итого 58 651,1 млрд.руб).
32,55% 21,35%
Наличные деньги

46,09% Депозиты населения

Депозиты организаций 7
 The Banking System
The main agents in the money market are banks.
Banks are the main financial intermediaries, standing between
lenders (those who have spare money and want to get percent
income on it) and borrowers (those who need money) and
facilitating the flow of saving to real investment.
The modern banking system consists of two levels.
Central Bank

Commercial Banks
 The Central Bank
and its Functions
Federal Reserve System Bank of England
The functions of the Central bank are:
Conduct monetary policy (the most important function);
Supervise and regulate commercial banks and other
financial institutions;
Serve as lender of last resort to commercial banks and
other financial institutions;
Provide banking services to the government;
Issue currency and coins;
Provide financial services to commercial
banks and other financial institutions.
Bank of Russia
 The Central Bank Balance Sheet

Assets Liabilities
Loans to the commercial banks Money (currency)
Loans to the government Commercial banks’ deposits
Government bonds Government deposits
Short-term government
securities
Gold and foreign currency
The two sides of the T account must always balance:
Assets = Liabilities
When something changes the total on one side of the T-account,
there must also be a chance on the other side.
 The Commercial Bank and its Balance Sheet
The major function of banks as financial intermediaries is to take money
from public (passive operations) and to give loans (active operations).
Assets Liabilities
Currency; Deposits of all types
Required reserves; (transaction, saving and time
Excess reserves, that can be loaned; deposits);
Loans; Reserves that can be borrowed
Private firms securities; from the Central bank;
Government securities Bank’s net worth
The T-account balance always holds: Assets = Liabilities
The Reduced Commercial Bank
Balance Sheet
Assets Liabilities
Reserves Deposits
Loans
 Reserve Banking Systems

100% Reserve System Fractional Reserve System

Assets Liabilities Assets Liabilities

Reserves = 1000 Deposits = 1000 Reserves = 100 Deposits = 1000
Loans = 0 Loans = 900

Reserve ratio (rr) = Reserve ratio (rr) =

Reserves Reserves
100% 100% 100% 10%
Deposits Deposits

All the amount of deposits Only a fraction of total deposits

is held on reserve and is held on reserve and
are not lent out. the rest is lent out.
 Commercial Banks’ Reserves:
Required Reserves
The banking system's ability to issue transaction (or checking, or
demand, or sight) deposits is controlled by the Central bank
through imposing a reserve requirement on these deposits.
Reserve requirement ratio (rrreq) is a percentage fraction of deposits
that each commercial bank is obliged to keep as reserves. Thus,
Required reserves = Deposits × Reserve Requirement =
= D × rrreq
 Commercial Banks’ Reserves:
Excess Reserves
Excess reserves are the characteristic of a commercial bank’s
possibilities to give loans. It is the sum that can be potentially lent
out by a commercial bank and with receiving each deposit equals to
the difference between the sum of a deposit and required reserves:
Excess reserves = Deposits – Required reserves =
= D – D × rrreq = D × (1 – rrreq)
If a part of excess reserves is held by a commercial bank and is not
loaned to the clients, then actual reserves of this bank will be:
Actual reserves = Required reserves + Excess reserves =
= Rrequired + Rexcess
and alternatively can be calculated as the difference between the sum
of deposits and the sum of loans actually given by this bank:
Actual reserves = Deposits – Loans =
=D–K
Lending out of this amount of excess reserves leads to
the additional increase in the supply of money.
 How Banks Create Money

Bank I Reserve ratio = 10%

Assets Liabilities Bank III
Reserves = 100 Deposits = 1000 Assets Liabilities
Loans = 900 Reserves = 81 Deposits = 810
Loans = 729

Bank II

b
Assets Liabilities
Reserves = 90 Deposits = 900
Loans = 810
 The Deposit Multiplier
The necessary condition of money creation is the
fractional reserve system.
The conditions of maximum increase in money supply:

banks hold no public holds

excess reserves no currency
М = D = DI + DП + DШ + DIV + … =
= D1 + D1 × (1 – rr) + [D1 × (1 – rr)] × (1 – rr) +
+ [D1 × (1 – rr)2] × (1 – rr) + [D1 × (1 – rr)3] × (1 – rr) + … =
= D1 × (1/rr)
M 1 1
Deposit multiplier =
D1 reserve ratio rr
The deposit multiplier shows the amount of money supply
created by 1 money unit of deposits.
In our case,
M = 1000 + 900 + 810 + 729 + … = D1 × (1/0.1) = 1000 × 10 = 10000
 The Deposit Expansion Process
Bank I D1 = 1000

K1 R1 K1 = D1 × (1 – rr)
Bank II D2 = 900 100

K2 R2 K2 = [D1 × (1 – rr)] × (1 – rr)

Bank Ш D3 = 810 90

K3 R3 K3 = [D1 × (1 – rr)2] × (1 – rr)

Bank IV D4 = 729 81

K4 R4 K4 = [D1 × (1 – rr)3] × (1 – rr)

Bank V D5 = 656.1 72.9

K5 R5 K5 = [D1 × (1 – rr)4] × (1 – rr)

 The Loan Multiplier Effect

DМ = DП + DШ + DIV + DV + …
= D1 × (1 – rr) + [D1 × (1 – rr)] × (1 – rr) +
+ [D1 × (1 – rr)2] × (1 – rr) + [D1 × (1 – rr)3] ×
× (1 – rr) + [D1 × (1 – rr)4] × (1 – rr) + …
i.e. DМ = K = КI + КII + КIII + КIV + . . . =
= К1 + К1 × (1 – rr) + К1 × (1 – rr)2 + К1 × (1 – rr)3 + . . .
= K1 × (1/rr)
In our example, DМ = 900 + 810 + 729 + 656.1 + … =
= 900 × 1/0.1 = 900 × 10 = 9000
 The Value of the Loan Multiplier
The loan multiplier equals to the deposit multiplier minus 1:
1 1
DM K1 D1 (1 rr )
rr rr Loan 1
1
1 rr 1 multiplier = rr
D1 D1 1
rr rr

The loan multiplier shows the change in the money supply

due to the change in loans for 1 money unit.
In our example, DМ = D1 × (1/rr – 1) = 1000 × 9 = 9000
Thus the change in the money supply
can be calculated
either by applying deposit multiplier to loans
DМ = K1 × (1/rr)
or by applying loan multiplier to deposits
DМ = D1 × [(1/rr) – 1]
 Limitations to the Deposit Multiplier Process
These two obstacles are:
the desire of public to hold the desire of banks to keep
more money in currency rather excess reserves in order not to
than on bank accounts in the take loans from the CB or from
form of deposits other commercial banks

The change in money supply in these cases will be smaller

and the money multiplier (not deposit multiplier)
will determine the money supply.
 Determinants of the Money Supply
The M1 money supply consists of currency outside the banking system
(CU) plus demand (or check-writing or transaction) deposits (D):
M = CU + D
The money supply (M) depends on the behavior:
of the Central bank, which puts money in circulation and
sets the reserve requirement (rr);
of the commercial banks, which hold a definite amount of
reserves (R = Rrequired + Rexcess);
of the public, which holds a definite amount of currency (CU).
 The Monetary Base
Thus the Central bank can directly influence money supply only
through the change in the monetary base (Н), also called
the high-powered money or the Central bank money or
the money supply aggregate M0.
Monetary base includes:
currency outside the banking system held by the public (CU), and
currency held by the commercial banks in the form of reserves (R):
Н = CU + R
The ratio of money supply to monetary base is known as:
Money multiplier = M/Н
Hence, money supply (M) can be calculated by multiplying
the monetary base (Н) by the money multiplier (mm):
M = mm × Н
The Monetary Base and the Money Supply

Monetary Base (Н)

Currency Reserves

Currency Deposits

Money Supply (M)

 The Money Multiplier
The value of the money multiplier depends:
• on the proportion, in which public divides money between
deposits and currency - currency-to-deposit ratio (cr = CU/D) and
• on banks’ reserve ratio (rr = R/D):

M CU D cr D D D (cr 1) cr 1
Money multiplier =
Н CU R cr D rr D D (cr rr ) cr rr

The money multiplier shows the change in money supply

due to the change in the monetary base for 1 money unit.
The value of the money multiplier increases when:

The Central bank The desire of banks Public prefers to hold fewer
decreases reserve to hold excess money in the form of currency,
requirements reserves falls increasing deposits to the banks
 The Monetary Base and the Money Supply

сr2 rr
Н сr rr Н М
сr1 rr
М 1 cr2
М
1 cr 1 cr1
D
Н2
А D A
Н1 Н

М1 М2 М М2 М1 М
The rise in monetary base Н The rise in currency-deposit ratio cr
increases the supply (or in the reserve ratio rr)
of money decreases the supply of money
 The Nominal Money Supply Curve
The money supply is assumed to be independent from the interest rate,
and graphically is represented as a vertical line.
The causes of the shifts of the money supply curve are
the changes in the money stock provoked by the Central bank.
When the Central bank When the Central bank
increases money supply, decreases money supply,
the MS curve shifts to the right. the MS curve shifts to the left.
i MS i MS1 MS2 i MS2 MS1

26
M M M1 M2 M M2 M1 M
 The Real Money Supply Curve
The real money supply (MS/P) changes due to the changes in:
the nominal money supply by the central bank (MS);
the price level (Р).
Because the real money supply also does not depend on the interest
rate, its curve has a vertical shape. Along the curve the real money
supply is constant (MS/P = const).

i (MS/Р)1 (MS/Р)2 The real money supply curve shifts to the right, if:
the central bank increases the supply of money
and/or
the price level falls in the economy.
And vice versa, when the central bank decreases
the supply of money or the price level rises,
the real money supply curve shifts to the left.
(M/P)1(M/P)2 (M/P) 27
 The Demand for Money
The motives for holding money are based on two key functions
of money: a medium of exchange and a store of value.
There are three motives for holding money:
a transaction motive – money is necessary to make transactions,
i.e. to buy goods and services;
a precautionary motive – money is needed for unplanned
purchases;
a speculative (or asset) motive – money is an asset, but there are
other assets (bonds and shares) that serve a better store of value,
because they not only keep value, but increase it in time (bear
interest income).
 Determinants of the Demand for Money

Level of real output Y Price level P Nominal

Higher output means the With higher interest rate i
increased amount of prices more With higher interest rate,
goods and services money is i.e. higher opportunity
produced in the needed by the costs of holding money
economy more public to buy (instead of, for example,
money is demanded by these more interest-bearing bonds)
the buyers and is needed expensive the lower amount of
to serve the larger goods and money would be
number of transactions services. demanded in the economy.

Transaction Motive Speculative Motive

MD M D(Y , P ,i )
i The Nominal Money Demand Curve
The nominal money demand curve has a negative
i2 B slope that reflects the negative effect of the change in
the interest rate on the amount of money demanded.
i1 A For example, the increase in the interest rate
(from i1 to i2) decreases the quantity of money
MD demanded in the economy (from M1 to M2)
and corresponds to the movement along the
M2 M1 M
MD curve (from point A to point B).
When there is the increase in real output Y or the rise in prices P,
the MD curve shifts to the right.
i
It means the increase i
in the quantity
of money,
demanded at
M (Y2) each level of the
D
MD(P2)
MD(Y1) interest rate. MD(P1)
M M
 The Liquidity Preference Theory
Was proposed by J.M.Keynes, who:
added the precautionary and speculative motives of holding money
to the transaction motive (the only one that existed in the classical
model), and grounded the inverse relation of the quantity of money
demanded from the interest rate;
suggested that an individual has a financial portfolio, which
contains of money (liquid assets) needed for transactions, and of
interest-bearing bonds (earning assets);

Liquid Bonds
assets
The proportions of money and bonds a person wishes to hold
depend on his/her level of transactions and the interest rate on bonds.
 The Liquidity Preference Theory
J.M.Keynes
treated the overall demand for money as the demand for
“real money balances” (M/P)D that is determined by:
real output Y (the quantity of transactions in the economy);
nominal interest rate i (opportunity costs of holding money),
a change of which leads to a change in the composition of the
financial portfolio;
expected changes in the future interest rate that determines the
speculative motive of holding money;
proceeded from the assumption that prices are fixed (Р = сonst),
i.е. there is no inflation, therefore the nominal interest rate i
coincides with the real interest rate r (i = r).
The liquidity preference theory explains how the equilibrium
in the money market and in the whole financial market is achieved. 32
 The Liquidity Preference Theory
The key idea of the liquidity preference theory:
the bond price is inversely related to the interest rate, and
the interest rate is inversely related to the bond price.
When the interest rate is low, When the interest rate is high,
the bonds prices are high, and the bonds prices are low,
public will sell bonds, exchanging and it is gainful for public to
bonds for money, hence increasing buy bonds, hence decreasing
the demand for money. the demand for money.

33
 The Interest Rate and the Bond Price
The relation between the bond price and the interest rate is negative.
When making decision whether to buy a bond, an individual hopes
to receive in future the greater sum of money (future value – FV)
than he or she has initially paid (present value – PV, that is the
bond price – PB), i.e. to get a capital gain (PB × i).
Example. A person buying a bond in the beginning of the period
wants to receive in the end of the period $100. If the interest rate
is set 10% (i = 0.1), he must pay:
PB (1 + i) = $100
hence FV $100 $100
PB PV $91
(1 i ) 1 i (1 0.1)
If the interest rate is higher, say, 20% (i = 0.2), he must pay less:
$100 $100
PB $83
1 i (1 0.2)
 S
The Interest Rate and the Bond Price
Equivalently
$100 PB
i 100%
PB
Thus, the bond price is negatively related to the interest rate
and the interest rate is negatively related to the bond price.
For example, if
PB $80
then
$100 $80 $20
i 100% 100% 25%
$80 $80
The relation in the general form
Price of Bond Capital Gain
Time is Money
Nominal (Face) Value
Nominal Value Price of Bond Capital Gain
Rate of Return ( i ) 100% 100%
Price of Bond Price of Bond
 The Price of Bond as a Present Value
The inverse relation between the bond price and the interest
rate can be proved using discounting.
The price of a bond with a maturity period (issued for t years)
that bears annual income of Х money units, is:
T
T X X X X X
PB PV { X }i 1 T 2 3
...
i 1 (1 i ) 1 i (1 i ) (1 i ) (1 i )T
The price of a bond with no maturity period (consol) that
bears annual income of Х money units, is:
X X
PКОНСОЛИ 0 ... 0 qX q2 X ...
1 i (1 i ) 2
X 1 1 X
PКОНСОЛИ PV { X }i 0 q X( )
1 q 1 i 1 i
1
1 i
36
 The Walrus Law for the Financial Market
The key idea to determine the demand for money: what part
of financial assets a person wants to hold in the for of money
(liquid assets) bearing no income, and what part – in the
form of assets, bearing interest income (bonds). Leon Walras
W = М D + BD
where W is aggregate financial wealth (value of all financial assets in the
economy); МD is aggregate demand for liquid (money) assets, and
BD is aggregate demand for bonds.
At the same time aggregate financial wealth consist of money and bonds:
W = М S + BS
We get: М S + BS = W = М D + B D
or МS/P + BS/P = W/P = (М/P)D+ BD/P
that implies МS/P – (М/P)D = BD/P – BS/P

excess supply of money excess demand for bonds 37

The Walrus Law for the Financial Market:
Conclusions

The equilibrium in one of the segments of the financial

market (money market) implies the equilibrium in the
other segment (bonds market) and the equilibrium in the
whole financial market, that facilitates the analysis and
allows to confine the study of only the equilibrium in the
money market.
When there is the disequilibrium in the money market,
the restoration of equilibrium occurs via the change of the
situation in the bonds market.

38
 Transaction Demand for Real Money Balances
Can be derived from:
the quantity theory of money, the foundations of which
were laid by the representatives of the classical school
(David Hume, Charles-Louis de Montesquieu) and the
equation proposed by Irving Fisher: M × V = P × Y
where M – quantity of money in circulation, V – velocity of money
(average number of times one money unit is used in transitions per year),
P – price level and Y – real GDP M/P = (1/V) × Y
the Cambridge equation (the alternative presentation of the quantity
equation, proposed by Alfred Marshall): М=k×P×Y
where k – liquidity preference (coefficient that shows the share of
nominal income held in the liquid form) М/P = k × Y
Transaction demand for real money balances is positively
related to real output/income Y
 Transaction Demand for Money on the Graphs
D D D
The function of the transaction M M or in linear M
demand for real money balances: P (Y ) k Y
T P T
form P T

Graphically it may be presented:

as a vertical line as a line with a positive slope equal to k,
on the money market that reflects positive relation of real transaction
graph, since it demand for money from real output/income
does not depend from D ( M / P ) D
income sensitivity
k
the interest rate DY of money demand

i shows M/P
(M/P) Т
D
the change in
the demand for (M/P)DТ
real money
balances due
to the change in
real output by k
M/P one money unit Y
 Speculative Demand for Real Money Balances
Speculative demand for real money balances (demand for money as
a financial asset) is negatively related to the nominal interest rate and is
derived from the Keynes’ liquidity preference theory, the key idea of
which: bond prices (РВ) are inversely related to the interest rate i
the higher is i, the lower is РВ and the lower is (M/P)D (public changes
money for bonds), and vice versa.
D D D
The function of the speculative M M M
( i ) or in the h i
demand for real money balances: P A P A linear form P A

i
D( M / P ) D interest sensitivity
h
Di of money demand

shows the change in the demand

for real money balances due to (M/P)DА
1
the change in the interest rate by
h
one percentage point M/P
41
 Total Demand for Real Money Balances
i i i
(M/P)D Т (M/P)DА (M/P)D

M/P M/P M/P

Transaction Demand + Speculative Demand = Total Demand
D D D
M M M
P
k Y + P
h i kY hi
T A P
determines the distance of the
horizontal shift of the demand for determines the slope of the
money curve due to changes in Y demand for money curve

42
 The Real Demand for Money Curve
i
The real demand for money curve
(= the demand for real money balances
curve) has a negative slope that reflects i2 B
the inverse effect of the changes in the
interest rate i on the quantity of money i1 A
demanded. Changes in the interest rate 1 (M/Р)D
correspond to the movement along h
the (M/P)D curve. (M/P)2 (M/P)1 M/P
i D
The shifts of the (M/P)D curve are
M
D k DY caused by the changes in real
P
output/income Y and imply the
change in the demand for real
money balances at each level of the
(M/Р)D(Y2)
(M/Р)D(Y1) interest rate.
M/P
 Interest Sensitivity of Money Demand
This sensitivity shows the reaction of the change in the real money
demand on the change in the interest rate, and graphically is
represented by the change of the slope of the (M/P)D curve.
Low interest sensitivity High interest sensitivity
of money demand of money demand
i i
(M/P)D
i1 h is small h is large
i1
i2 i2
1 (M/P)D
1
h1
(M/P)1 (M/P)2 h2
(M/P)1 (M/P)2 (M/P) (M/P)
The change in the interest rate causes The change in the interest rate
the small change of the quantity of causes the large change of the
money demanded quantity of money demanded
the (M/P)D curve is steep. the (M/P)D curve is flat. 44
 Equilibrium Condition in the Money Market
The money market equilibrium condition is the equity between
the quantity of money supplied with the quantity of money demanded:
MS/P = (M/P)D.
The point of the intercept of the MS/P curve with the (M/P)D curve
allows to determine the equilibrium level of the interest
__ rate iE and
the equilibrium level of the money stock (M/P)E.

i MS/P

iE A

(M/P)D
( M / P) E M/P
 Restoration of the Equilibrium
in the Money Market from the Disequilibrium
According to the liquidity preference theory the equilibrium in the
money market is restored via the changes in the interest rate
as a result of the changes in the situation in the bonds market.
i MS
Excess Supply
i1 A B
(M/P)D
iE C
MS/P
(M/P)D
(M/P)D< MS/P M/P
Suppose, initially money market is in a disequilibrium in point A, where
(M/P)D < MS/P. Excess supply, equal to AB, will provoke public to buy
bonds (to change money for bonds) the increase in the demand for
bonds will cause the rise in bonds prices and hence the fall in the interest
rate and the movement from point A to point C, where (M/P)D = MS/P.
 Changes in the Money Market Equilibrium
There are two main causes for the changes in the equilibrium
in the money market:
changes in the demand changes in the supply
for money (M/P)D of money MS/P
For example, the increase in the demand for money ends with
the rise in the interest rate, while the increase in money supply leads to
the fall in the interest rate that equates the amounts of money supplied
and demanded in the economy.
The explanation again is via the changes that occur in the bonds market.
i MS/P i MS1/P MS2/P

i2 B
i1 A

i1 i2 B
A
(M/P)D(Y2)
(M/P)D(Y1) (M/P)D(Y1)
M/P M/P (M/P)1 (M/P)2 M/P
Restoration of Equilibrium in the Money Market
Case I: Increase in the demand for money
When money demand rises (M/P)D due to the increase in output
from Y1 to Y2, then at the initial level of the interest rate i1 there is
excess demand for money (=AB) public begins to sell bonds
supply of bonds increases (BS ) (= excess supply of bonds) bonds
prices fall (PB ) interest rate rises (i ) equilibrium in the
money market is restored, but at the higher level of the interest rate i2.
Money Market Bonds Market
i MS/P PB BS1 S
B2
i2 C Excess Demand
Excess Supply
PB1 A B
i1 B PB2
A
(M/P)D(Y2) C
(M/P)D(Y1) BD
M/P M/P B 48
 Restoration of Equilibrium in the Money Market
Case II: Increase in the supply of money
When the central bank increases the supply of money (MS ),
then at the initial level of the interest rate i1 and with the level of output
Y1 there is excess supply of money (=AB) public begins to buy bonds
demand for bonds increases (BD ) (= excess demand for bonds )
bond prices rise (PB ) interest rate falls (i ) equilibrium in the
money market is restored, but at the lower level of the interest rate i2.
Money Market Bonds Market
i MS1/P MS2/P PB BS
Excess Supply
C Excess Demand
i1 A B PB2
PB1 A B
i2 C
B D
2
(M/P)D(Y 1) B D
1
(M/P)1 (M/P)2 M/P B
 Lecture 7
Monetary Policy
• Monetary Policy: its Ultimate Goals
and Intermediate Targets
• Tools of Monetary Policy
• Types of Monetary Policy
• Money Transmission Mechanism
• Problems Associated with Monetary Policy

Federal Reserve System Bank of Russia Bank of England

 Monetary Policy: its Goals and Targets
Monetary policy is a type of stabilization policy conducted by the
central bank through money supply management in order to
promote the ultimate goals:
stable (non-inflationary) growth of real GDP;
full employment of economic resources;
stable price level;
balance of payments (= external) equilibrium,
The intermediate targets of the central bank policy
can be the control over:
the money supply;
the interest rates;
the exchange rate of national currency.
The financial revolution has reduced the reliability of money
supply as an indicator and central banks increasingly
2
use inflation forecasts as the intermediate target.
 The Tools of Monetary Policy

The central bank has three primary tools with which

to control the money supply:
adjustments in the required reserve ratio
adjustments in the discount rate
open market operations
affecting on
the money multiplier or/and the monetary base

М = mm Н

3
 The Required Reserve Ratio
Required reserve ratio (rrreq) 1
is a key factor of money creation process M K
rr
The change in the required reserve ratio means the change in the
portion of deposits banks must hold as reserves, and hence in their
ability to give loans. This effects the value of the deposit and loan
multipliers, thus the amount of total deposits ultimately created
by each new deposit.
When the central bank wants to increase the money supply, it can
decrease the required reserve ratio and thereby require banks to hold
less money in reserves. This increases the multipliers and expands the
money creation process.
When the central bank wants to decrease the money
supply, it can increase the required reserve ratio.
Banks then are obliged to hold more money in
reserves. This decreases the multipliers and
4
contracts the money creation process.
Example. Suppose a bank receives a new deposit of $1000. If the reserve
requirement is 12.5%, the change in money supply will be:
1 1
M K (1000 1000 0.125) 875 8 7000 or
rr 0.125
1 1
M D ( 1) 1000 ( 1) 1000 7 7000
rr 0.125
and the money supply will be:
1 1
M D 1000 1000 8 8000
rr 0.125
The central bank wants to increase money supply and decreases the
reserve requirement from 12.5% to 10%. The change in money supply
now will be: 1 1
M K (1000 1000 0.1) 900 10 9000 or
rr 0 .1
1 1
M D ( 1) 1000 ( 1) 1000 9 9000
rr 0 .1
while the money supply will be:
1 1
M D 1000 1000 10 10000 5
rr 0 .1
The Required Reserve Ratio as an Instrument of
Monetary Policy
Changes in the reserve requirement ratio rrreq influences
only the value of deposit and loan multipliers and thus
the value of the money multiplier

1 cr
mm
cr (rrreq rrexcess )

while the monetary base does not change

ΔМ = Δmm Н

6
 The Discount Rate %%
The discount rate is the interest rate commercial banks pay to borrow
money from the central bank.
When the discount rate is low, banks are more likely to borrow from the
central bank, if the banks' excess reserves do not satisfy their demand
for loans.
When the discount rate is high, banks are less willing to loan money from
the central bank.
The central bank can thus
increase the money supply by decreasing the discount rate, making its
loans cheaper, or
decrease the money supply by increasing the discount rate, and
making borrowing from the central bank expensive and less attractive
for banks. 7
 The Discount Rate as an Instrument of
Monetary Policy
When, for example, the central bank decreases the discount rate

commercial banks can take cheap loans commercial banks take loans
no need to hold large amount of in the form of currency that
excess reserves increases banks’ reserves R
rrexcess falls that increases increase in the amount of
the value of the money multiplier currency in the economy
= increase in the monetary base
1 cr
mm Н CU R
cr ( rrreq rrexcess )

ΔМ = Δmm ΔН
 Interest Rates of the Central Banks
in Different Countries, 2018
Central Banks % Central Banks %
Bank of Russia 7.75 Bank of England 0.75
Federal Reserve System of US 2.25 Bank of Norway 0.5
Central Bank of New
Reserve Bank of Australia 1.5 1.75
Zealand
National Bank of Switzerland -0.75 Bank of China 4.35
European Central Bank 0.0 Bank of Brazil 6.5
Central Bank of the
Bank of Japan -0.1 Argentine Republic 60.0
Bank of Canada 1.5 Bank of Turkey 24.0
Central Bank of
Bank of Sweden -0.5 Venezuela 20.56
Bank of Denmark -0.75 Central Bank of Egypt 16.75
 Interest Rates of the Central Banks
in Different Countries, 2021
Central Banks % Central Banks %
Bank of Russia 4.25 Bank of England 0.1
Federal Reserve System of US 0.25 Bank of Norway 0.0
Central Bank of New
Reserve Bank of Australia 0.1 0.25
Zealand
National Bank of Switzerland -0.75 Bank of China 3.85
European Central Bank 0.0 Bank of Brazil 2.25
Central Bank of the
Bank of Japan -0.1 Argentine Republic 38.0
Bank of Canada 0.25 Bank of Turkey 17.0
Central Bank of
Bank of Sweden 0.0 Venezuela 38.15
Bank of Denmark 0.05 Central Bank of Egypt 8.25
 Bank of Russia Discount Rate, %
Period Rate Period Rate Period Rate
1990 20 2002 21 June 2009 11.5
1991 20 2003 16 July 2009 11
1992 80 2004 13 August 2009 10.75
1993 210 2005 13 September 2009 10
1994 180 2006 10 November 2009 9
1995 160 2007 10.25 January 2010 8.5
1996 48 April 2008 10,5 April 2010 8
1997 28 July 2008 11 June 2010 7.75
1998 60 November 2008 12 Февр. 2011 8
1999 55 December 2008 13 Май 2011 8.25
2000 25 April 2009 12.5 December 2011 8
2001 25 May 2009 12 September 2012 8.25
 0
4
6
8
10
12
14
16
18

2
5,5
7
7,5
8
9,5
10,5
17

Source: Bank of Russia

15
14
12,5
11,5
11
10,5
10
9,75
9,25
9
8,5
8,25
7,75
7,5
7,25
7,5
7,75
The Key Rate in Russia, %

7,5
7,25
7
6,5
6,25
6
5,5
4,5
4,25
 The Open Market Operations USTh.e T reas the Unite
bearer of is hereby promi
nd
bo
ond
uryd StaBtessed
ple
Treasury ent of the princi it
ich
the repaym the interest wh ted
s sta
value plu gh the terms
ou
incurs thr
thereo f.
ay
justly rep
tes will
ited Sta and
The Un entirety
s in its
its bearer fault under any
de
will not
nces.
circumsta

Open market operations (OMO) involve the central bank's Signature

______
of the Pre

______
sident

______
_

purchase and sale of government securities.

This tool is the most frequently used in the developed countries.
The central bank can buy government bonds from and sell them to
the public and the commercial banks
When the central bank sells government bonds to the public, it
takes money from the buyers and decreases money supply. In
order to pay for the bonds public have:
either to reduce their holding of cash this removes money
from circulation;
or to withdraw some of their bank deposits this causes the
decrease in banks’ reserves, banks can give fewer loans, which
means money supply contraction.
13
 The Open Market Operations USTh.e T reas the Unite
bearer of is hereby promi
nd
bo
ond
uryd StaBtessed
ple
Treasury ent of the princi it
ich
the repaym the interest wh ted
s sta
value plu gh the terms
ou
incurs thr
thereo f.
ay
justly rep
tes will
ited Sta and
The Un entirety
s in its
its bearer fault under any
de
will not
nces.
circumsta

sident

Open market operations (OMO) involve the central bank's

of the Pre
Signature
_
______
______
______

purchase and sale of government securities.

When the central bank wants to increase money supply, it buys
government bonds from the public, paying money to the sellers.
This action:
increases the amount of cash people hold in their pockets; and
increases the amount of money people keep in bank accounts.
It means that the quantity of liquid assets in the economy rises
= increase in the monetary base

ΔМ = mm ΔН

14
 The Open Market Operations USTh.e T reas the Unite
bearer of is hereby promi
nd
bo
ond
uryd StaBtessed
ple
Treasury ent of the princi it
ich
the repaym the interest wh ted
s sta
value plu gh the terms
ou
incurs thr
thereo f.
ay
justly rep
tes will
ited Sta and
The Un entirety
s in its
its bearer fault under any
de
will not
nces.
circumsta

When the central bank buys government bonds from Signature

______
of the Pre

______
sident

______
_

or sells them to the commercial banks, the quantity of

the excess reserves in the banking system and thus the ability
of banks to give loans changes:
the purchase of government bonds by the CB increases the
amount of the excess reserves that banks can loan out that
increases the supply of money in the economy;
the CB‘s sale of government bonds decreases the amount of the
excess reserves and thus of the commercial banks’ loans that
provokes monetary contraction.

15
Monetary Policy and Open Market Operations
The assets of the central bank are the bonds that it holds.
The liabilities is the stock of money in the economy.
An open market operation, in which the central bank buys
government bonds (for example, for $1 million) and issues
money, increases both assets and liabilities by the same amount.
Balance Sheet of the Central Bank
Assets Liabilities
Bonds Money (currency)
Effect of the Expansionary Open Market Operation
Assets Liabilities
Change in bond Change in money
holdings: stock:
+$1 million +$1 million
The opposite happens, when the CB sells government bonds
in the open market (contractionary open market operation). 16
 The Types of Monetary Policy

Expansionary (or mild) Contractionary (or tight)

is used to cure recessions and is held in order to fight inflation
to fight unemployment. and overemployment during booms
The central bank then The central bank in this case
increases money supply (MS ) by decreases money supply (MS ) by
decreasing the required reserve increasing the required reserve
ratio; ratio;
decreasing the discount rate; increasing the discount rate;
buying government bonds. selling government bonds.

17
 Monetary Policy on the Graph
When the central bank by changing the monetary base H or/and
the money multiplier mm,
increases money supply (that is decreases the required reserve
ratio and/or the discount rate and/or buys government bonds on
the open market), the MS/P curve shifts to the right;
decreases money supply (that is increases required reserve ratio
and/or discount rate and/or sells government bonds on the open
market), the MS/P curve shifts to the left.
i MS1/P MS2/P i
MS2/P MS1/P

(M/P) 1 (M/P) 2 M/P (M/P) 2 (M/P) 1 M/P 18

 The Money Transmission Mechanism:
Expansionary Monetary Policy
AE Keynesian Cross
AE=Y
Money Market Investment Demand B AEР(I2)
i MS1/P MS2/P r
A
AEР(I1)
I
i1 A r1 A
450
i2 B r2 B Y1 Y2 Y
I(r) P AD-AS Model
(M/P)D LRAS SRAS
(M/P)1 (M/P)2 M/P I1 I2 I P
2 B
P1 A

MS i (= r) I AD IUN AD(I2)
Y unemployment AD(I1)
Y1 Y* 19 Y
The Monetary Expansion and the Interest Rate
The link between the money and the goods markets is the interest rate.
When during recessions the central bank (CB) wants to stimulate
economic activity, it increases money supply (MS ). The increase in
money supply by the CB (via the decrease in required reserve ratio or
in the discount rate or the purchase of government bonds) expands
banks’ reserves, leading to the increase in the supply of loans and the
fall in the price of loans, i.e. the interest rate (i ). This encourages
investment spending (I ), that leads to the rise in aggregate demand
(AD ) and therefore in output (Y ) and employment (u ) .
.

20
 Expansionary Monetary Policy: the Mechanism
When the central bank increases the supply of money (MS ):
by reducing the reserve requirement ratio or the discount rate,
there is excess supply of money in the money market public
starts to buy bonds the demand for bonds increases (BD )
bond prices rise (PB ) the rate of return on bonds (= the
opportunity costs of holding money) goes down the quantity
of money demanded rises the equilibrium in the money
market is restored at the lower level of the interest rate (i ) that
leads to the following chain of changes:

MS BD PB i (= r) I AD IUN Y u

by the purchase of government bonds, it cuts the interest rate

(i ), that they yield, thereby increasing their price (PB ), that
makes profitable to the public to sell bonds the result of the
21
policy is the same.
 The Money Transmission Mechanism:
Contractionary Monetary Policy
AE Keynesian Cross
AE=Y
Money Market Investment Demand AEР(I1)
i MS2/P MS1/P r A AEР(I2)

B I
i2 B r2 B
A 450
i1 A r1 Y2 Y1 Y
(M/P)D I(r) AD-AS Model
P LRAS
SRAS
(M/P)2 (M/P)1 M/P I2 I1 I P A
1
P2
B
MS i (= r) I AD IUN AD(I2)
Y and P AD(I1)
Y* Y1 22 Y
The Monetary Contraction and the Interest Rate
During booms the central bank attempts to “cool” the overheated
economy by the decrease in money supply (MS ) using measures
aimed to reduce the banks’ reserves (increase in the required
reserve ratio or in the discount rate or the sale of government
bonds) and thus the amount of loans in the economy. Banks are
enforced to offer loans at a higher interest rate (i ) in order to
restore deteriorated deposits. As a result investment activity falls
(I ), causing the decrease in aggregate demand (AD ) that gives
the downward pressure on prices (P ).

23
Contractionary Monetary Policy: the Mechanism
When the central bank decreases the supply of money (MS ):
by raising the reserve requirement ratio or the discount rate,
there is excess demand for money in the money market
public starts to sell bonds the supply of bonds increases
(BS ) bond prices fall (PB ) the rate of return on bonds
(= the opportunity costs of holding money) goes up the
quantity of money demanded falls the equilibrium in the
money market is restored at the higher level of the interest rate
(i ) that leads to the following chain of changes:

MS BS PB i (= r) I AD IUN Y and P

by the sale of government bonds, it has to cut their price (PB ),

thereby increasing the interest rate (i ) that they yield, wishing
to make them attractive to the buyers… that eventually ensures
24
the same result of the policy.
Problems Associated with Monetary Policy

Outside lag
Multistage character of the money
transmission mechanism
Uncertainty
Possibility of the inflationary pressure
Existence of the side effects
Contradictoriness of the targets
(«monetary policy trilemma»)

25
Problems Associated with Monetary Policy:
the outside lag

The outside lag (the efficiency lag) – the period of time

between the moment, when the change in the economic
stabilization policy is undertaken (the moment when
the central bank has made a decision about the change
in the money supply), and the moment, when the result
of the policy is achieved (which is expressed in the
change in aggregate real output).
The outside lag arises from the multistage character
and possible malfunction and even failure in the
money transmission mechanism.

26
 Problems Associated with Monetary Policy:
possible failure in money transmission mechanism
Having received additional funds due to the expansionary monetary
policy banks may not hurry to lend them, hence the supply of
money would change negligibly;
The demand for money may be highly interest sensitive (the (М/P)D
curve is very flat), thus the interest rate would fall insignificantly;
The investment demand may be low interest sensitive (the I curve is
very steep), and investment would increase to a very little degree;
The autonomous spending multiplier may be small (the АЕР curve
is flat), and the increase in spending may lead to a negligible growth
of real output;
Economy may be on the full-employment level or near this level
the result of the increase in aggregate demand would be the higher
price level, rather than higher real output.
27
 Possible Failure in Money Transmission Mechanism
Money Market Investment Demand Keynesian Cross
i MS1/P MS2/P r AE AE=Y AE (I )
B Р 2
A
i1 B r1 A
i2 r2 B AEР(I1)
A
(M/P)D I(r)
450
(
M M
)1 ( ) 2
M I1 I2 I Y1 Y2 Y
P P P

banks hold excess investment autonomous

reserves and don’t demand is low spending multiplier
lend them out; sensitive to the is small
demand for money interest rate
is highly sensitive to
the interest rate
28
 Monetary Policy and Inflation
Monetary policy effects aggregate output only in the short run.
In the long run expansionary monetary policy (increase in the supply
of money) leads only to the rise in the price level, while real output
remains unchanged money is neutral.
This conclusion explains the view of classical economists on the
ineffectiveness of monetary policy and arises from the quantity equation:
M×V=P×Y
P LRAS
Under the assumptions of constant velocity of
money (V = const) and aggregate output equal
to potential output (Y = Y*), the increase in the P B
2
supply of money leads to proportional rise in
P1 A
the price level with no impact on real output
AD2
M × V = P × Y* AD1
Y* Y
29
 Problems Associated with Monetary Policy:
existence of side effects
When the сentral bank increases the supply of money,
the interest rate falls:

it decreases the opportunity costs of it lowers the desire of

holding money and may motivate commercial banks to give
public to convert funds from the bank loans that increases the
deposits into currency that increases banks’ excess reserves, and
the currency-deposit ratio hence the reserve ratio
(cr = СU/D) (rr = R/D)
1 cr
the money multiplier ( ) falls
cr rr
the monetary impulse becomes weaker.

30
 Problems Associated with Monetary Policy:
existence of side effects
Н cr2 rr2
M
cr2 1
cr1 rr1
M
Н2 C B cr1 1
Н1 А

1/mm2
1/mm1
М1 М3 М2 М

The increase in monetary base from Н1 to Н2 can lead to the increase

in the money stock from М1 to М2, if the size of the money
multiplier is unchanged, and only to М3, if the size of the money
multiplier falls (due to the rise in the currency-deposit ratio cr
and/or in the reserve ratio rr) from mm1 to mm2.
31
 Problems Associated with Monetary Policy:
contradictoriness of targets
The Central bank cannot simultaneously i (MS /Р) (MS /Р)
1 2
control both the supply of money МS and
the interest rate i. If the Central bank is
pegging the interest rate i, then each time i
2 В
when the demand for money goes up
(from (M/P)D1 to (M/P)D2), since the i1 А C
interest rate rises from i1 to i2, the Central (M/Р)D2
bank is forced to increase the supply of (M/Р)D1
money to MS2, and the latter becomes M M M
( )1 ( ) 2
endogenous variable, fully subject to the P P P
target of maintaining the constant level of As a result, monetary
the interest rate. And vice versa, if the policy may lead
Central bank targets the constant supply to the destabilization
of money, it loses the control over the of the economy.
interest rate. 32
The Problem of the Central Bank Independence

The Central bank cannot conduct the independent policy, and

the supply of money becomes the endogenous variable, if:
government forces the Central bank to finance its
increased expenditures via printing money;
there is the fixed exchange rate regime in the economy.

33
 Lecture 8
Fiscal and Monetary Policy:
Absolute and Comparative Effectiveness
• Fiscal Policy Mechanism
• Monetary Policy Mechanism
• Determinants of Absolute Effectiveness of
Fiscal and Monetary Policy
• Determinants of Comparative Effectiveness of
Fiscal and Monetary Policy
• Approaches to Macroeconomic Policy
 Fiscal Policy Mechanism:
the Liquidity Preference Approach
The increase in government purchases (G ) leads to the rise in
aggregate demand (AD ) and hence in output (Y ), that provokes the
increase in the real transaction (and thus in the overall) demand for
money (M/P)D . Because the supply of money is unchanged, there is
excess demand for money. Public starts to change the composition of
financial portfolio and to sell bonds in order to get currency, i.e.
increases the supply of bonds (BS ), that lowers the bonds price (PB )
and raises the rate of return of bonds. With higher opportunity costs of
holding money the quantity of money demanded falls, and the
equilibrium in the money market restores at higher level of the interest
rate (i ). The higher interest rate lowers the investment demand (I ),
because fewer investment projects now have the internal rate of return
that exceeds this increased interest rate and hence will not be financed
(= part of investment spending will be crowded out), aggregate demand
falls (AD ), firms will not be able to sell all that they produce, they
accumulate the stocks of unsold goods (IUN ) and decrease output
(Y ). But because the first round effect is larger than the second round
effect, output rises (Y ).
 Fiscal Policy Mechanism:
the Liquidity Preference Approach

Multiplier – Crowding-out Output

=
Effect Effect Effect

G AD IUN Y (M/Р)D
Y
BS PB i (= r) I AD IUN Y

Public changes the composition

of the financial portfolio in the situation
of the excess demand for money
 Fiscal Policy Mechanism via Deficit Spending
The increase in government purchases (G ) is usually financed by
borrowing from the public (= by issuing government bonds and selling
them in the bonds market), that increases the supply of bonds (BS ).
To make the purchase of government bonds attractive to the public,
government decreases their prices (PB ) that raises their rate of return
and thus increases the opportunity costs of holding money, that
decreases the quantity of money demanded the money market
equilibrium restores at a higher level of the interest rate (i ). The
higher interest rate causes crowding out of private firms’ investment
(I ) and other interest-sensitive private sector expenditures. The
decrease in aggregate expenditures (that is aggregate demand (AD )
causes the fall in real output (Y ). In the standard case it is suggested
that in the short run crowding-out is partial (second-round effect is
weaker than the first-round effect of the increase in G), and the
outcome of the expansionary fiscal policy is the increase in output
(Y ) output falls by less than initially rises.
 Fiscal Policy Mechanism via Deficit Financing

Multiplier – Crowding-out Output

=
Effect Effect Effect

AD IUN Y
G S Y
BG PB i (= r) I AD IUN Y

Government sells
government bonds =
borrowing from the public

5
Fiscal Policy Mechanism via Deficit Financing:
Alternative Explanation

Multiplier – Crowding-out = Output

Effect Effect Effect

AD IUN Y
G Y
FD r I AD IUN Y

Government increases the

demand for loanable funds

6
 Monetary Policy Mechanism:
Liquidity Preference Approach
When the central bank increases the supply of money (MS ), at the
initial level of the interest rate i1 and the initial level of output Y1
there is excess supply of money public begins to change the
composition of the financial portfolio and to buy bonds demand
for bonds increases (BD ) bonds price rises (PB ) the rate of
return on a bond goes down = opportunity costs of holding money
fall the quantity of money demanded increases, and the
equilibrium in the money market restores at a lower level of the
interest rate (i ) with a lower interest rate more investment
projects will have the internal rate of return (IRR), exceeding the
decreased interest rate and hence will be financed investment
demand rises (I ) that increases aggregate demand (AD ) the
stocks of unsold goods decline (IUN ), and aggregate output
increases (Y ).
7
 Monetary Policy Mechanism:
Liquidity Preference Approach

Liquidity Output
Effect Effect

MS BD PB i (= r) I AD IUN Y

Public changes the composition of

the financial portfolio in the situation
of the excess supply of money

8
 Monetary Policy Mechanism
via the Open Market Operations
The increase in the supply of money (MS ) is usually the result of
the expansionary open market operations, when the central bank
buys government bonds, that causes the increase in the demand for
bonds (BD ) in the bonds market. To make the sale of government
bonds attractive to the public and to the commercial banks, the
central bank raises bonds price (PB ), that cuts the rate of return,
which they yield, and thus decreases the opportunity costs of
holding money, that increases the quantity of money demanded
the money market equilibrium restores at a lower level of the
interest rate (i ). The lower interest rate stimulates investment
spending (I ) and other types of interest sensitive private sector
spending. The rise in aggregate demand (AD ) provokes firms to
expand output (Y ).
 Monetary Policy Mechanism
via the Open Market Operations

Liquidity Output
Effect Effect

MS = BD PB i (= r) I AD IUN Y

The Central bank buys

government bonds
in the open market

10
 Absolute and Comparative Effectiveness of
Fiscal and Monetary Policy
The effectiveness of any stabilization policy is estimated according to its
ability to cure the recessionary or the inflationary gap, i.e. to its
influence on the level of output (the key ultimate goal of an
expansionary policy) and on the price level (the key ultimate goal of a
contractionary policy).
The degree of the effect of both types of stabilization policy – fiscal and
monetary – is determined by the four following factors:
• the interest sensitivity of the investment demand (b);
• the value of the spending multiplier (multĀ);
• the interest sensitivity of the demand for money (h);
• the income sensitivity of the demand for money (k).
The first and the third parameters determine the
comparative effectiveness of fiscal and monetary
policies, while the second and the forth determine
their absolute effectiveness. 11
 Conditions for Absolute Effectiveness of
Monetary and Fiscal Policy

Monetary Policy Fiscal Policy

is Effective is Effective
Value of the High
spending
(the aggregate planned expenditure AEP curve
multiplier (multĀ)
is steep)
Income sensitivity Low
of the demand for (the shift of the money demand (M/P)D curve
money (k) in response to changes in output is small)

12
The Value of the Autonomous Spending Multiplier
AE AE =Y
B AE (mult )
P Ā2

B' AEP(multĀ1)
A
A'
multĀ2 > multĀ1

450
Y1' Y1Y2' Y2 Y
multĀ k h b
G AEP Y (M/P) D i (= r) I AEP Y
the larger is multĀ, the greater is the increase in Y in response to the rise in G

h b multĀ k
MS i (= r) I AEP Y (M/P)D i (= r) …
the larger is multĀ, the greater is the increase in Y in response to the rise in I13
The Value of Income Sensitivity of Money Demand
i MS/P i MS1/P MS2/P
k1 < k2 k1 < k2
i2 ' B'
i2 i1 A
B i3' B'
i1 A (M/P)D(Y2)(k2) i3 B (M/P)D(Y )(k )
2 2
(M/P)D(Y2)(k1) i2 (M/P)D(Y2)(k1)
(M/P)D(Y1) (M/P)D(Y1)
M/P M/P
multĀ k h b
G AEP Y (M/P)D i (= r) I AEP Y
the smaller is k, the smaller is the rise in i due to the increase in Y
and the smaller is the crowding-out effect
h b multĀ k
MS i (= r) I AEP Y (M/P)D i (= r) …
the smaller is k, the smaller is the rise in (M/P)D in response
to the increase in Y 14
 Conditions for Comparative Effectiveness of
Fiscal and Monetary Policy

Monetary Policy Fiscal Policy

is Effective is Effective
Interest sensitivity High Low
of the investment (the investment demand (the investment demand
demand (b) I curve is flat) I curve is steep)
Interest sensitivity Low High
of the demand for (the money demand (the money demand
money (h) (M/P)D curve is steep) (M/P)D curve is flat)

15
 Interest Sensitivity of the Investment Demand
Interest sensitivity of the investment demand shows the reaction of the
demand for investment to the changes in the interest rate and
graphically is represented by the slope of the investment demand curve.
Low interest sensitivity of High interest sensitivity of
the investment demand the investment demand
r I r I
b1 is low b2 is high
r r
r2 B r2 B
r1 r1 A
A
I(r)
1 I(r) 1
b1
b2
I2 I1 I I2 I1 I
A change in the interest rate causes A change in the interest rate causes
a small change in the demand for a large change in the demand for
investment (the I curve is steep). investment (the I curve is flat).
16
 The Value of Interest Sensitivity of
Investment Demand
r r

r2 B' B b1 < b2 b1 > b2

r1 A r1 A
r2 B' B
I(b2) I(b1)
I(b1) I(b2)
I2 ' I2 I1 I I1 I2 ' I2 I
multĀ k h b
G AEP Y (M/P)D i (= r) I AEP Y
the smaller is b, the smaller is the fall in I due to the rise in r
and the smaller is the crowding-out effect
h b multĀ
MS i (= r) I AEP Y
the larger is b, the greater is the increase in I in response to the fall
17 in r
 Interest Sensitivity of the Demand for Money
Interest sensitivity of the demand for money shows the reaction of
the demand for money to the changes in the interest rate and
graphically is represented by the slope of the money demand curve.
Low interest sensitivity of High interest sensitivity of
the demand for money the demand for money
i ( M / P )D i ( M / P )D
h1 is low h2 is high
i i
i1 A i1 A
i2 i2 B M D
B ( )
M D P
1 P)
(
1
h1 h2
M M M M D M D M
( ) D1 ( ) D 2 ( ) 1( ) 2
P P P P P P
A change in the interest rate causes A change in the interest rate causes
a small change in the demand for a large change in the demand for
money (the (M/P)D curve is steep). money (the (M/P)D curve is flat).18
 The Value of Interest Sensitivity of
Money Demand
i MS/P i MS1/P MS2/P
(M/P)D(Y1)(h2)
i2' B' (M/P)D(Y2)(h2)
i2 B
h1 > h2 i1 A h1 < h2
i1 A
i2 ' B'
(M/P)D(Y2)(h1) i2 B (M/P)D(h2)
(M/P)D(Y1)(h1) (M/P)D(h1)
M/P M/P
multĀ k h b
G AEP Y (M/P)D i (= r) I AEP Y
the larger is h, the smaller is the rise in i due to the increase in (M/P)D
and the smaller is the crowding-out effect
h b multĀ
MS i (= r) I AEP Y
the smaller is h, the larger is the fall in i
(= greater liquidity effect) as a result of the increase in MS 19
 Approaches to Macroeconomic Policy
Keynesians versus
believe demand for money is
highly sensitive to the changes in
the interest rate, because pay
much attention to the speculative
motive of holding money, highly
responsive to the changes in the
interest rate in the bonds market;
suggest demand for investment
is primarily determined by business
confidence rather than by the level
of the interest rate and thus almost
insensitive to the changes in the
interest rate;
consider fiscal policy to be the
main to stabilize the economy.
Monetarists
believe demand for money is
low sensitive to the changes in the
interest rate, because consider the
key purpose to hold money the
transaction motive, responsive to
the changes in real output, rather
than in the interest rate;
suggest demand for investment
is highly sensitive to the changes in
the interest rate, which is supposed
to be the major determinant of the
investment spending;
consider monetary policy to be
most important in the stabilization
of the economy. 20
 Monetary Policy: Monetarist View
As the demand for money is insensitive to the interest rate, an increase
in money supply leads to the essential fall in the interest rate, that under
the condition of high responsiveness of investment demand to the
interest rate causes the great increase in investment and in turn in output.
Money Market Investment Demand Keynesian Cross
M S1 M S 2
r AE=Y
i AE B
P P
AEР(I2)
i1 A r1 A

B AEР(I1)
i2 B r2 I(r) I
M D A
( )
P
M D M D M I1 I2 I Y1 Y2 Y
( ) 1( ) 2
P P P
Under the assumptions of monetarists
monetary policy is very effective 21
 Monetary Policy: Keynesian View
As the demand for money is highly sensitive to the interest rate, an
increase in money supply leads to a very small fall in the interest rate,
that under the condition of low responsiveness of investment demand to
the interest rate causes almost no change in investment and thus in output
Money Market Investment Demand Keynesian Cross
M S1 M S 2 r
i AE
P P
AE=Y
AEР(I2)
i1 A r1 A B AEР(I1)
i2 r2 B
B A
M D I(r)
( )
P
M M M I1 I2 I Y1 Y2 Y
( ) D1 ( ) D 2
P P P
Under the assumptions of Keynesians
monetary policy is ineffective 22
 Fiscal Policy: Keynesian View
As the demand for money is highly sensitive to the interest rate, an
increase in the demand for money caused by the increase in output due
to the fiscal expansion leads to a small change in the interest rate, that
under the condition of low responsiveness of investment demand to the
interest rate almost doesn’t change investment spending. Crowding-out
is minimal. Output increases by nearly the full multiplier.
Keynesian Cross Money Market Investment Demand
AE AE=Y MS
AEP(G2,I1) i P
r
B AEP(G2,I2)
C
AEP(G1,I1)
B
( ) (Y2 ) r2
I i2 B M D
G i1 P r1 A
A A
(
M D
) (Y1 )
I(r)
P
Y1 Y3Y2 Y M M I2 I1 I
P P
Under the assumptions of Keynesians
fiscal policy is very effective 23
 Fiscal Policy: Monetarist View
As the demand for money is insensitive to the interest rate, an increase
in the demand for money caused by the increase in output due to the
fiscal expansion leads to an essential rise in the interest rate, that under
the condition of high responsiveness of investment demand to the
interest rate ends in a great fall in the investment spending. There is
nearly full crowding-out, and the increase in output is minimal.
Keynesian Cross Money Market Investment Demand
AE AE=Y M S

B AEP(G2,I1) i r
P

I
AEP(G2,I2) i2 B r2 B
AEP(G1,I1)
GC A
i1 A r1
M
( ) D (Y2 ) I(r)
A M PD
( ) (Y1 )
P M
Y1Y3 Y2 Y I2 I1 I
P
Under the assumptions of monetarists
fiscal policy is ineffective 24
 Lecture 8
Fiscal and Monetary Policy:
Absolute and Comparative Effectiveness
• Fiscal Policy Mechanism
• Monetary Policy Mechanism
• Determinants of Absolute Effectiveness of
Fiscal and Monetary Policy
• Determinants of Comparative Effectiveness of
Fiscal and Monetary Policy
• Approaches to Macroeconomic Policy
 Fiscal Policy Mechanism:
the Liquidity Preference Approach
The increase in government purchases (G ) leads to the rise in
aggregate demand (AD ) and hence in output (Y ), that provokes the
increase in the real transaction (and thus in the overall) demand for
money (M/P)D . Because the supply of money is unchanged, there is
excess demand for money. Public starts to change the composition of
financial portfolio and to sell bonds in order to get currency, i.e.
increases the supply of bonds (BS ), that lowers the bonds price (PB )
and raises the rate of return of bonds (= the rate of interest). With
higher opportunity costs of holding money the quantity of money
demanded falls, and the equilibrium in the money market restores at
higher level of the interest rate (i ). The higher interest rate lowers the
investment demand (I ), because fewer investment projects now have
the internal rate of return (IRR) that exceeds this increased interest rate
and hence will not be financed (= part of investment spending will be
crowded out), aggregate demand falls (AD ), firms will not be able to
sell all that they produce, they accumulate the stocks of unsold goods
(IUN ) and decrease output (Y ). But because the first round effect is
larger than the second round effect, output rises (Y ).
 Fiscal Policy Mechanism:
the Liquidity Preference Approach

Multiplier – Crowding-out Output

=
Effect Effect Effect

G AD IUN Y (M/Р)D
Y
BS PB i (= r) I AD IUN Y

Public changes the composition

of the financial portfolio in the situation
of the excess demand for money
 Fiscal Policy Mechanism via Deficit Spending
The increase in government purchases (G ) is usually financed by
borrowing from the public (= by issuing government bonds and selling
them in the bonds market), that increases the supply of bonds (BS ).
To make the purchase of government bonds attractive to the public,
government decreases their prices (PB ) that raises their rate of return
(= the rate of interest) and thus increases the opportunity costs of
holding money, that decreases the quantity of money demanded the
money market equilibrium restores at a higher level of the interest rate
(i ). The higher interest rate causes crowding out of private firms’
investment (I ) and other interest-sensitive private sector expenditures.
The decrease in aggregate expenditures (that is aggregate demand
(AD ) causes the fall in real output (Y ). In the standard case it is
suggested that in the short run crowding-out is partial (second-round
effect is weaker than the first-round effect of the increase in G), and
the outcome of the expansionary fiscal policy is the increase in output
(Y ) output falls by less than initially rises.
 Fiscal Policy Mechanism via Deficit Financing

Multiplier – Crowding-out Output

=
Effect Effect Effect

AD IUN Y
G S Y
BG PB i (= r) I AD IUN Y

Government sells
government bonds =
borrowing from the public

5
Fiscal Policy Mechanism via Deficit Financing:
Alternative Explanation

Multiplier – Crowding-out = Output

Effect Effect Effect

AD IUN Y
G Y
FD r I AD IUN Y

Government increases the

demand for loanable funds

6
 Monetary Policy Mechanism:
Liquidity Preference Approach
When the central bank increases the supply of money (MS ), at the
initial level of the interest rate i1 and the initial level of output Y1
there is excess supply of money public starts to change the
composition of the financial portfolio and to buy bonds the
demand for bonds increases (BD ) the bonds price rises (PB )
the rate of return on a bond (= the rate of interest) goes down =
opportunity costs of holding money fall the quantity of money
demanded increases, and the equilibrium in the money market
restores at a lower level of the interest rate (i ) with a lower
interest rate more investment projects will have the internal rate of
return (IRR) that exceeds the decreased interest rate, and hence will
be financed the investment demand rises (I ) that increases
aggregate demand (AD ) the stocks of unsold goods decline
(IUN ), and aggregate output increases (Y ).
7
 Monetary Policy Mechanism:
Liquidity Preference Approach

Liquidity Output
Effect Effect

MS BD PB i (= r) I AD IUN Y

Public changes the composition of

the financial portfolio in the situation
of the excess supply of money

8
 Monetary Policy Mechanism
via the Open Market Operations
The increase in the supply of money (MS ) is usually the result of
the expansionary open market operations, when the central bank
buys government bonds, that causes the increase in the demand for
bonds (BD ) in the bonds market. To make the sale of government
bonds attractive to the public and to the commercial banks, the
central bank raises the bonds price (PB ), that cuts the rate of
return (= the rate of interest), which they yield, and thus decreases
the opportunity costs of holding money, that increases the quantity
of money demanded the money market equilibrium restores at a
lower level of the interest rate (i ). The lower interest rate
stimulates investment spending (I ) and other types of interest
sensitive private sector spending. The rise in aggregate demand
(AD ) provokes firms to expand output (Y ).
 Monetary Policy Mechanism
via the Open Market Operations

Liquidity Output
Effect Effect

MS = BD PB i (= r) I AD IUN Y

The Central bank buys

government bonds
in the open market

10
 Absolute and Comparative Effectiveness of
Fiscal and Monetary Policy
The effectiveness of any stabilization policy is estimated according to its
ability to cure the recessionary or the inflationary gap, i.e. to its
influence on the level of output (the key ultimate goal of an
expansionary policy) and on the price level (the key ultimate goal of a
contractionary policy).
The degree of the effect of both types of stabilization policy – fiscal and
monetary – is determined by the four following factors:
• the interest sensitivity of the investment demand (b);
• the value of the spending multiplier (multĀ);
• the interest sensitivity of the demand for money (h);
• the income sensitivity of the demand for money (k).
The first and the third parameters determine the
comparative effectiveness of fiscal and monetary
policies, while the second and the forth determine
their absolute effectiveness. 11
 Conditions for Absolute Effectiveness of
Monetary and Fiscal Policy

Monetary Policy Fiscal Policy

is Effective is Effective
Value of the High
spending
(the aggregate planned expenditure AEP curve
multiplier (multĀ)
is steep)
Income sensitivity Low
of the demand for (the shift of the money demand (M/P)D curve
money (k) in response to changes in output is small)

12
The Value of the Autonomous Spending Multiplier
AE AE =Y
B AE (mult )
P Ā2

B' AEP(multĀ1)
A
A'
multĀ2 > multĀ1

450
Y1' Y1Y2' Y2 Y
multĀ k h b
G AEP Y (M/P) D i (= r) I AEP Y
the larger is multĀ, the greater is the increase in Y in response to the rise in G

h b multĀ k
MS i (= r) I AEP Y (M/P)D i (= r) …
the larger is multĀ, the greater is the increase in Y in response to the rise in I
The Value of Income Sensitivity of Money Demand
i MS/P i MS1/P MS2/P
k1 < k2 k1 < k2
i2 ' B'
i2 i1 A
B i3' B'
i1 A (M/P)D(Y2)(k2) i3 B (M/P)D(Y )(k )
2 2
(M/P)D(Y2)(k1) i2 (M/P)D(Y2)(k1)
(M/P)D(Y1) (M/P)D(Y1)
M/P M/P
multĀ k h b
G AEP Y (M/P)D i (= r) I AEP Y
the smaller is k, the smaller is the rise in i due to the increase in Y
and the smaller is the crowding-out effect
h b multĀ k
MS i (= r) I AEP Y (M/P)D i (= r) …
the smaller is k, the smaller is the rise in (M/P)D in response
to the increase in Y 14
 Conditions for Comparative Effectiveness of
Fiscal and Monetary Policy

Monetary Policy Fiscal Policy

is Effective is Effective
Interest sensitivity High Low
of the investment (the investment demand (the investment demand
demand (b) I curve is flat) I curve is steep)
Interest sensitivity Low High
of the demand for (the money demand (the money demand
money (h) (M/P)D curve is steep) (M/P)D curve is flat)

15
 Interest Sensitivity of the Investment Demand
Interest sensitivity of the investment demand shows the reaction of the
demand for investment to the changes in the interest rate and
graphically is represented by the slope of the investment demand curve.
Low interest sensitivity of High interest sensitivity of
the investment demand the investment demand
r I r I
b1 is low b2 is high
r r
r2 B r2 B
r1 r1 A
A
I(r)
1 I(r) 1
b1
b2
I2 I1 I I2 I1 I
A change in the interest rate causes A change in the interest rate causes
a small change in the demand for a large change in the demand for
investment (the I curve is steep). investment (the I curve is flat).
16
 The Value of Interest Sensitivity of
Investment Demand
r r

r2 B' B b1 < b2 b1 > b2

r1 A r1 A
r2 B' B
I(b2) I(b1)
I(b1) I(b2)
I2 ' I2 I1 I I1 I2 ' I2 I
multĀ k h b
G AEP Y (M/P)D i (= r) I AEP Y
the smaller is b, the smaller is the fall in I due to the rise in r
and the smaller is the crowding-out effect
h b multĀ
MS i (= r) I AEP Y
the larger is b, the greater is the increase in I in response to the fall
17 in r
 Interest Sensitivity of the Demand for Money
Interest sensitivity of the demand for money shows the reaction of
the demand for money to the changes in the interest rate and
graphically is represented by the slope of the money demand curve.
Low interest sensitivity of High interest sensitivity of
the demand for money the demand for money
i ( M / P )D i ( M / P )D
h1 is low h2 is high
i i
i1 A i1 A
i2 i2 B M D
B ( )
M D P
1 P)
(
1
h1 h2
M M M M D M D M
( ) D1 ( ) D 2 ( ) 1( ) 2
P P P P P P
A change in the interest rate causes A change in the interest rate causes
a small change in the demand for a large change in the demand for
money (the (M/P)D curve is steep). money (the (M/P)D curve is flat).18
 The Value of Interest Sensitivity of
Money Demand
i MS/P i MS1/P MS2/P
(M/P)D(Y1)(h2)
i2' B' (M/P)D(Y2)(h2)
i2 B
h1 > h2 i1 A h1 < h2
i1 A
i2 ' B'
(M/P)D(Y2)(h1) i2 B (M/P)D(h2)
(M/P)D(Y1)(h1) (M/P)D(h1)
M/P M/P
multĀ k h b
G AEP Y (M/P)D i (= r) I AEP Y
the larger is h, the smaller is the rise in i due to the increase in (M/P)D
and the smaller is the crowding-out effect
h b multĀ
MS i (= r) I AEP Y
the smaller is h, the larger is the fall in i
(= greater liquidity effect) as a result of the increase in MS 19
 Fiscal Policy is Effective
When the demand for money is highly sensitive to the interest rate,
an increase in the demand for money caused by the increase in
output due to the fiscal expansion leads to a small change in the
interest rate, that under the condition of low responsiveness of
investment demand to the interest rate almost doesn’t change
investment spending. Crowding-out is minimal. Output increases by
nearly the full multiplier.
Keynesian Cross Money Market Investment Demand
AE AE=Y MS
AEP(G2,I1) i P
r
B AEP(G2,I2)
C
AEP(G1,I1)
B
( ) (Y2 ) r2
I i2 B M D
A
G i1 P r1 A
A
(
M D
) (Y1 )
I(r)I
P
Y1 Y3Y2 Y M M I2 I1 I
P P 20
 Fiscal Policy is Ineffective
When the demand for money is low sensitive to the interest rate,
an increase in the demand for money caused by the increase in
output due to the fiscal expansion leads to an essential rise in the
interest rate, that under the condition of high responsiveness of
investment demand to the interest rate ends in a great fall in the
investment spending. There is nearly the complete crowding-out,
and the increase in output is minimal.
Keynesian Cross Money Market Investment Demand
AE AE=Y MS
B AEP(G2,I1) i r
P

I AE (G ,I ) i B B
P 2 2 2 r2
AEP(G1,I1)
GC A
i1 A r1
A M
( ) D (Y2 )
I(r)
M PD
( ) (Y1 )
P M
Y1Y3 Y2 Y I2 I1 I
P 21
 Monetary Policy is Effective
When the demand for money is low sensitive to the interest rate,
an increase in money supply leads to the essential fall in the interest
rate, that under the condition of high responsiveness of investment
demand to the interest rate causes the great increase in investment
spending and in turn in output.
Money Market Investment Demand Keynesian Cross
M S1 M S 2
r AE=Y
i AE B
P P
AEР(I2)
i1 A r1 A

B I AEР(I1)
i2 B r2 I(r) A
M
( )D Y
P
M D M D M I1 I2 I Y1 Y2
( ) 1( ) 2
P P P 22
 Monetary Policy is Ineffective
When the demand for money is highly sensitive to the interest rate,
an increase in money supply leads to a very small fall in the interest
rate, that under the condition of low responsiveness of investment
demand to the interest rate causes almost no change in investment
spending and thus in output
Money Market Investment Demand Keynesian Cross
M S1 M S2 r
i AE
P P
AE=Y
AEР(I2)
i1 A r1 A B AEР(I1)
B A
i2 r2
B
M I(r)
( )D
P
M M M I1 I2 I Y1 Y2 Y
( ) D1 ( ) D 2
P P P
23
 Lecture 9
Labour Market Equilibrium and Aggregate Supply
• Demand for Labour & Supply of Labour
• Equilibrium in the Labour Market
• Aggregate Supply in the Long run
• Aggregate Supply in the Short run
• Modern Models of the Short-run Aggregate Supply
 Aggregate Supply
Aggregate supply refers to the total output of goods and services
that all the firms in the economy want produce, assuming that
they can sell all that they wish to sell.
Aggregate supply thus depends on the decisions of firms to use
workers and all other inputs in order to produce goods and
services to sell to households, government and other firms,
as well as for export.

In order to construct aggregate

supply curve in the (P – Y) space,
we need to relate aggregate
supply to the price level.

2
 The Aggregate Supply Curves
There are two types of such curves:
the long-run aggregate supply (LRAS) curve relates
the price level to total quantity of output supplied when
all markets have fully adjusted to the existing price
level, hence when all prices both for goods and for
factors of production are flexible.
the short-run aggregate supply (SRAS) curve relates the price level
to the quantity that firms would like to produce and to sell on the
assumption that the prices of all factors of production remain
constant, while goods prices can be either constant or flexible.

The aggregate supply relation is derived from the behavior

of prices and wages.
 The Production Function
Output is determined by the production function that shows the
amount of goods and services which can be produced in the economy
with the existing quantity of labour (L) and of capital (K) available to
the producers and the existing technology (A):
Y = AF(L, K)
Since in the short run and in the medium run the stock of capital and the
level of technology are assumed to be constant, the major factor input
to produce output is labour. Then the production function shows the
amount of output that each additional worker can produce. The slope
of this production function equals to the marginal product of labour:
when labour increases by 1 unit, output Y increases by MPL units.
Y Diminishing MPL – – The higher is the number of workers
Y=АF(L,К) hired by firms (L2 > L1), the more
Y2 B
output is produced in the economy
MPL
Y1 A (Y2 > Y1). Hence to understand and
1
to derive aggregate supply we need
L L L to examine the labour market.
2
 The Demand for Labour
The demand for labour comes from firms. Firms
would hire additional workers up to the moment
when the marginal revenue product of labour
becomes equal to the marginal cost of labour.
The maximizing profit condition for the competitive firm is:
MR = MC or P × MPL = W
Thus, the function of demand for labour
is the function of the marginal product of labour:
LD = LD (MPL)
Since MPL falls with each extra worker, hired by a firm,
𝑊
and MPL = , the demand for labour is the
𝑃
decreasing function of the real wage:

LD = LD (W/P)
–
 The Labour Demand Curve
Hiring additional workers (L2 >L1) will
raise output (Y2 > Y1), but the extra
Y
– – amount each new worker can produce is
Y3 Y=АF(L,К) less than the output of the last worker
Y2 B
C hired, i.e. marginal product of labour
Y1 A diminishes (MPL2 < MPL1). Since firms
will hire workers until the real wage is
equal to the marginal product of
L labour, the labour demand (L ) curve is
D
L1 L2 L3
the same as the MPL curve.
MPL 𝑊
𝑃

MPL1 A (W/P)1 A
MPL2 B
C
(W/P)2 B
MPL (W/P)3
C LD
MPL3
L1 L2 L3 L L1 L2 L3 L
The Slope and Shifts of the Labour Demand Curve
𝑊
The labour demand (LD) curve has a

negative slope that reflects the negative

𝑃
relation of the quantity of labour
𝑊 demanded by firms to the real wage.
( )2 B 𝑊 𝑊
𝑃
A The higher is the real wage (( )2 > ( )1),
𝑊 𝑃 𝑃
( )1 LD the smaller number of workers will be
𝑃
hired by firms (L < L1) (movement from
L2 L1 L point A to point B2 along the LD curve).
The shifts of the labour demand curve 𝑊
are determined by all factors that change 𝑃
the marginal product of labour, such as:
𝑊
changes in the stock of capital and ( )2 A A'
𝑃
other economic resources, and/or 𝑊 B B'
changes in technology, ( )1 LD 2
𝑃
i.e. anything that shifts the production LD 1
function. It means, at each level of the L1 L2 L1' L2' L
real wage firms will hire more workers.
 The Supply of Labour
Labour is supplied by households. When making a
decision whether to work or not to work households
choose between labour and leisure. The only thing, that can enforce
them to choose labour, is the size of compensation which they can
receive for this sacrifice, i.e. the real wage. (We assume, that
households have no money illusions, and never mix nominal
(money) income (nominal wage, W) with real income (or the
𝑊
purchasing power of the nominal sum received, ). The higher is
𝑃
the real wage, the higher will be the willingness of households to
work and the greater will be the opportunity costs of leisure.
Hence the supply of labour is the
increasing function of the real wage:

LS = LS(W/P)
+
To work? Or not to work?
The Labour Supply Curve The labour supply (LS) curve has a
positive slope that reflects the
𝑊 LS positive relation between the real
𝑃 wage and the desire of people to
𝑊 B work. The higher is the real wage
( )2 𝑊 𝑊
𝑃 (( )2 > ( )1) = the higher is the
𝑊 A 𝑃 𝑃
( )1 compensation for the denial of
𝑃
idleness, the larger number of
workers will be eager to be hired
(L2 > L1) (movement along the LS
L1 L2 L curve from A to B).
The shifts of the labour supply curve are 𝑊
L S
1
LS2
determined by all factors that increase the 𝑃
amount of labour supplied at the existing
𝑊
market level of the real wage, such as: ( )1 A A'
𝑃
increase in the population of the working age;
increase in the labour force participation rate;
immigration;
decline in welfare;
expected future fall in the real wage, etc. L1 L1' L
 The Equilibrium in the Labour Market
The labour market equilibrium occurs when the quantity of labour
demanded by firms equals the quantity of labour supplied by
households, and graphically corresponds to the intersection of the
labour demand and the labour supply curves, resulting in the
𝑊
equilibrium real wage level ( )E and equilibrium amount of labour LE.
𝑃
𝑊
𝑃 LD LS
Equilibrium condition:
L D = LS
𝑊
( )E
𝑃

LE L
It is assumed that LE = LF, that is all the workers who want to work
𝑊
at the existing in the labour market equilibrium real wage ( )E,
𝑃
will find a job unemployment is at its natural level.
 Changes in the Labour Market Equilibrium
Increase in the Demand for Labour Increase in the Supply of Labour
𝑊 LD 1 LD 2 LS 𝑊 LD LS1 LS
𝑃 𝑃 2

𝑊
( )2 B
𝑃 𝑊
𝑊 ( )2 A
( )1 A 𝑃
𝑃 𝑊 B
( )1
𝑃
L1 L2 L L1 L2 L
= rightward shift of the LD curve = rightward shift of the LS curve
the cause: increase in MPL the cause: increase in the number of
(= marginal benefit from each workers, willing to work
extra worker ) real wage competition for jobs nominal
amount of labour supplied wage real wage amount of
by households labour demanded by firms
= movement along the LS curve = movement along the LD curve
increase in L increase in L
 Aggregate Supply in the Long Run and
in the Short Run
The assumptions for the economy behavior in the long run and
in the short run are different.

In the long run all prices
are fully flexible
both for goods and for factors
of production (nominal wages),
and change proportionally, and
information is symmetric.
In the short run there can be
nominal rigidities
both in the goods market and
especially in the labour market
(nominal wages are fixed in labour
contracts), and
asymmetry of information is possible.

That is why aggregate supply curve has different shapes

in the long run and in the short run.
Restoration of Equilibrium in the Labour Market
Assume, initially the economy is at the full employment level (point A)
𝑊1
= all workers, who want to work at the equilibrium real wage , have jobs.
𝑃1
Suppose, the price level (P) decreases (P2 < P1) the real wage will rise
𝑊
to 1. At this higher wage firms will want to hire the number of workers
𝑃2
L , while households will supply the amount of labour LS. The difference
D

between these amounts (= BC) is unemployment (U). Unemployed

workers will agree to work at a lower nominal wage. Besides the power
Demand higher wages under Supply
of trade-unions to negotiate the condition of high
unemployment is very low. Thus, nominal wage will start to fall.
𝑊 In the long run the nominal wage will
LD LS
𝑃 fall proportionally to the fall in the price
𝑊1 B C
level the real wage will return to its
𝑃2 𝑊1 𝑊2
𝑊1 𝑊2 A initial level: = the equilibrium
𝑃1
= 𝑃2
𝑃1 𝑃2
U of the labour market will restore at the
full employment level (LF).
LD LF LS L
Aggregate Supply in the Long Run In the long run
aggregate supply
curve (LRAS curve)
Y Y is vertical at the full
Y=Y
– – employment (potential
Y=АF(L,К) or natural) level of
Y* Y* output (Y*), that
reflects production
450 possibilities of the
LF L Y* Y economy.

Investment Goods
𝑊 P LRAS
𝑃 LD LS

PPF
𝑊
𝑃

LF L Y* Y Consumption Goods
 The Long-run Aggregate Supply Curve

P LRAS Changes in the price level can’t influence

the level of output, because it is
P2 B determined by the quantity and quality
(productivity) of economic resources and
P1 A the existing level of technology, and
correspond to the movement along the
Y* Y LRAS curve (from point A to point B).

In the long run all prices change proportionately to each other,

and real variables (real output, real income, real wages, etc.)
remain unchanged.
 Shifts of the Long-run Aggregate Supply Curve
The LRAS curve shifts
Y – Y when there is a change in:
Y=АF(L,К2) Y=Y
В
the quantity and
– В
Y*2 Y=АF(L,К1)Y*2 quality of economic
Y*1 Y*1 А resources (labour L,
А physical capital K,
human capital H,
450
natural resources N);
LF L Y*1 Y*2 Y technological
P progress A, that
LRAS1 LRAS2
increases the
productivity of
resources
government policy
that provides larger
incentives to work and
Y*1 Y*2 Y to invest in capital or
technology.
Long-run Aggregate Supply and Economic Growth
The sustained rise in the potential level of output
(the rightward shift of the LRAS curve)
corresponds to the economic growth
= the increase in the production possibilities of the economy
(the rightward shift of the PPF curve).
Investment Goods

P LRAS1 LRAS2

PPF2
PPF1

Consumption Goods Y*1 Y*2 Y

 Points off the Long-run Aggregate Supply Curve

P LRAS Any point to the right from the LRAS curve

(such as point В) is unattainable for the
economy in the long run, because with the
D В
existing amount of economic resources and
the level of technology firms are incapable
to produce this level of output.
Y* Y

Investment Goods
Any point to the left from the LRAS
curve (such as point D) implies lower В
than full (= ineffective) employment of
economic resources, that corresponds D PPF
to a recession or a slump.
Consumption Goods
 The Vertical Aggregate Supply Curve
The conditions for the aggregate supply curve
to be vertical are:
fully flexible prices and wages;
perfect information;
rational expectations.
Under the assumption that all there conditions are fulfilled in the short
run (as in the Classical model or in the Rational expectations theory),
even in the short run the aggregate supply curve can be vertical
output is always at its potential (full-employment) level (Y = Y*),
and unemployment is at its natural level (u = u*).
But in practice there are price rigidities both in the goods market and
especially in the labour market, and information is asymmetric.
Therefore, in the short run real output can deviate
from its potential level (Y Y*).
 Aggregate Supply in the Short Run

The first economist, who examined the economy’s behavior

in the short run in order to explain the Great Depression
and to find the remedy to fight prolonged recessions,
was J.M.Keynes.
The important assumptions of his model are:
resource prices (nominal wage W) are rigid;
goods prices Р are rigid as well (this assumption can be
applied not only to depressive economy, but is a reasonable
preposition for a normal economy, but for rather short
periods of time).
 Aggregate Supply in the Short Run:
the Keynesian Case
Under the assumption of rigid prices short-run aggregate supply (SRAS)
𝑊
is horizontal. Since Р = const and W = const, then = const, and
𝑃
the demand for labour curve LD at some range is horizontal.
The supply of labour LS doesn’t matter, because during a depression
with the employment of resources substantially less than full, firms
can hire any number of workers without raising nominal wages and
would produce such level of output, which is demanded in the
economy.
Since at some range of the curve MPL = const, the production function
graph at this range has a linier shape.
Aggregate Supply in the Short Run: The increase in
the case of rigid prices output will occur only
due to the increase in
Y Y aggregate demand.
– – Y=Y When economic agents
Y=АF(L,К)
B B
wish to buy the amount
Y2 Y2 of goods and services
A A
Y1 Y1 equal to Y2, rather than
to Y1, firms will
450
increase the demand for
L1 L2 L Y1 Y2 Ylabour under the constant
𝑊 P 𝑊
𝑃 nominal wage .
𝑃
AD1 AD2 Since the costs of
𝑊 LD production stay
A B SRAS unchanged, firms will
𝑃 A B P
not change prices for
their goods. Output will
L1 L2 L Y1 Y2 Y grow under the constant
price level 𝑃.
 Aggregate Supply in the Short Run:
the case of flexible goods prices & rigid resource prices

Contemporary economy in the short run is characterized by

flexible (rather than rigid) prices for goods and by rigid
prices for economic resources (rigid nominal wage W).
Under these assumptions short-run aggregate supply (SRAS)
curve must have a positive slope. It implies that the amount
of output supplied by firms positively depends from the
changes in the price level P.
Hence, the short-run aggregate supply curve shows the amount
of output, which firms wish to produce and to supply in the
goods market at each price level.
 Aggregate Supply in the Short Run:
the case of flexible goods prices & rigid resource prices
Y Y Under the assumption
Y=Y of the rigid nominal
– –
Y=АF(L,K) B wage W1 (= constant
Y2 B Y2
A costs of production
Y* Y* A
for firms)
450
the increase in the
price level
LF L2 L Y
Y* 2 Y (from P1 to P2)
𝑊 P LRAS
𝑃 LD decreases the real
SRAS wage, that stimulates
𝑊1 P2 B firms to hire more
A
A workers (L2) and to
𝑃1
B P1 produce more output
𝑊1
𝑃2 output rises to Y2.
LF L2 L Y* Y2 Y
 The Slope of the Short-run
Aggregate Supply Curve
The short-run aggregate supply curve has a
P positive slope, because with the unchanged
SRAS
costs of production (rigid nominal wage W) the
P2 B higher price level makes profitable for firms to
P1 A increase output. Since higher output ensures to
hire additional workers, each of whom is less
productive than the previous one, real wage
Y1 Y2 Y must fall to stimulate firms to produce more
and hence the price level must rise.
For example, the increase in the price level from P1 to P2, while the
nominal costs remain constant, leads to higher employment and
output (Y rises from Y1 tо Y2) (= movement along the SRAS curve
from point A to point B). The larger is the fall in productivity with
each extra worker, the steeper is the SRAS curve.
 Shifts of the Short-run Aggregate Supply Curve
Along the SRAS curve:
nominal wage (W) and prices of other inputs
are rigid;
determinants of labour demand (characterized
by the production function) are fixed.

The shifts of the SRAS curve are caused by:

changes in the firms’ costs of production that
induce firms to produce more or less at each
P
level of prices: when the costs of production SRAS1 SRAS2
fall, the SRAS curve shifts to the right, because
firms wish to produce more output at each price
level, while when the costs of production rise,
the SRAS curve shifts to the left.
any changes that shift the production function
and influences labour productivity.
Y
 Shifts of the SRAS Curve:
an increase in the nominal wage
Y Y When the nominal
Y=Y wage increases from
– –
Y=АF(L,К) B W1 to W2, under the
Y2 B Y2
A price level P2
Y1 Y1 A workers become
450
more expensive
firms hire fewer
L1 L2 L Y1 Y2 Y workers (movement
𝑊 P along the LD curve)
𝑃 SRAS(W2) and produce fewer
LD SRAS(W1)
goods and services:
P2 A'
𝑊2 𝑊
B output falls from Y2
= 1 A, A'
𝑃2 𝑃1 P1 A to the initial level Y1
B
𝑊1 (leftward shift of the
𝑃2
SRAS curve).
L1 L2 L Y1 Y2 Y
 Determinants of Aggregate Supply
in the Short Run
Factors, that affect aggregate supply in the short run and that
hence shift the SRAS curve, include all the changes, which
influence the firms’ costs of production and the quantity and
quality of resources used by firms:
Resource prices – nominal wages and other input prices;
Amount of resources – labour supply, changes in the stock of
capital due to investment, new discoveries of raw materials;
Resource productivity – primarily labour productivity due to
improvements in education and/or training;
Technological advances – which reduce costs of the unit of
output;
 Determinants of Aggregate Supply
in the Short run
Inflationary expectations;
Government policies, such as:
changes in taxes;
deregulation (= reduction of the number of civil servants);
reforms in welfare or unemployment insurance programs;
investment tax credit, direct subsidies to firms, etc;
Weather and natural disasters;
Social & political disturbances, such as wars, revolutions,
military coup d’états, etc.
 Points off the SRAS Curve
Since the SRAS curve shows different combinations of output Y and
the price level P that correspond to the profit maximization
condition, any point off the SRAS curve will not be chosen by firms.
Points to the right from the SRAS curve (such as point C) imply
firms produce too much, hiring workers, whose marginal product of
labour is lower than their real wage. Firms can increase profits by
decreasing output.
P Points to the left from the SRAS
SRAS
curve (point D, for example) imply
firms produce too little, because
P2 D B
A additional workers can be hired,
P1 C
whose marginal product of labour
exceeds their real wage. Firms can
increase profits by increasing output.
Y1 Y2 Y
 The Short-run Aggregate Supply Curve:
Modern Explanations
In the modern macroeconomic theory the positive slope of the short run
aggregate supply curve is explained by the changes in expectations.
There are four such kind of models:
the sticky-wage model;
the workers’ misperception model (often called the «fooling model»);
the imperfect-information model (also known as the «island model»);
the sticky-price model.
The two former models explain the possible deviation
of actual output (Y) in the short run period from its potential level (Y*)
by the imperfections in the labour market and by the mistakes of workers,
while the two latter models explain this phenomena
by the imperfections in the goods market and by the mistakes of firms.
 Types of Expectations

Static Adaptive Rational

– expectations – expectations – expectations that suggest:
that are equal that are based on people use all available
information to forecast future
to the inflation the principle and never make systematic
of the «learning mistakes: «Nobody treads on
previous year on mistakes» the rake twice»

Pet = Pt –1 Pet = Pet –1 + × (Pt –1 – Pet –1 ) Pet = Pt (x1 , x2 , x3 ,…)

Backward-looking Expectations Forward-looking Expectations

(Static expectations are the kind of
adaptive expectations when α = 0).
 The Sticky-Wage Model
The foundation of this model was laid by Keynes and later it
was completed by Stanley Fisher.
The stickiness of nominal wage arises from the specific institutional
features of the modern economy: ▪ labor contracts system; ▪ trade-
unions activity; ▪ government minimal wage laws; ▪ the maintenance of
sufficiently high wages by firms viewed as an instrument of motivation
and high productivity of workers (efficiency wage theory), etc.
According to this model, if the nominal wage is sticky (𝑊 ) , while
prices for goods (Р) are flexible, the unexpected rise in the price level
𝑊
(P ) leads to the fall in the real wage ( ). Because labour becomes
𝑃
cheaper, firms hire more workers (L ). Larger number of workers,
engaged in the production process, produce more output (Y ) in the
short run (until workers renegotiate their labour contracts) output can
exceed its potential level (YSR > Y*) SRAS curve has a positive slope.
 The Sticky-Wage Model
The model is based on the assumption of static expectations. It is also
assumed that workers have no money illusions and never mix their
nominal wage with the real wage. The workers’ mistakes arise from
the fact, that prices increase unexpectedly for them. When signing
labour contracts and calculating the real wage workers are guided by
the existing price level, which they expect will remain in future
(P1 = Pe), therefore they agree to work for a nominal wage equal to
𝑊
W = w × Pe w= 𝑒
𝑃
where w – equilibrium real wage. But if an P LRAS
unexpected rise in the price level occurs in the SRAS
economy (to P2 = Pact), then since Pact > Pe, Pact B
the real wage becomes lower than they
𝑊 𝑊 Pe A
expected < 𝑒 , the quantity of labour
𝑃𝑎𝑐𝑡 𝑃
demanded by firms increases (because
LD = LD(W/Pact)), and output increases. Y* YSR Y
–
 The Sticky-Wage Model on the Graphs

P Y 𝑊
AD2
AD0 SRAS – – 𝑃
Y=АF(L,K)
Y2
P2 AD1 W
Y0 P1
P0
Y1 W
P1 P0
W
LD
P2

Y1 Y0 Y2 Y L1 L0 L2 L L1 L0 L2 L
 The Slope of the SRAS Curve
in the Sticky-Wage Model
The features of the model:
the cyclical fluctuations are caused by the aggregate demand
shocks;
the behavior of the SRAS curve is determined only by the
demand for labour;
it is assumed that workers will (and wish) to supply the quantity
of labour, demanded by firms under the fixed nominal wage.
The slope of the SRAS curve is determined by technological
parameters that determine the slope of the demand for labour
curve (LD).
The flatter demand for labour curve (LD) corresponds to the flatter
SRAS curve, because the larger is the MPL, the greater will be
the change in employment and output in response to the change
in the price level.
The Workers’ Misperception Model
The model was proposed in the late 1960-s by the
famous U.S. economist Milton Friedman, the founder
of the adaptive expectations theory.
The difference from the sticky-wage model is that not only prices
for goods are flexible, but the nominal wage is also flexible.
The main idea is asymmetric information: only firms possess the
exact information about the unexpected rise in the price level (from
Pe до Pact), and when hiring workers are guided by the actual price
level, hence the function of the demand for labour is:
LD=LD(W/P
_ act).
But workers do not possess this information and estimate the size of
their real wage on the base of the existing price level (Pe), not
expecting any change in prices, hence the function for the supply of
labour is:
LS=LS(W/Pe).
+
 The Workers’ Misperception Model
When the price level rises (Pact > Pe), only firms know
about it, and they raise the nominal wages, but the
change is smaller than the change in prices.
Because workers do not possess the 𝑊
information about the increase in the price 𝑃 LS1 LS
level and still think it is P1 = P , they interpret
e L D
2
the increase in the nominal wages as the rise 𝑊
in their real wages (= make the systematic 𝑃𝑒 A
mistake), and increase the supply of labour 𝑊 B
(the LS shifts to the right). This results is 𝑃𝑎𝑐𝑡
higher output. L1 L2 L
In this model the level of employment and thus Y
output depends both on the demand for labour – –
(determined by technological parameters) and on Y Y=АF(L,K)
B
2 A
the supply of labour (determined by the Y
1
preferences of consumers, reflected by the
marginal rate of substitution). The flatter are the
LD and LS curves the flatter is the SRAS curve. L L2 L
 The Imperfect Information Model
The model was proposed by the U.S. economist
Robert Lucas, one of the founders of the rational
expectations theory.
According to this model (named the «island model»),
each producer (the competitive firm) has rational expectations, but
produces only one good and can monitor the price changes only for this
good (i.e. the change in the relative price), but not the changes in the
overall price level in the economy. Therefore, when the general price
level rises, and the firms did not expect it to rise, they interpret it as the
rise in the relative prices for their own production, and temporarily
(in the short run) increase output, that leads to the P LRAS
larger quantity of goods supplied in the economy SRAS
(movement along the SRAS curve), and YSR Pact B
exceeds Y*. Thus the deviations of output are
explained by the mistakes of firms (due to the Pe A
incomplete and imperfect information) rather than
workers as in the two previous models.
Y* YSR Y
 The Sticky-Price Model
According to this model, proposed by N.Gregory Mankiw,
there are two types of firms in the economy:

Firms that announce their prices in advance Firms that set their
(follow the sticky-price rule), because: prices in accord with
prices may be fixed in the long-term observed prices and
contracts between the firms and their clients; output.
by frequent price changes firms can scare
away their constant clients;
P LRAS
the menu costs can be very high. SRAS
The greater is the proportion of firms of the Pact B
second type in the economy, Pe A
the larger is the increase in output
in response to an unexpected increase in prices,
that is the flatter is the SRAS curve. Y* YSR Y
 The Short-Run Level of Output
The equation for the short-run level of output was
proposed by Robert Lucas (Nobel prize, 1995):

Y = Y* + × (Pact – Pe)
where (Pact – Pe) is so called «price surprise» and
is a positive parameter ( > 0), which characterizes
output sensitivity to the unexpected changes in prices.
Though this formula was derived from the imperfect-information
model, it is consistent with all the other models of the short-run
aggregate supply.
If Pact > Pe, actual output is higher than potential output (Y > Y*).
If Pact < Pe, actual output is lower than potential output (Y < Y*).
It implies that the short-run aggregate supply curve
must have the positive slope.
 The International Differences in the Slope
of the Short-run Aggregate Supply Curve
From the Lucas’ equation for the short-run output, we get, that the
slope of the short-run aggregate supply curve equals 1/ .
Lucas examined the situation in different countries and came to the
conclusion, that in those countries, where the citizens have got used to
frequent changes in aggregate demand and therefore in prices, i.e. to
high inflation (such as Brazil), is small a considerable price
shock is needed for an increase in output
the short-run aggregate supply SRAS P SRAS'
LRAS (high-inflation
curve is steep. While in the low-inflation
country)
countries (such as the United States),
P'act B SRAS
where the price level is relatively stable, (low-inflation
responsiveness of output to unexpected Pact country)
Pe A B'
changes in prices is high, i.e. is large
a negligible price shock is needed 1/
for a substantial increase in output Y
Y* YSR
the SRAS curve is flat.
From the Short-Run to the Long-Run Equilibrium
Deviations of actual output from its potential level can occur
only in the short run.
In the long run economic agents (workers and firms) recognize their
mistakes and change expectations in a way that Pe = Pact.
Workers demand the increase in nominal wages until their change is
proportional to the change in the goods prices, that increases the
firms’ costs of production, enforcing firms to decrease output.
Firms find out, that the increase in prices for their own production is
the part of the rise in the general price level,
and start to reduce output. P LRAS
As a result the SRAS curve shifts to the left, SRAS2
SRAS1
output falls, and in the long run economy P C B
act
returns to the potential level of output.
Hence the transition of the economy Pe A
from the short-run to the long-run equilibrium
in the modern models is explained by
changes in price expectations. Y* YSR Y
 Lecture 10
Aggregate Demand and Aggregate Supply
• The Aggregate Demand and Aggregate Supply Model
• Equilibrium in the Aggregate Demand and Aggregate
Supply Model
• Shocks of Aggregate Demand and Aggregate Supply
• From the Short-run to the Long-run Equilibrium
• How to Fight Stagflation
 The Aggregate Demand and
Aggregate Supply Model

Aggregate demand (AD) and aggregate supply (AS)

are the key concepts in macroeconomics,
and the «aggregate demand – aggregate supply model»
(the «AD-AS model»)
is the base model, that characterizes
general macroeconomic equilibrium,
which corresponds to the simultaneous equilibrium
in the goods, money and labor markets.
 The Aggregate Demand and
Aggregate Supply Model

Keynesian Equilibrium in the

Cross Goods Market
Aggregate
Liquidity
Equilibrium in the Demand
Preference
Money Market
AD-AS
Theory Model
Aggregate
Labor Equilibrium in the Supply
Market Labor Market
 The Importance of the AD-AS Model

The AD-AS model allows:

to define the conditions of the general macroeconomic
equilibrium and to determine the equilibrium level of
real output and the equilibrium price level;
to explain the fluctuations of real output and of the price
level in the economy, that is the business cycle;
to show the causes and ends of the changes in aggregate
demand and in aggregate supply both in the short run
and in the long run;
to analyze the effects of different types of
macroeconomic policy on real GDP, employment, and
the general price level.
 Aggregate Demand: a Revision

Aggregate demand is the relationship between all spending on

domestic output and the general price level of that output.
Aggregate demand comes from four sources and is the sum of
spending of all macroeconomic agents: consumption spending of
households (C), investment spending of firms (I), government
purchases of goods and services (G) and net exports (NX)
bought by foreigners:
AD = C + I + G + NX P

Since the desire of agents

to buy goods and services
falls with the rise in the
price level, the AD curve AD
has a negative slope.
Y 5
 Aggregate Supply: a Revision
Aggregate supply is the relationship between the general price level of
all domestic output and the level of domestic output produced. There
are two types of AS curves, the shape of which depends upon whether
the economy has fully adjusted to market forces and price changes:
in the macroeconomic short run (SR) period of time the goods prices
can be rigid (then the AS curve is a horizontal line) or flexible (then
the AS curve has a positive slope), while the input prices (nominal
wages, for example) are rigid;
the macroeconomic long run (LR) period of time is long enough for
input prices to have fully adjusted to market forces, hence all the
markets are in equilibrium and the economy is at full employment
(that is, the AS curve is vertical at its potential level).
P P SRAS P LRAS

SRAS
P

Y Y Y* Y
 Short-run and Long-run Equilibrium in
the AD-AS Model
Equilibrium in the AD-AS model occurs when the quantity of real output
demanded is equal to the quantity of real output supplied.
Graphically it is the point, where the aggregate demand (AD) curve
intersects the aggregate supply (AS) curve (point A).
The intersection of the AD curve with the short-run aggregate supply
SRAS curve corresponds to the short-run equilibrium (equilibrium
price level PE and actual equilibrium level of output YE).
The intersection of the AD curve with the long-run aggregate supply
LRAS curve corresponds to the long-run equilibrium (equilibrium
price level PE and potential level of output Y*).
LRAS
P P SRAS P

A SRAS P A
PE A
P E

AD AD AD
YE Y YE Y Y* Y
 The Restoration of the Equilibrium
in the AD-AS Model
When economy is out of equilibrium,
the equity between the quantity of output demanded
and the quantity of output supplied in the short run is restored
via changes in the stock of unintended inventories
of unsold production (IUN) and corresponding changes
in the price level P (if we assume flexible goods prices).
No external intervention is needed.

8
 The Restoration of the Equilibrium
in the AD-AS Model
The equilibrium of AD and AS is in point A at the price level PE
and the level of real output YE.
At the price level of P' there would we excess supply of output, equal
to BC. Firms will not be able to sell all their production there would
be the increase in the stock of unsold goods (IUN ). Firms will be
obliged to decrease output (Y ) and to reduce prices (P ) until
economy reaches the equilibrium at point A.
P Quantity of Inventory SRAS At the price level of P" there would we
Accumulation
excess demand for goods and services,
P' C equal to DF. The stocks of unsold in the
B
previous period production will decrease
PE A
quickly (IUN ), and firms will start to
D F increase output (Y ) in order to satisfy
P"
AD the increased demand trying to sell their
Quantity of Inventory
Reduction production at higher prices (P ), until
YE Y economy is in the equilibrium in point A.
 Changes in Aggregate Demand and the
Equilibrium in the AD-AS Model
Consequences of the changes in aggregate demand are different in
each of three cases:
(1) change in real output, while prices stay unchanged;
(2) change both in real output and in the price level;
(3) change in price level, while real output stays unchanged.

(1) (2) (3)

P P P LRAS
SRAS
B P2 B
P2
A B SRAS A
P P1 A P1
AD2 AD2 AD2
AD1 AD1 AD1
Y1 Y2 Y Y1 Y2 Y Y* Y
 Changes in Aggregate Supply and the
Equilibrium in the AD-AS Model
Consequences of the changes in aggregate supply are the same in all
three cases: the change both in real output and in the price level.
The only difference is that in the long run there is a change
not in the actual but in the potential output.
(1) (2) (3)
P P P LRAS1 LRAS2
SRAS1
SRAS2
A SRAS1 P1 A
P1 B P1 A
B P
P2 P2 B
SRAS2 2
AD AD AD
Y1 Y2 Y Y1 Y2 Y Y*1 Y*2 Y
 Shocks of Aggregate Demand and
Aggregate Supply
Changes in aggregate demand or in aggregate LRAS
supply (usually unexpected) are called P SRAS
shocks of aggregate demand
and aggregate supply. These shocks are
the base for the business cycle.
Real . AD2
GDP Y2 TREND AD0
AD1
Y1 Y* Y2 Y
Business
Y* Cycle
P LRAS SRAS1
Y1 SRAS0
Time (years) SRAS

Shocks of aggregate Shocks of aggregate

demand can be supply can be
AD
Positive Negative Favourable Adverse Y1 Y* Y2 Y
 Shocks of Aggregate Demand
The causes are unexpected changes in:
consumption spending as a result of
changes in consumer confidence; Private

Internal Shocks
investment spending provoked by sector shocks
changes in business confidence;
government policy
- changes of the supply of money
by the central bank (monetary shock); Government
sector shocks
- changes of budget expenditures or tax
revenues by fiscal authorities (fiscal shock);
net exports as a result of

External
Shocks
- changes in foreign prices; Foreign
- changes in foreign income; sector shocks
- changes in the exchange rate.
13
 Shocks of Aggregate Demand
P
SRAS Negative aggregate demand shock
P2 B = decrease in aggregate demand.
P1 A It leads to the decrease in real
output and to the fall in prices.
AD2
AD1
Y1 Y2 Y P
Positive aggregate demand shock SRAS
= increase in aggregate demand. P1 A
It leads to the increase in real P2 B
output and to the rise in prices. AD1
AD2
Y2 Y1 Y
 From the Short-run to the Long-run Equilibrium
The Positive Demand Shock
P LRAS Point A (Y*): AD IUN Y ;P
point B (YSR>Y*) (W/P)
P2 C workers demand higher wages
SRAS2
A B
W firms’ costs AS (SRAS
P1 SRAS1 curve shifts to the left) Y ;P
AD2 point C: (Y = Y*).
AD1 P LRAS SRAS
2
Y*LR YSR Y SRAS1
P3 C
Point A (Y*): AD IUN Y P2 B
point B (YSR>Y*) workers P1 A
demand higher wages W
AD2
firms’ costs AS (SRAS AD1
curve shifts up) Y ; P
point C: (Y = Y*) Y*LR YSR Y
Conclusion: In the long run changes in aggregate demand can’t affect
real output hence demand management policy is ineffective. Through
price adjustment mechanism economy returns to potential level of output
From the Short-run to the Long-run Equilibrium
The Negative Demand Shock

P LRAS
SRAS1 Point A (Y*): AD IUN
SRAS2 Y ;P unemployment (u)
P1 A point B (Y < Y*): u is high (W/P)
P2 B firms decrease nominal wages
P3 C W firms’ costs AS (SRAS
AD1
AD2 curve shifts to the right) Y ;P
point C (Y = Y*).
YSR Y* Y
Conclusion: If there is a recession, economy can overcome it and
return to the potential level of output and full employment by itself
without any government intervention, thus
government policy is not needed to cure the recession.
It is a classical approach. 16
 Shocks of Aggregate Supply
The causes of:
Favorable Supply Shocks Adverse Supply Shocks
Everything that provokes and allows Everything that raises firms’ costs
firms to produce more: of production:
a decrease in the prices of inputs rise in resource prices –
(nominal wages, prices of raw examples: Oil shock of the
materials, etc.); middle 1970s; the Gulf War of
a decrease in inflationary expectations; 1990-1991;
an increase in the quantities of inputs strengthening of the unions’
(labor, capital, land); bargaining power in the labor
technological advances (that lead to market (that is the base for
the higher resource productivity). higher nominal wages);
(The latter two factors affect both an increase in inflationary
SRAS and LRAS, and raise production expectations;
possibilities of the economy, that is environmental government policy;
the potential output Y*). natural and social disasters.
Normally, when considering AS shocks, 17
fully flexible wages and prices are assumed.
 Shocks of Aggregate Supply
P
SRAS1 Adverse aggregate supply shock =
SRAS2 decrease in aggregate supply.
A It leads to the simultaneous
P1 decrease in real output (stagnation)
B
P2 and the rise in the price level
AD (inflation) – the situation, which
Y1 Y2 Y was called stagflation.
P
Favorable aggregate supply shock SRAS2
= increase in aggregate supply. SRAS1
It leads to the increase in real output P2
B
and to the fall in the price level. P A
1
For the analysis of the supply shocks AD
effect on the economy
the Phillips curve relation is used Y2 Y1 Y
From the Short-run to the Long-run Equilibrium
The Favorable Supply Shock
P LRAS
SRAS1
SRAS2
P1 A
P2 B

AD
Y* Y2 Y
If this shock is caused by the decrease in the resource prices or by
the decrease in inflationary expectations, firms will expand the
supply of production (the rightward shift of the SRAS curve), and
the level of output in the short run will rise (to Y2).

19
From the Short-run to the Long-run Equilibrium
The Favorable Supply Shock
P LRAS1 LRAS2
SRAS1
SRAS2
P1 A
P2 B

AD
Y*1 Y*2 Y

If this shock is caused by the increase in the quantity or quality of

economic resources or the level of technology, aggregate supply
increases not only in the short run, but in the long run as well, that
implies the change in the production possibilities, and corresponds to
the long-run economic growth (Y2 = Y*2).

20
 The Adverse Supply Shock and
the Demand Management Policy Dilemma
The result of the adverse aggregate supply shock is stagflation –
a combination of low output, high unemployment (that corresponds
to the slump in the economy) and the rise in the price level (high
inflation). With an adverse supply shock, if policymakers choose:
the contractionary aggregate demand policy to lower the price level
(to fight inflation), the result would be the further fall in output and
increase in unemployment;
the expansionary aggregate demand policy to increase output and to
reduce unemployment, the price level would rise further.
P LRAS SRAS2 P LRAS SRAS2
SRAS1 SRAS1
P2 B
P 3 C
P B
P3 C 2
P1 A P1 A
AD2
AD1 AD1
AD2
Y3 Y2 Y* Y Y2 Y3 Y* Y 21
 The Scenarios to Fight Stagflation
To overcome the consequences of the adverse supply shock only the
policy that affects aggregate supply can be used.
There were several scenarios in the late 1970s – early 1980s how to
fight stagflation, caused by the Oil shock of 1973, which lead to the
World crisis of 1974-1975:
Classical economists (from 1975 to 1979) – to do nothing:
Y is low, u is high firms reduce nominal wages W
firms’ costs AS (SRAS shifts to the right) Y , u , P
Monetarists (used in the UK in 1979) – to decrease money supply:
MS i I AD (shifts to the left) P
inflationary expectations E AS ,
…but in reality
Y u hysteresis, while the fall in P didn’t result
in the change in inflationary expectations E. Margaret
Thatcher
 The Scenarios to Fight Stagflation
Keynesians – to use incomes policy:
establish wage and price controls
inflationary expectations E P
without causing recession;
Supply-siders (Reaganomics in the U.S. from 1980)
– to lower tax rates:
t AS Y ,P
combined with the increase in the discount rate: Ronald Reagan
discount rate i (that is the rate of return on financial assets)
US securities become more attractive to foreigners
capital inflow to cure recession in the US.
Policymakers in developed countries did their best to overcome
stagflation, and to return economy to its initial (before-shock) position.
 Lecture 11
Unemployment
• Population and Labour Force
• Measurement of Unemployment
• Reasons for and Types of Unemployment
• Natural Rate of Unemployment
• Consequences of Unemployment
• Okun’s Law

1
 Population

Population of Children
Working Age (under 16 years)

Civilian Population Military

Non-institutional Institutional
Population
(= Adult Population) Population • in prisons;
• in mental hospitals;
• in retirement homes.
Labour Force Non-Labour Force
(LF) (NLF) • students;
• retired persons;
• housewives;
Employed Unemployed • vagrants;
• discouraged workers.2
(E) (U)
 The Composition of the Labour Force
Labour force (LF) (economically active population) includes people
holding a job or registered as being willing and available for work.
Thus it consists of employed and unemployed adults: LF = E + U
Employed (E) is a person who works at a paid job and leaves it only for
holidays, vacations, diseases, strikes and because of the bad weather.
Unemployed (U) is a labour force participant without a job, who
• is willing and able to work;
• has made an effort to seek work in the past four weeks;
• is registered as being willing to work.
Unemployed
are those who are

on temporarily layoffs or looking for job

3
or waiting to start a new job
 Labour Market Flows

New hires
Recalls
Employed Job-losers
Unemployed
Lay-offs
Quits

Retiring Discouraged
Temporarily workers
leaving
Taking Non Re-entrants
a job Labour Force New entrants

4
 Measuring Unemployment
Because people move into and out of the
labour force so often, unemployment is
difficult to measure and interpret.
The main measure of unemployment is the unemployment rate –
the percent of the labour force that is unemployed:

Unemployed
Unemployme nt rate ( u) 100%
Labor Force

U U
100% 100%
LF E U
LF E E
100% (1 ) 100%
LF LF
Unemployment Rate in Selected Countries, 2007-2020
Country 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Russia 6.0 6.2 8.3 7.3 6.5 5.5 5.5 5.2 5.6 5.5 5.2 4.8 4.55 6.1
Germany 8.6 7.5 7.7 7.1 6.0 5.5 5.3 5.0 4.6 4.2 3.7 3.6 3.2 5.9
Italy 6.1 6.7 7.8 8.4 8.4 10.7 12.2 12.7 11.9 11.7 11.3 11.0 9.2 9.6
Canada 6.0 6.1 8.3 8.0 7.5 7.2 7.1 6.9 6.9 7.0 6.4 6.3 6.1 8.6
Great
Britain 5.2 5.3 7.7 7.8 8.0 7.8 7.6 6.2 5.4 4.9 4.3 4.2 3.8 4.9
United
States 4.6 5.8 9.3 9.6 8.9 8.1 7.4 6.2 5.3 4.9 4.4 4.3 3.9 6.9

France 8.0 7.4 9.1 9.7 9.6 10.2 10.8 10.3 10.4 10.0 9.7 9.7 9.1 7.8
Spain 8.2 11.3 17.9 19.9 21.4 24.8 26.1 24.5 22.1 19.9 17.4 19.1 14.7 16.2
Greece 8.4 7.8 9.6 12.7 17.9 24.4 27.5 26.5 25.0 23.8 21.4 22.9 18.1 15.8
Japan 3.9 4.0 5.0 5.1 4.6 4.4 4.0 3.6 3.4 3.1 2.8 2.6 2.4 3.0
China 4.0 4.2 4.3 4.1 4.1 4.1 4.1 4.1 4.1 4.0 4.7 4.7 4.4 5.2
South
Korea 3.3 3.2 3.7 3.7 3.4 3.2 3.1 3.5 3.6 3.7 3.8 3.7 3.7 4.0

Source: World Bank, OECD Economic Outlook, IMF 6

 Unemployment – UK, US, Eurozone
%

7
 0
2
4
6
8
10
12
14
%
5,3
7,2
8,3
9,7
11,7

Source: Goscomstat
13,2
13,0
10,6
9,0
7,9
8,2
7,8
7,1
7,1
6,0
6,2
8,3
7,3
6,5
5,5
5,5
5,2
5,6
5,5
5,2
4,8
Unemployment Rate in Russia, 1993 – 2020

4,6
8

5,9
 The Drawbacks of Unemployment Rate

The unemployment rate is not an exact measure of unemployment,

because there are:

Discouraged workers Dishonest workers

those who are willing and able to
work, but become so frustrated in
their attempts that they stop trying.
They are not counted as the
unemployed in official statistics, and
are a reason why the unemployment
rates might understate the true
unemployment problem.
who claim to be unemployed
in order to receive
unemployment benefits, but, in
fact, they don’t want a job or
are working for cash in an
unreported job they raise
unemployment figures upward
and overstate unemployment.

9
Additional Variables of Labor Force Statistics
That’s why in addition to the unemployment rate
labour statistics use:
the employment rate (e) – the percent of employed in the
total population of the working age (= adult population):
Employed
e 100%
Adult population

the labour force participation rate (PR) – the percent of the

total adult population that is in the labour force:
Labor force
PR 100%
Adult population
that explains why a fall in unemployment is not always associated
with a rise in employment, or why an increase in unemployment
can occur simultaneously with an rise in employment. 10
 Variations of Unemployment
The unemployment rate and the labour-force
participation rate varies widely across the
demographic groups: men, women, young, old.
Women have lower labour force participation rates than men, but
once in the labour force they have lower unemployment rates.
Teenagers have higher unemployment rates than older workers.
Besides, unemployment among low-skilled
workers is much more higher than among
high-skilled ones.

11
 Short-term versus Long-term Unemployment
Evidence suggests that most spells are short-term, but most
unemployment at any given time is long-term.
This means that many people are unemployed for short periods, but a
few people are unemployed for very long periods.
Short-term unemployment is much less of a social
problem than long-term unemployment.
The longer is the period of being unemployed:
the lower is the chance for a person to find highly paid job;
the greater is the loss of skills and qualification.
The existence of long-term unemployment is the threat
of the decrease in the productivity of total labor force,
and therefore of the production possibilities
of the economy, and of the potential level of output.
12
 Types of Unemployment

Individuals may be unemployed because of

frictional causes cyclical causes

structural causes
A frictionally unemployed person is one who is temporarily between
jobs because of temporary layoff or because he/she quits previous
job and is looking for new one or who moves into the labour market.
Frictional unemployment
occurs as unemployed workers and firms search for the best
available worker-job matches;
is considered to be a good thing, because allows
workers to move into new jobs that are more
satisfying for both the worker and the employer
than a previous matching and where workers
will be more productive.
 Types of Unemployment
A structurally unemployed person is one who has lost a job because
his/her skill is no longer demanded due to
• a change in the structure of demand, or
• globalization, or
• a technological advance.
The type of structural unemployment is regional unemployment.
Structural unemployment is primarily the result of a skills mismatch
(examples: typists, blacksmiths, lighters, chimney-sweeps, etc).
A seasonally unemployed person is those who loses his job because
of the season (agricultural, tourist, construction, school breaks;
the classical example is ski instructors).
Seasonal unemployment is the result of changes in hiring
patters due to the time of year. Seasonal unemployment
is often included in frictional unemployment.
Frictional and structural unemployment form
search unemployment
because it takes time for job candidates and job vacancies to match.14
 The Natural Rate of Unemployment

is the typical rate of unemployment, that the economy normally

experiences;
is often thought of as the sum of frictional and structural
unemployment;
is considered as the level of full employment (sometimes called
non-accelerating inflation rate of unemployment – NAIRU);
is about 5% in the developed countries, i.e. full employment is
not 100% employment;
corresponds to the equilibrium in the labor market;
is the unemployment rate, that exists when real GDP equals
potential GDP and the GDP gap is zero;
the normal average rate of unemployment, around which the
unemployment rate fluctuates.

15
The Natural Rate of Unemployment on the Graph

W/P LS Labour Force

With the labour force larger than

the number of persons prepared
NRU to accept jobs at the going
(W/P)E A B
equilibrium wage rate (W/P)E,
there exists a certain level of
voluntary unemployment (=AB)
which is defined as the natural
LD rate of unemployment (NRU).

L1 L2 L

"Natural" does not mean desirable.

It means, that it is the unemployment, that doesn't go away on its own.
16
The Natural Rate of Unemployment in US
U.S. Actual & Natural Rates of Unemployment,1950-2020
%
12,0

10,0

8,0

6,0

4,0

2,0

0,0

Natural Rate of Unemployment Actual Rate of Unemployment

Source: U.S. Congress: Congressional Budget Office. 18

Non-Accelerating Inflation Rate of Unemployment
Each point on the trend of Real GDP TREND

economic growth corresponds to D Y*

the potential or full-employment Y
GDP (Y*) (points А and С). А С
BUSINESS
Each point on the business cycle CYCLE
В
line corresponds to the actual
GDP (Y) (points В and D).
Time (years)
When Y > Y* (point D), actual level of unemployment is lower than its
natural level (u < u*) overemployment. When Y < Y* (point B)
u > u* underemployment. When economy moves from point С to
point D, the price level begins to rise (= inflation accelerates), because
aggregate demand exceeds aggregate supply. When economy moves
from point A to point B, the price level falls (= inflation decelerates).
When economy is at its potential level (on the trend: points A and C) =
natural rate of unemployment (u*) inflation does not accelerate. 19
Actual Rate of Unemployment, NAIRU and
Natural Rate of Unemployment

20
 Natural Rate of Unemployment (NAIRU), 1989-2017
Country 1989-98 1999-08 2009 2010 2011 2012 2013 2014 2015 2016 2017
US 5.5 5.0 5.2 5.2 5.1 5.1 5.0 5.0 4.9 4.9 4.9
UK 8.3 5.9 6.0 6.1 6.1 6.1 6.2 5.9 5.6 5.4 5.1
France 9.4 8.7 8.9 9.0 9.2 9.4 9.6 9.6 9.6 4.8 4.7
Italy 9.2 8.2 7.8 8.0 8.1 8.4 8.8 9.0 9.1 9.2 9.2
Germany 7.0 7.8 7.5 6.8 6.2 5.7 5.4 5.2 4.9 4.8 4.7
Japan 2.9 4.0 4.1 4.0 3.9 3.8 3.7 3.7 3.6 3.4 3.4
Spain 15.1 13.3 15.1 15.5 15.8 16.1 16.0 16.0 15.9 15.7 15.4
Sweden 6.8 7.4 7.4 7.5 7.4 7.4 7.4 7.5 7.5 7.5 7.5
Canada 9.2 7.5 6.7 6.7 6.7 6.6 6.5 6.5 6.5 6.5 6.5
Greece 8.2 10.3 13.0 14.1 15.2 16.1 16.4 16.9 17.3 17.5 17.3
South
3.1 3.8 3.5 3.5 3.4 3.3 3.3 3.4 3.4 3.4 3.4
Korea
Netherland 4.8 4.8 5.1 5.1 5.2 5.3 5.3 5.4 5.4 5.3 5.1
Switzerland 2.5 3.5 3.9 3.9 3.9 4.0 4.0 4.0 4.0 4.4 4.4
In 2019 in US is was 4.52% and decreased to 4.48% in 2020.
21
Source: OECD Economic Outlook, US Bureau of Labor Statistics.
Determinants of the Natural Rate of Unemployment
The level of the natural rate of unemployment (NAIRU) is different:
in different countries: in the European countries it is higher than in
US, while in Japan it is lower than in the US; and
in different times.
The key determinants of the natural rate of unemployment are:
- demographic shifts such as the changes in the share of women and
young people in the labour market;
- changes in the educational structure of the labour force;
- institutional specifics such as the extent of the trade unions’ market
power, or the presence of the barriers to the workers’ mobility, etc;
- changes in the labour market policy such as the changes in the
unemployment insurance programs; in the government minimum
wage laws; in the system of information about the existing
vacancies; creation of employment agencies and worker training
programs;
22
- changes in the labour productivity.
 Changes in the Natural Rate of Unemployment
on the Graphs
The increase in the natural rate of unemployment implies the fall in
the potential level of output and is represented by a leftward shift of
the long-run aggregate supply curve (LRAS) and by an
inward shift of the production possibilities frontier (PPF).
P LRAS2 LRAS1

PPF1

PPF2

Y*2 Y*1 Y Consumption Goods

And vice versa, the fall in the natural rate of unemployment implies
the rise in the potential level of output and is represented by a
rightward shift of the long-run aggregate supply curve (LRAS) 23
and
by an outward shift of the production possibilities frontier (PPF).
 The Model of Labor Force Dynamics
This model, proposed by Milton Friedman, helps to find
the natural rate of unemployment (u*).
Employed (E)
People moving out of People moving into
unemployment (f ×U) unemployment (s×E)
Unemployed (U)
In the steady state (= long-run equilibrium) unemployment rate is
constant: the number of unemployed workers who find jobs (their part is f)
is equal to the number of employed workers who are laid-off (their part is s):
s×E=f ×U
Since E = LF – U then s × (LF – U) = f ×U s × LF – s × U = f × U
hence f × U + s × U = s × LF U × (s + f) = s × LF
Dividing both parts by LF, we get:
U s
(s f) s u* 100% 24
LF s f
 The Model of Labor Force Dynamics
Parameter s is called the job separation rate, and shows the average
number of months of being employed, i.e. the average period of time,
when 1 worker loses his job, hence:
1
s
average number of months of employment
Parameter f is called the job finding rate, and shows the average
number of months of being unemployed, i.e. the average period of
time, when 1 worker finds a job, hence:
1
f
average number of months of unemployme nt
The higher is the job finding rate
(= unemployed workers find jobs more quickly), and/or
the lower is the job separation rate
(= the workers have jobs for a longer period of time) 25
the lower is the steady state unemployment level.
 Types of Unemployment (continued)
The deviation in unemployment from the natural rate is known as
cyclical unemployment.
A cyclical unemployment is caused by the downturns in the business
cycle. It exists when real output is below an economy's potential
output due to an inadequate level of aggregate spending (that is why
often called demand-deficient or Keynesian unemployment). During
recessions and depressions, firms are likely to hire fewer workers or
let existing workers go. When the economy recovers, many of these
cyclically unemployed workers will again find work.
Real Trend (Y*)
D
GDP
C Business cycle (Y)
A
Cyclical
B unemployment
Time (years) 26
 Keynesian Demand Deficient Unemployment
on the Graph

W/P LS Labour Force

Keynesian A reduction in aggregate demand

unemployment
A NRU leads to a fall in the demand for
(W/P)E C B labour (from LD1 to LD2) which,
assuming wages are fixed at
(W/P)E, causes demand deficient
unemployment (=AC)
of L1 to L2
LD1
LD2
L2 L1 LF L

27
UK Unemployment
 The Cyclical Character of Unemployment
% Unemployment in the United States (1890 – 2020)
25

20

15

10

Source: Bureau of Labor Statistics. 29

 The Cyclical Character of Unemployment
%
25 Unemployment in the United Kingdom (1881 – 2020)

20

15

10

Source: Labour Market Trends, Office for National Statistics. 30

 The Cyclical Unemployment
Actual unemployment rate (u) = natural rate of unemployment +
+ cyclical unemployment rate = u* + ucyclical
During recessions actual unemployment rate exceeds natural
(u > u*), thus actual output is below its potential level (Y < Y*).
During booms actual unemployment rate is lower than natural
(u < u*), thus actual output exceeds potential level (Y > Y*).

P LRAS In point D there is

C SRAS a recessionary gap
B (Y1 < Y* and u > u*)
A
AD2 cyclical unemployment.
D
F In point B there is
AD1 an inflationary gap
Y1 Y* Y2 (Y2 > Y* and u < u*)
Y 31
overemployment.
 Unemployment Voluntary versus Involuntary
Unemployment is considered to be:
voluntary, which is caused by the unwillingness of workers to
accept a job at the going wage rate. The best example is frictional
(or search) unemployment.
involuntary, when a worker would be willing to accept a job at
the going wage but cannot get an offer. The examples are
cyclical (Keynesian) unemployment and real-wage (Classical)
unemployment.
In practice the distinction between voluntary and involuntary
unemployment is hard to draw.
Thus, structural (or mismatch) unemployment, though is considered
part of natural rate of unemployment, can be involuntary,
because may reflect choices made by the unemployed in the past.
32
 Classical (Real-Wage) Unemployment

In most markets prices adjust to balance supply and demand. In the

ideal labour market, wages would adjust in a way, that there
would be no unemployment.
However, even when the economy is doing well, the unemployment
rate never falls to zero. All the reasons why the labour market
falls short of the ideal market come from a general rule:

If a real wage is held above the equilibrium

(market-clearing) level
the result is unemployment

33
 Real-Wage Unemployment
Real-wage (or Classical) unemployment is unemployment resulting
from the disequilibrium in the labour market when the real wage is
artificially pushed up above the market-clearing wage (W/P)E (i.e. the
competitive market equilibrium wage, at which the demand for labour
equals to the supply of labour), causing the number of job-seekers to
exceed the number of vacancies. A worker would be willing to accept
a job at the going wage (W/P)act, but cannot get an offer.
(W/P) The reasons for this disequilibrium:
LS LF
LD government minimum wage laws;
(W/P)act B C D unions and collective bargaining;
(W/P)E A the efficiency wages theory.
Natural rate of
unemployment
Real-wage Search
unemployment Unemployment

34
QLD LF QLS LF L
 Causes of the Real-Wage Unemployment:
the Minimum-Wage Laws
The minimum-wage laws force the wage to remain above the
equilibrium wage, that causes the quantity of labour supplied to exceed
the quantity of labour demanded, i.e. a surplus of labor or
unemployment.
Studies indicate: a 10% increase in the minimum wage reduces
employment of workers receiving it by 1–3%.
But the equilibrium wage for most workers exceeds the minimum
wage, the minimum wage tends to cause unemployment only for
teenagers, and the least skilled and least experienced workers.
 Causes of the Real-Wage Unemployment:
Unions and Collective Bargaining
A union is a worker association that engages in
collective bargaining with employers over wages and
working conditions. If the union and firm fail to reach an
agreement, the union can strike.
Because of the threat of a strike, workers in unions
earn about 10 to 20 percent more than nonunion workers.
Unions benefit insiders (members)
at the expense of outsiders (nonmembers).
When the union raises the wage above
the equilibrium wage, unemployment rises.

Unionization rates:
Germany – 90%, Spain – 68%, US – 18%.
36
 Causes of the Real-Wage Unemployment:
Unions and Collective Bargaining
Percent of Workers Covered by Collective Bargaining,
Selected Countries
South Korea 10% Israel 56%
United States 13 Germany 61
Turkey 13 Greece 65
Japan 16 Spain 73
Canada 29 Netherlands 84
Poland 29 Italy 85
United Kingdom 31 Sweden 91
Australia 45 France 92
Switzerland 49 Belgium 96

Source: OECD 37
 Causes of the Real-Wage Unemployment:
the Theory of Efficiency Wages
The theory of efficiency wages suggest that firms may have an
incentive to hold wages above the competitive equilibrium,
because it is efficient for them to do so: higher wages increase
worker productivity.
The reasons why firms voluntarily maintain a wage in excess of
the market-clearing rate are that by paying a higher wage:
worker health may be improved: better paid workers eat a
better diet and are more productive (an argument applicable to
firms in developing countries);
worker turnover may be reduced: workers will find it difficult
to find alternative jobs at a higher wage and firms can avoid
costs associated with hiring and training new workers;

38
 Causes of the Real-Wage Unemployment:
the Theory of Efficiency Wages
worker effort may be increased: as a worker’s
effort cannot be easily monitored, workers may
shrink their responsibilities. Higher wages
increase the opportunity costs of being laid off
and make workers eager to keep their jobs and
work hard;
worker quality can be improved: higher quality workers have a
higher reservation wage — the minimum wage
they are willing to accept. By paying a wage
above the competitive equilibrium, firms have
a higher probability of attracting high quality
applicants for a job opening.

39
 The Theory of Efficiency Wages and
Asymmetric Information
The "worker effort" and "worker quality" variants of efficiency
wage theory demonstrate the economic problem of
asymmetric information.
Workers (agents) know their own effort and quality,
but firms (principals) do not. Paying workers a low wage:

may cause may increase

workers to provide little effort, the number of low quality
which is the phenomenon called applicants, which illustrates
moral hazard adverse selection

40
 Effects of Unemployment
Fluctuations in the aggregate unemployment rate affect:
• the welfare and the well-being (happiness) of individual workers.
• wages.
Higher unemployment affects workers:
• through a decrease in hires – it becomes more difficult to
find jobs.
• through higher layoffs – the risk of loosing a job becomes
higher.

41
 Consequences of Unemployment
Consequences of unemployment can be
economic and non-economic.
On the individual level:
loss of income or part of income;
loss of skills that can not allow to find highly paid job in future;
personal loss of self-confidence, crime, the breakup of families,
and suicide.

On the societal level:

increase in social tension;
higher level of crimes, deaths, heart and
nervous diseases, etc;
losses to output and income.
42
 The Okun’s Law
American economist Arthur Okun, the economic adviser
of the U.S. President John Kennedy, in the early 1960s
examining the U.S. empirical data, derived the percentage
relation between cyclical unemployment and the GDP gap
Y Y*
100% ( u u*)
Y*
where is the Okun’s coefficient (2 < < 3).
Okun also has estimated, that each percentage point of increase in the
annual unemployment rate reduces actual output by 2 percentage points
Yt Yt 1
100% 3% 2 ( ut ut 1 )
Yt 1
where 3% is the average annual rate of the US long-run economic growth,
that smoothens the effect of unemployment on the actual output.
These simple formulas were named the «Okun’s law»:
the first is known as «the gap version», while the second
as «the difference version» or «the growth rate version». 43
 The Gap Version of the Okun’s Law

Real GDP

D Trend (Y*)
Inflationary Yn
Gap
Y*n C
A
Y*t Business Cycle (Y)
Recessionary
Gap
Yt
B

Year t Year n Time (years)

44
Percentage change in real GDP
The Growth Rate Version of the Okun’s Law

Change in unemployment rate

45
Sources: U.S. Department of Commerce, U.S. Department of Labor
 The Growth Rate Version of the Okun’s Law

Real GDP
Trend (Y*)

Y*t D
Y*t –1 A Business Cycle (Y)
F
Yt –1 B G
Yt
Y t' C

t –1 t Time (years)
Due to the general trend of the long-run economic growth
real output in year t falls only to Yt (point G), and not to Yt' (point C).
46
 Government Policy
to Reduce Unemployment
Government can be able to lower search unemployment by
engaging in activities that shorten the job search time.
Two such programs are:
government-run employment agencies to help match workers and
jobs;
worker training programs to retrain workers laid off from
contracting sectors.
To lower real-wage unemployment government can undertake
measures to decrease the market power of trade unions.
The key remedy to combat cyclical unemployment – the conduct of
the stabilization policy.

47
 Government Policy to Support Unemployed
There are unemployment insurance programs, that provide the
worker partial protection against job loss and that may improve the
efficiency of the job market by allowing workers to search longer
for the best job match.
But these programs have a controversial impact: unemployment
insurance increases search unemployment (and hence natural rate of
unemployment u*), because unemployed workers are more likely:
to devote less effort to their job search;
to turn down unattractive job offers;
to be less concerned with job security.

48
Trade-off Between Inflation and Unemployment:
Policy Dilemma
It follows from the AD-AS model, that in LRAS
the short run the increase in aggregate P
SRAS
demand leads to the simultaneous rise in
output Y, that corresponds to the higher P2 B
level of employment (= lower level of P1 A
unemployment u) and to the increase in AD2
the price level Р (= higher level of AD1
inflation ) in the short run Y* Y2 Y
policymakers face a dilemma:
to choose a low to reduce inflation at the
unemployment and have or expense of higher
a higher rate of inflation unemployment
Low High
UNEMPLOYMENT INFLATION
High Low 4
 Lecture 12
Inflation
• Inflation and its Rate
• Causes of Inflation
• Quantity Equation and Inflation
• Costs of Inflation
• Expected and Unexpected Inflation
• Hyperinflation
 Inflation and its Measurement
Inflation is a sustained increase in the overall price level.
sustained it is a tendency, not a simple short-run jump in prices;
overall price level prices for different goods can behave
differently: increase, decrease or stay unchanged, but there must be
an increase in the price index (GDP deflator or CPI).
The major measure for inflation is the inflation rate ( ) – the rate,
at which the price level increases.
Pt Pt
Inflation rate 1
100%
Pt 1

P Pt
100% ( 1) 100%
Pt 1
Pt 1

The opposite of inflation – a sustained decline in the general

price level (or a negative inflation rate) – is called deflation.
The increase in the price level during deflation is called reflation.
The fall in the inflation rate is known as disinflation.
 Types of Inflation
creeping inflation – inflation that remains steady for a long
period at a low rate (3–4% per year is considered a normal rate
for contemporary economy);
galloping inflation – unsteady inflation that exceeds 10 percent
per year and grows month after month;
high inflation – inflation that is measured in percents per month
and that can reach 200-300% per year;
hyperinflation – extraordinarily high inflation with very rapid
price increases in excess of 50 percent per month.
There is great variation in inflation over time and across countries.
Prices
 The Cyclical Character of Inflation
% Inflation (by CPI) in the US (1913–2020)
20

15

10

-5

-10

-15

Source: Bureau of Economic Analysis, Bureau of Labor Statistics.

 Inflation in Selected Countries, 2000-2020
(by CPI in %)

Country 2000 2005 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Russia 20.8 12.7 14.1 11.7 8.8 8.4 5.1 6.8 7.8 15.5 7.0 3.7 4.4 4.5 3.2

Germany 1.4 1.9 2.8 0.2 1.2 2.5 2.1 1.6 0.8 0.1 0.4 1.5 1.8 1.45 0.5

Italy 2.6 2.2 3.5 0.8 1.6 2.9 3.3 1.2 0.2 0.1 -0.1 1.2 1.9 0.6 0.1

Canada 2.7 2.2 2.4 0.3 1.8 2.9 1.5 0.9 1.9 1.1 1.4 1.6 2.7 1.95 0.6
Great
0.8 2.0 3.6 2.2 3.3 4.5 2.8 2.6 1.5 0.1 0.6 2.6 2.34 1.74 0.8
Britain
USA 3.4 3.4 3.8 -0.3 1.6 3.1 2.1 1.5 1.6 0.1 1.3 2.1 2.44 1.8 1.5

France 1.8 1.9 3.2 0.1 1.7 2.3 2,2 1.0 0.6 0.01 0.3 1.0 1.6 1.1 0.5

Japan -0.5 -0.6 1.4 -1.4 -0.7 -0.3 -0.1 0.3 2.8 0.8 -0.1 0.5 1.4 0.5 -0.1

China 0.3 1.8 5.9 -0.7 3.3 5.4 2.6 2.6 2.0 1.4 2.0 1.6 2.55 2.9 2.9

Source: OECD Economic Outlook, IMF, World Bank 5

 Countries with Deflation, 2020

Montenegro -0.1
Taiwan -0.1
Ireland -0.2
Spain -0.2
Singapore -0.4
Thailand -0.4
Israel -0.5
Greece -0.6
Cyprus -0.6
Switzerland -0.8
United Arab Emirates -1.5
Qatar -2.2
 Inflation in Russia, 1991 – 2020 (by CPI)
%
84,4
90

80
1991 1992 1993 1994 1995
70
160,4 2508,8 839,9 215,1 131,3
60

50
36,5

40

30
21,8

20,2
18,6
15,1

13,3

12,9
20
12,0

11,9
11,7

11,4
10,9
11,0

9,0

8,8
8,8

6,6
6,5
6,1

5,4

3,04
4,9
10

4,3
2,5
0

Source: Goscomstat
 Causes of Inflation
Inflation can result from:
increases in aggregate demand (rightward shifts of the AD curve)
which is called demand-pull inflation and is caused by any
change that leads to the rise in aggregate expenditures;
decreases in aggregate supply, primarily resulting from an
increase in resource costs (leftward shifts of the SRAS curve),
this is called cost-push or supply-side inflation.
Demand-pull Inflation Supply-side Inflation
P SRAS P SRAS2
SRAS1
P2 B P2 B
P1 A P1 A
AD2
AD1 AD
Y1 Y2 Y Y2 Y1 Y
 Supply-side Inflation
Supply-side inflation, caused by the adverse supply shocks
is accompanied by a decrease in real GDP.
The types of the supply-side inflation:
wage push;
raw materials prices push; cost-push
inflation
import-price push;
profit push.
The possible causes for supply-side inflation can be the decreases
in the quantity, quality and/or productivity of economic resources.
The combination
of falling output with rising prices

stagnation inflation
is called
stagflation
 Demand-pull Inflation and
the Quantity Equation
The major cause for demand-pull inflation is considered
the increase in money supply. The effect of the money
supply growth on price level is usually explained with the
quantity equation (also called Fisher equation or equation of
exchange), which is considered to be the theory of the velocity of money:
M×V=P×Y
where M is the quantity of money in
circulation, V – the income velocity of money P LRAS
(= the average number of times that one
money unit is spent in buying goods and P В
services during a year), P – the price level 2
and Y – real GDP (so P×Y is nominal GDP). P1 А AD2
In the classical quantity theory of money (the
rigid version) V and Y are constant numbers AD1
and Y = Y*, thus the increase in M leads to Y* Y
the rise in P.
 The Cambridge Equation
The alternative form of the quantity equation
is the Cambridge equation, proposed by the
professor of Cambridge University (UK)
Alfred Marshall:

M=k×P×Y
where M is the quantity of money; k – the liquidity preference
(a positive parameter, which shows the portion of nominal income held
in a liquid form, that is in the form of currency), and represents the
income sensitivity of the demand for money; P – the general price
level and Y – real output (real GDP), thus P × Y is nominal GDP.
 The Quantity Theory of Money
The conclusions from the quantity theory of money are:
the quantity of money in the economy determines
the price level (and the value of money);
an increase in the money supply increases the price level which means
that growth in the money supply causes inflation.
Milton Friedman famously claimed:
«Inflation is always and everywhere
a monetary phenomenon»
it results, when money supply grows
more rapidly than real output.
In reality this is not always the case. The velocity of money can be
unstable in the short run. It can change, for example, due to innovations
in banking system (the introduction of ATM – automatic teller
machines – that increased the velocity of money), or can be influenced
by the changes in the interest rates.
The Classical Dichotomy & the Neutrality of Money
From the quantity equation we get the classical dichotomy,
which suggests that economic variables can be divided into two groups:

nominal variables real variables

measured in money units measured in physical units
example: prices example: real output
Changes in the money supply affect only nominal variables, but not
real variables.
If the money supply doubles, in long run prices double, nominal
wages double, and all dollar values double. However, real output,
employment, real interest rates, and real wages remain unchanged.
This result is known as the neutrality of money.
Money is unlikely to be neutral (i.e. changes in money supply do
influence real variables) in the short run, but it is likely to be
neutral in the long run.
The Quantity Equation and the Monetary Rule
If the quantity equation is used as the equation of exchange, real
GDP is not at its potential level, and Y and V can change, then
when the changes are less than 10%, we can get approximately
M(%) + V(%) = P(%) + Y(%)
where P(%) = , that is the rate of inflation.
Under the assumption of the stable velocity of money, to keep the
rate of inflation unchanged (Δ = 0), the central bank must
maintain the rate of money growth (m) at the same level, as the
average rate of real GDP growth (g):
m= +g
This idea, proposed by monetarists, is called
«the monetary rule».
 The Inflation Tax
The purpose why countries print too much money in spite they know
it causes inflation is that governments do it to pay for expenditures.
When governments spend, they get the money by:

taxing borrowing printing money

Countries that have high spending, inadequate tax revenue, and limited
ability to borrow, may turn to printing money.
When a government raises revenue by printing money, it has engaged in
an inflation tax. When the government prints money and prices rise,
the value of the existing money held by people falls.
An inflation tax is a tax on people who hold money. The tax rate is
equal to the rate of inflation. Thus when inflation is very high, there
is a flight from money.
The revenue, received by the government by printing money, is called
seignorage.
 Inflation and the Purchasing Power of Money
An increase in the overall price level is equivalent to a proportionate
fall in the value of money. During inflation money loses its
purchasing power.
If P is the price level (the value of goods and services measured in
money) then 1/P is the value of money measured in terms of goods
and services. If prices double, the value of money has fallen to 1/2 its
prior value.
Prices Prices
Purchasing Power of Money
 Inflation and Real Incomes
If all prices, wages, salaries, rents, and so forth increase by the same
percentage – the case called pure inflation – the real effects of
inflation might be minimal.
But … in reality there is no such thing as pure inflation: during
inflation not all prices and wages rise proportionately. Thus, inflation
affects income distribution.
Among people mostly hurt by inflation are those with fixed incomes.
Even if during inflation nominal (= money) incomes rise, for many
categories of population the increase in prices (P) exceeds the increase
in nominal (= money) incomes (say, nominal wages W), real incomes
(W/P) fall:
Nominal Income
Real Income =
Price Level
Nominal Income
=
1+ Rate of Inflation
the treat of the fall in the social welfare
 Inflation and Money Illusion

If a person notes the increase in his/her money wage,

but does not notice the similar increase in all prices,
( = mixes the change in the nominal income
with the change in the real income),
he/she might think he/she is better off.
This is called the money illusion.
 Costs of Inflation: Waste of Resources
• Shoe leather costs (transaction costs): during inflation
in order to avoid inflation tax, people hold less money and
have to go to the bank or to sell financial assets more
often. The result: worn out shoes or payments of broker’s
fee, wasted time and inconvenience;
• Menu costs: associated with changing prices – the cost
of printing new menus, catalogs and price lists, mailing
costs to distribute them, the cost of advertising new prices,
and the cost of deciding the new prices themselves;
• Relative-price variability and the misallocation of resources: since it
is costly to change prices, firms change prices as rarely as possible.
During inflation, the relative price of goods whose price is held
constant for a period of time is falling with respect to the average
price level. This misallocates resources because economic decisions
are based on relative prices;
Costs of Inflation: Deterrent to Economic Growth
Inflation erodes the purchasing power of the people’s financial wealth
that discourages saving. Because saving is the base for investment,
the decrease in saving can slowdown or even discourage economic
growth

S FS r I K production possibilities
Because of the fear of the fall in the value r FS2
of profits in future, firms can refuse to FS1
finance investment projects with relatively r2 B
low internal rate of return in the productive r1 A
sector of the economy the threat of the
decline in the productive capacities FD
F

20
Costs of Inflation: Deterrent to Economic Growth
Inflation also decreases the incentive for saving (that can as well
slowdown the long-run economic growth), because it raises the
tax burden on income earned from saving the cause: taxes are
imposed on nominal rather than real incomes, provoking tax
distortions, that affect two types of taxes on saving:

. taxes on taxes on
capital gains nominal interest

21
 Costs of Inflation: Tax Distortions
Capital gains – the profits made from selling an asset for more
than its purchase price. Nominal capital gains are subject to
taxation.
Example. Suppose you buy a stock for $20 and sell it
for $50. Imagine, the price level doubles while you owned the
stock. You only have a $10 real gain (because you would need
to sell the stock for $40 just to break even), yet you must pay
taxes on the $30 nominal capital gain, because the tax code
does not account for inflation.
If we suppose the income tax rate is 13%, then
your real after-tax income would be only $6.1
($10 – $30 × 0.13).

«Save your money. Pay NO Taxes».

Alexander Hamilton 22
 Costs of Inflation: Tax Distortions
Nominal interest – it is taxed even though part of the nominal
interest rate is to compensate for inflation. When government
takes a fixed percent of the nominal interest rate as taxes, the
after tax real return falls.
Example. Suppose you are going to lend money ($100) in the
beginning of the year, and want to receive real interest 5%. If
you expect inflation of 10% by the end of the year, you will
set the nominal interest rate 15% (5% + 10%) in order to
compensate inflation, i.e. wishing to receive $15 as a nominal
interest, and $5 as real income. But since a tax is levied on
the nominal income, really you will receive less than $115.
If we suppose the income tax rate is 13%, your
real income will be only $3.05 ($15 –$10 – $15×0.13).

23
 Costs of Inflation: Confusion and Inconvenience
• Confusion and inconvenience: money serves a unit of
account, that means a money unit (dollar, pound, ruble)
is the yardstick by which we measure economic values.
During inflation, the value of money decreases and
shrinks the size of the economic measuring stick. This
makes accounting for firms' profits more difficult, and,
thus, makes choosing investments more complicated.
It also makes daily transactions more confusing.
1 meter

value of ₤1

All these costs of inflation exist even if inflation is stable and predictable.
 Expected and Unexpected Inflation
If inflation is expected (or anticipated), economic agents can try to
adjust the changes in their nominal incomes with the changes in
prices in order to minimize the fall in their real incomes.
A specified cost of unexpected (or unanticipated) inflation is
the arbitrary redistribution of wealth
Unexpected inflation works like

a tax on future receipts a subsidy to future payments

When inflation turns out to be higher than was expected ( > e)
actual

The lenders (recipients of the The borrowers are better off,

future payments) are worse off,
because they receive money
with less purchasing power
than they had bargained for.
because they were able to
use the money, when it had
greater value, yet they were
allowed to repay the loan
with money of lower value.
Costs of Unexpected Inflation

Example. Suppose you gave a loan to your friend

wishing to receive 5% of real interest and expecting
inflation 10%, thus the appointed nominal interest
rate was 15% (5% + 10%), but if inflation appeared

to be 12%, you will actually to be 16%, your actual

receive only 3% of real interest real income will be negative
(15% – 12%) (15% – 16%)
= a relative loss of income = an absolute loss of income

Your friend gained at the expense of you.

the borrower the lender

 The Fisher Effect
The adjustment of the nominal interest rate to inflation
is called the Fisher effect.
The nominal interest rate is the rate actually paid.
The real interest rate is the actual return the lender receives.
If you expect the inflation rate of 10% and wish to receive 5% of
real income, you will give the loan under the nominal interest rate of
15%. But if the expected rate of inflation is 11%, the appointed
nominal interest rate will be 16%. It means, that each percentage point
of the increase in the expected inflation leads to the one-to-one
increase in the nominal interest rate, while the real interest rate stays
unchanged (under the assumptions of the classical model, real
variables are determined in the real markets, and are not influenced by
the changes in nominal variables):
i =r+ e
 The Real Interest Rate

Economists distinguish:

Expected real interest rate Actual real interest rate

(ex ante), which is influenced by
the expected inflation:
rе = i – e
which real value when inflation
rate is high, will be:
(ex post), which is influenced by
the actual inflation:
r= i –
which real value when inflation
rate is high, will be:

r = i–
i– e
re =
1+ e 1+
 Costs of Unexpected Inflation
When inflation is higher than expected actual > e,

wealth and incomes are redistributed

from lenders from workers (employees) from old

to borrowers to firms (employers) to young
The persons who are most heavily hurt by unexpected inflation

the receivers
savers of fixed incomes old people

The influence of inflation on government budget

on the one hand, on the other hand,
receiving the seignorage Olivera-Tanzi effect
Besides the redistribution of wealth and incomes, unexpected inflation
causes uncertainty.
Redistribution of wealth and uncertainty induced by inflation tend
to increase social tensions and can lead to the political disturbances.
 Hyperinflation
Hyperinflation is a situation,
when prices rise very quickly.
200000 marks 100 mln. marks
The classical examples are:
Germany in 1922-1924: in October 1923 prices tripled each day and
increased by 32,400% during a month (there were short periods of
time, when inflation was 10% per hour!);
Hungary in 1945-1946: during a year price level increased by 3,8×1027;
Argentina and Bolivia in the middle 1980-s.
The recent hyperinflations:
Georgia in the middle 1990-s;
Zimbabwe from the middle 2000-s: in 2008 the rate
of inflation was 14,9×109 percent.
Venezuela: in 2018 the rate of
inflation exceeded 1.29×106 percent
100 trillion dollars Fire stoves with banknotes!
Images of Hyperinflation

14 mln. bolivars
 Consequences of Hyperinflation

a crash of the banking system and

a severe recession
of the entire financial system and a decrease in
a fall in the efficiency of the economy production
a redistribution of wealth +
serious political
a destruction of the welfare and well-being
disturbances,
a catastrophic reduction of saving provoked by a sharp
a disruption and even destruction strengthening of the
of the investment mechanism social tension
 How to Stop Hyperinflation
The criteria for hyperinflation was formulated by
the U.S. economist Phillip Cagan in 1956 in the article
«Monetary Dynamics of Hyperinflation»: the increase in prices
by 40-50% during not less than three subsequent months.
Hyperinflation is the result of the extremely high rates
of money growth needed to finance large budget deficits.
Thus, paraphrasing Milton Friedman’s statement
it can be concluded that:
«The end of hyperinflation is a fiscal phenomenon».
In order to stop hyperinflation economists recommend

to decrease simultaneously the reduction

government expenditures with of the money growth rate
 Lecture 13
The Phillips Curve
• Trade-offs between Inflation and Unemployment
• The Short-run Phillips Curve
• The Phillips Curve as the Model of Aggregate Supply
• The Long-run Phillips Curve
• Movement from the Short Run to the Long Run
• Costs of Reducing Inflation

1
 The Misery Index
Inflation and unemployment are the two forms of macroeconomic instability
and are both undesirable, they are the twin evils of any economy, therefore
their sum have been termed by A.Okun as the misery index:
Misery index = rate of unemployment + rate of inflation
= u+
%
35

30 Russia, 2000-2020
25

20 Misery Index
15 Inflation Rate
10

5
Unemployment Rate
0
 Trade-offs between Inflation and Unemployment

Inflation and unemployment:

are independent in the long run,
because
- unemployment is determined by
the features of the labor market,
- inflation is determined by
money growth and thus by the
situation in the money market
but are related in the short run,
because
an increase in aggregate demand
temporarily
- increases inflation and output,
- while it lowers unemployment.

3
Trade-off Between Inflation and Unemployment:
Policy Dilemma
It follows from the AD-AS model, that in LRAS
the short run the increase in aggregate P
SRAS
demand leads to the simultaneous rise in
output Y, that corresponds to the higher P2 B
level of employment (= lower level of P1 A
unemployment u) and to the increase in AD2
the price level Р (= higher level of AD1
inflation ) in the short run Y* Y2 Y
policymakers face a dilemma:
to choose a low to reduce inflation at the
unemployment and have or expense of higher
a higher rate of inflation unemployment
Low High
UNEMPLOYMENT INFLATION
High Low 4
 The Original Phillips Curve
The trade-off between inflation and unemployment was
first examined and explained in 1926 by the famous U.S.
economist Irving Fisher. But the idea became widespread
only after 1958, when a New Zealand economist, professor of London
School of Economics Alban William Phillips, while analyzing
empirical data for UK from 1861 to 1957, found the negative relation
between unemployment and the rate of nominal wage growth:
Wt Wt 1 Wt Wt
= -φ × (u – u*) 1

Wt 1 Wt 1

The explanation is that, The Original

Phillips curve
when unemployment u is low,
the bargaining power of workers is high, and
they can negotiate higher nominal wages W.
And vice versa, when u is high, u* u
workers can agree to work for a lower W. 5
 The Short-run Phillips Curve
Later in 1960 the U.S. economists Paul Samuelson and Robert Solow
took Phillips' work and replaced the nominal wage rate by the rate of
inflation. In fact, the nominal wage constitutes the major part of firms'
costs, thus the price can be represented as the nominal wage plus a mark-
up, and from the original formula of Phillips the relationship between
unemployment and the change in prices, i.e. inflation, can be derived.
Рt Рt 1
= -γ × (u – u*)
Рt 1
The Trade-off between Inflation and
Unemployment in the US, 1960-1969
that is: = -γ × (u – u*)

This negative relationship

between unemployment and
inflation has been found for
other countries and has been
6
termed the Phillips curve.
 The Phillips Curve and Aggregate Supply
Though the relation described by the Phillips curve appeared as a set of
observations, later it was interpreted as a theory of aggregate supply,
and is treated as a model of aggregate supply, the alternative way of
thinking about the AS relation. It can be shown graphically, proved
theoretically and derived algebraically.
The graph of the short-run Phillips curve is something like
a mirror image of the short-run aggregate supply curve (SRAS).
The very same reasons:
Produce in the short run a positive slope in aggregate supply curve
and a negative slope in the Phillips curve.;
provoke the movements along both the SRAS curve and the
short-run Phillips curve;
shift the short-run aggregate supply curve and the short-run Phillips curve.
7
 The Slope of the Short-run Phillips Curve
The short-run aggregate supply curve SRAS has a positive slope,
The explanation is that in the short run the increase in the price
level (from Р1 to Р2), when wages remain unchanged, stimulates
firms to expand output. In order to produce more output (Y2) firms
hire more workers, and unemployment falls (from u1 tо u2), thus the
short-run Phillips curve (SRPC) has a negative slope. In the linear
form it can be graphically represented as a down sloped line.

P
SRAS
P2 B SRPC
P1 A B
2
A
1

Y1 Y2 Y u2 u1 u 8
 The Slope of the Short-run Phillips Curve
The slope of the short-run Phillips curve is determined by
parameter γ, that reflects the sensitivity of inflation to the
changes in the unemployment rate (γ = / u).
The more sensitive is inflation to the changes in unemployment,
the steeper is the short-run Phillips curve. It means that even
small deviations of actual unemployment from its natural level
causes large changes in the inflation rate.

SRPC
SRPC
2 B
B
2
A A
1 1

u2 u1 u u2 u1 u
More sensitive (γ is large) Less sensitive (γ is small)
9
 Movements Along the Short-run Phillips Curve
An increase in aggregate demand (the rightward shift of the AD
curve) moves the economy along a short-run aggregate supply
(SRAS) curve from point A to point B to a higher price level (from P1
to P2) and a higher level of output (from Y1 to Y2) and, according to
the Okun's law, to a lower level of unemployment (from u1 to u2).
P Y employment
AD
u
P
SRAS
P2 B
P1 A B
2
AD2 A
1
AD1 SRPC(πе1)
Y1 Y2 u2 u1 u 10
Y
 Movements Along the Short-run Phillips Curve
P
SRAS
P1 A
A
P2 B 1
AD1 2 B
SRPC(πe1)
AD2
Y2 Y1 u1 u2 u
Y
And vice versa, the shifts in the aggregate demand curve to the left
result in lower price levels but lower output and higher unemployment.

Movements along the short-run Phillips curve

are caused by changes in aggregate demand and correspond
to the movements along the short-run aggregate supply curve.
11
 The Shifts of the Short-run Phillips Curve
The expression for the original Phillips curve implies that
the cause for its shifts are
changes in the natural unemployment rate.
When the natural unemployment rate u* rises,
the curve shifts to the right,
while when u* falls, the curve shifts to the left.
LRAS2 LRAS1
P SRAS2
SRAS1
P2 B B
2
P1 A
1 A
AD SRPC2
SRPC1
Y*2 Y*1 Y u*1 u*2 u
12
 Expectations-Augmented Phillips Curve
The strict negative relation between inflation and unemployment
had been observed up to the middle 1970-s. But in the middle 1970-s
the evidence was that unemployment and prices grew simultaneously
developed economies experienced stagflation. The conclusion was:
«the Phillips curve relation has disappeared».
The possibility of such а phenomenon was predicted as far as in
the late 1960-s by the famous U.S. economists, the Nobel prize winners
Milton Friedman and Edmund Phelps, who substantiated the necessity
of taking changes in agents’ inflation expectations into account. The
Phillips curve equation was modified – inflation expectations
(expectations of the changes in the price level in future) were included.
The equation was named «expectations-augmented Phillips curve»:

= е – γ × (u – u*)
13
 Inflation and Unemployment
in the United States, 1960-2020
12 14

12
10

10
8 Unemployment
8
6
6

4
4

2
2
Inflation
0 0

Source: U.S. Congress: Congressional Budget Office. 14

 Inflation and Unemployment
in the United Kingdom, 1960-2020
12 30

10 25

8
Unemployment 20

6 15

4 Inflation 10

2 5

0 0

Source: Economic Trends Annual Supplement, Labour Market Trends. 15

 Algebra of the Phillips Curve
One more evidence for the Phillips curve to be treated as the model of
aggregate supply is that the equation of the Phillips curve relation can
be derived from the equation of the AS relation. The positive slope of
the SRAS curve in the modern macroeconomic theory is explained by
the «price surprise» (that is the deviation of the actual price level P
from the expected price level Pe), and the level of output in the short
run is described by the Lucas equation:
Y = Y* + a × (Р – Ре)
Rearranging the above expression, we get:
Р = Ре + (1/a) × (Y – Y*)
Subtracting the price level of the previous year Р–1 from both parts,
we get:
Р – Р–1 = (Ре – Р–1) + (1/a) × (Y – Y*)
16
 Algebra of the Phillips Curve
In the equation
Р – Р–1 = (Ре – Р–1) + (1/a) × (Y – Y*)
under the low rates of inflation the expression (Р – Р–1) can be
considered as the actual rate of inflation ( ), while (Ре – Р–1) as
the expected rate of inflation ( е):
= е + (1/a ) × (Y – Y*)
According to the Okun’s law, the GDP gap is in the inverse
relation with the deviation of the actual unemployment rate from
the natural rate of unemployment:
(1/a) × (Y – Y*) = -γ × (u – u*)
As a result we get the expectations-augmented Phillips curve:

= е – γ × (u – u*)
17
 Shifts of the Short-run Phillips Curve:
the Role of Expectations
The equation of the expectations-augmented Phillips curve shows not
only the negative relation between unemployment and inflation, but also
one more cause for the shifts of the short-run Phillips curve: changes in
inflationary expectations е.
When е increases (for example, from e1 tо e2), the short-run Phillips
curve shifts to the right both u and rise, that corresponds to the
leftward shift of the short-run aggregate supply curve SRAS (movement
from B to C).
The decrease in е shifts the SRPC to the left, while the SRAS curve
shifts to the right both u and fall.
P LRAS SRAS
2
C SRAS1
P3
P2 B
B C
P1 2
A AD2 1 A
SRPC( е )
AD1 е
2
SRPC( 1)
Y* Y2 Y u2 u* u
 Types of Expectations

Static Adaptive Rational

– expectations – expectations – expectations that suggest:
people use all available
that are equal that are based on information to forecast future
to the inflation the principle and never make systematic
of the «learning mistakes: «Nobody treads
previous year on mistakes» on the rake twice»

e
t = t –1
e
t = e
t –1 +a×( t –1 – e
t –1 )
e
t = t (x1 , x2 , x3 ,…)

Backward-looking Expectations Forward-looking Expectations

19
 Built-in Inflation
Under static and adaptive expectations (because they are based on
the previous experience: = –1), the Phillips curve equation is:
= –1 – γ × (u – u*)
Expression –1 suggests that inflation possesses inertia. It means
that inflation exists until somebody stops it. Past inflation generates
expectations of inflation in future: economic agents begin to change
their behavior according to the expected price level. These inflation
expectations affect wages and prices that are set in the economy in
present. The expectations of inflation turn into the actual inflation.
In the AD-AS model inertia means, that the SRAS curve begins to
shift to the left, and the short-run Phillips curve begins to shift to
the right, that increases inflationary expectations:
Inflation in the past provokes inflation in future
Inflation of this type is called the «built-in inflation». 20
 Shifts of the Short-run Phillips Curve:
the Role of Supply Shocks
The third reason for the shifts of the short-run Phillips curve are
supply shocks. This was demonstrated in 1974 when OPEC raised
oil prices. This act raised the cost of production and shifted the
short-run aggregate-supply curve to the left causing prices to rise
and output to fall, or stagflation. Since both inflation and
unemployment has increased, this corresponds to a rightward
(upward) shift in the short-run Phillips curve.
P LRAS SRAS2
SRAS1
P2 B
2 B
P1 A
1 A SRPC2
AD SRPC1
Y2 Y* Y u* u2 u 21
The Short-run Phillips Curve as a Triangle Model
Now the whole formula for the short-run Phillips curve,
that reflects all the causes of inflation, is:

π = πe – γ × (u – u*) + ρ

Demand-pull Inflation
explains the negative slope
and the movements along
the short-run Phillips curve

Built-in Inflation Supply-side Inflation

explain the shifts
of the short-run Phillips curve
22
 Points Off the Short-run Phillips Curve
A point below the short-run Phillips curve (point C, for example)
represents an inflation rate ( 1) which is lower that chosen by firms
and workers, given the expected rate of inflation and the level of
output and unemployment (u1).
A point above the short-run Phillips curve (point D) represents an
inflation rate ( 2) which is higher that chosen by firms and workers,
given the expected rate of inflation and the level of output and
unemployment (u2).

В D
2

1 А
C SRPC( e)
23
u1 u2 u
 Natural Rate Hypothesis

In 1968, two prominent U.S. economists

Milton Friedman and Edmund Phelps
proposed the natural rate hypothesis, which states that
unemployment cannot be sustained below a certain level, a level
they called «natural rate of unemployment», and eventually
returns to this rate, regardless of inflation.
Natural rate of unemployment is the unemployment rate, such
that the actual inflation rate is equal to the expected inflation rate.
They argued that the Phillips curve is not a menu policymakers
can exploit. This is because in the long run money is neutral and
has no real effects.
Money growth just causes proportional changes in prices and
incomes, and should have no impact on unemployment.
24
 The Long-run Phillips Curve

Therefore, the long run Phillips curve (LRPC) should be

vertical at the natural rate of unemployment – the rate of
unemployment to which the economy naturally gravitates.
A vertical long-run Phillips curve corresponds to
a vertical long-run aggregate supply curve.

P Long-run Aggregate Long-run

Supply Curve Phillips Curve

Y* Y u* u
25
 Causes of the Shifts of the
Long-run Phillips Curve

All the factors that influence the natural rate of unemployment

cause the shifts of the long-run Phillips curve.
Primarily they are the result of the changes in labor market
policies, such as:
changes in minimum wage laws;
changes in unemployment insurance;
changes in job information;
establishment of employment agencies;
establishment of worker training and retraining programs, etc.

26
 Shifts of the Long-run Phillips Curve
The shifts of the long-run Phillips curve correspond to the
inverse shifts of the long-run aggregate supply curve.
If the labor market policy leads to the lower natural rate of
unemployment, the long-run Phillips curve shifts to the left and the
long-run aggregate-supply curve shifts to the right.
If the natural rate of unemployment becomes higher, the long-run
Phillips curve shifts to the right, while the long-run aggregate
supply curve shifts to the left.
P LRAS1 LRAS2 LRPC2 LRPC1

Y*1 Y*2 Y u*2 u*1 u 27

 Movements Along the Long-run Phillips Curve
In the long run, an increase in the money supply shifts AD to the right
and moves the economy from point A to point C, i.e. to the natural
level of output Y*.
An increase in money growth increases inflation but, because money
is neutral in the long run, prices and incomes move together and
inflation fails to affect unemployment. Thus, the economy moves
from point A to point C and traces out the long-run Phillips curve.
Though the long-run Phillips curve is vertical, in the short run
inflation can have a substantial impact on unemployment.
P LRAS SRAS2 LRPC
C SRAS1
P2
C
P1 A 2
AD2 1 A SRPC( e2)
AD1 SRPC( e1)
Y* Y u* u 28
 Points Off the Long-run Phillips Curve
A point to the right of the long-run Phillips curve but on the
short-run Phillips curve (point C) represents a situation in which
actual inflation exceeds expected inflation ( 2 > e2).
In such a situation there is an upward pressure
on the expected rate of inflation.
A point to the left of the
LRPC long-run Phillips curve but
on the short-run Phillips
curve (point D) represents a
D situation in which
3
1
А actual inflation is lower
C SRPC( e3)
2 than expected inflation
SRPC ( e1)
SRPC ( e2) ( 3 < e3), putting
a downward pressure
u* u on expected inflation.
29
 The Phillips Curve and Aggregate Supply
The analysis of the shape and shifts of the long-run Phillips curve still
more confirm the idea, that the Phillips curve can be considered as the
model of aggregate supply.
The Phillips curve equation and the aggregate supply equation reflect the
same macroeconomic ideas. Both equations show the relation between
real and nominal variables and the cause for the breach of the classical
dichotomy (division of variables into real and nominal) in the short run.
The Phillips curve and the aggregate supply curve are the two sides of
the same coin. Aggregate supply curve is more convenient in the study
of output and price level, while the Phillips curve is more convenient in
the study of unemployment and inflation.
The The
Aggregate
Supply Phillips
Curve Curve 30
Movement from the Short Run to the Long Run
In the short run, price expectations are fixed and an increase in
inflation can temporarily increase output and lower unemployment
below the natural rate (a movement from point A to point B).
However, in the long-run people adjust to the higher rate of inflation
by raising their expectations of inflation and the short-run Phillips
curve shifts to the right. The economy moves from point B to point
C with higher inflation, but no change in unemployment.

P LRAS SRAS2 LRPC

C SRAS1
P3
P2 B B C
2
P1 A A
1
AD2 SRPC( e2)
AD1 SRPC( e1)
Y* Y2 Y u2 u* u
31
 Expectations and Movement
from the Short Run to the Long Run
When actual inflation becomes equal to inflation expectations,
unemployment and thus output return to their natural levels:

When = e, then u = u* and Y = Y*

But the explanation of the process and the speed of the economy’s
movement from the short run to the long run strongly depends:
on the speed of wages and prices adjustment;
on the way how agents form their expectations.

adaptive expectations: rational expectations:

agents are backward-looking agents are forward-looking and use
and use past values of information effectively: they can make
observed variables in mistakes in forecasting future, but they
forecasting future never make systematic mistakes
32
 Expectations and Movement
from the Short Run to the Long Run
Under the assumption of the Under the assumption of the rational
adaptive expectations, wages expectations, any change in AD is
and prices adjust slowly and included in expectations and in wages.
People change their expectations
the Phillips curve has a
at once and economy moves from
negative slope. People change point A straight to point C, i.e. even in
their expectations over time the short run economy does not
and economy moves from A to deviate from the natural level of output
B and only then to C. and the Phillips curve is vertical.

LRPC LRPC

B C C
2 2
1 1
A SRPC( e2) A SRPC( e2)
SRPC( e1) SRPC( e1)
u2 u* u u* u 33
 The Importance of the Phillips Curve

The results obtained from the Phillips curve relation analysis

created the foundation for:
the study of the effects of aggregate supply shocks on the
economy;
the explanation of the inflation mechanism;
the estimation of the costs of reducing inflation (of the
disinflation policy);
the elaboration of the stabilization policy measures for the
optimal combination of such contradictory goals as
inflation and unemployment.

34
Supply Shocks and Demand-Side Policy Dilemma
With an adverse supply shock policymakers
face a less favorable trade-off between inflation and unemployment:
they must accept a higher inflation rate for each unemployment rate,
or a higher unemployment rate for each inflation rate.
have a difficult choice:
- if they reduce aggregate demand to fight inflation, they will
increase unemployment further.
- if they increase aggregate demand to reduce unemployment, they
increase inflation further.
P LRAS SRAS2 P LRAS SRAS2
SRAS1 SRAS1
P2
P3 C
B P2 B
P3 C
P1 A P1 A

AD1 AD2
AD2 AD1
Y3 Y2 Y* Y Y2 Y3Y* Y 35
 Costs of Reducing Inflation
Inflation can be reduced, if policymakers succeed to change
inflation expectations, thus they can choose to pursue a policy of
disinflation – a reduction in the rate of inflation – through
conducting a tight monetary policy. A reduction in the money
supply reduces aggregate demand, reduces output and increases
unemployment (a movement from point A to point B). Over time,
inflation expectations fall and the short-run Phillips curve shifts
downward and the economy moves from point B to point C.
LRPC

1 A
2 B
C
SRPC( e1)
SRPC( e2) 36
u* u2 u
 The Sacrifice Ratio

Thus the cost of disinflation policy is the fall in output and the
rise in unemployment, which is measured with the sacrifice ratio
– the number of percentage points of annual output (Y) that is lost
to reduce inflation ( ) by one percentage point:

Y
Sacrifice ratio =

The amount of aggregate output lost depends:

on how fast people lower their expectations of inflation and
on the unemployment elasticity of inflation, i.e. on the slope of the
short-run Phillips curve.

37
 Strategies to Reduce Inflation

Shock Therapy Gradualism

(also called «cold turkey» or «cold
shower»): the large and quick
decrease in money supply growth,
that leads to a great fall in output
and rise in unemployment, but for
a short period of time.
LRAS
SRAS1
SRAS2
=10%
the step-by-step decrease
in money supply growth,
that causes a small fall in
output and employment,
but the period of time is
much more longer.
LRAS
SRAS1
SRAS2
=10%

AD1 AD1
AD2
=3% AD2 =3% AD3

YSR Y* Y YSRY* Y
Strategies to Reduce Inflation: a Comparison
The Change in the The Change in the
Money Growth Rate Inflation Rate

The Change in the

Real Output

39
 Costs of Reducing Inflation:
Rational Expectations Approach
Some economists estimated the sacrifice ratio to be about 5, which is
very large.
Supporters of a theory of rational expectations believe that the cost
of disinflation could be much smaller and maybe zero.
Rational expectations suggests that people optimally use all available
information, including about government policies, when
forecasting the future.
It means that even in the short-run
there is no trade-off between inflation and unemployment;
actual inflation always equals expected inflation ( = e);
unemployment is always on the natural level (u = u*);
output is always on the potential level (Y = Y*).
It implies that both the short-run Phillips curve
40
and the short-run aggregate supply curve are vertical.
 The Role of Stabilization Policy:
Rational Expectations Approach
Rational expectations hypothesis has both positive and negative
implications for the policymakers.
On the one hand, under the assumption of rational expectations,
full flexible prices and symmetry of information,
the expected government policy has no effect on the economy,
because only unexpected policy changes can affect
the level of real output: that is the sense
of the «policy ineffectiveness preposition» (PIP).

Robert Lucas Thomas Sargent Neil Wallace

41
 The Role of Stabilization Policy:
Rational Expectations Approach

On the other hand, disinflation policy can be painless and costless.

The conditions for the sacrifice ratio to be zero are:
the announced policy of disinflation must be credible;
expectations must be rational;
the Central bank must be independent from fiscal authorities;
information must be true, full and perfect;
prices must be fully flexible, and
all markets must clear instantaneously.

42
 Lecture 14
The Open Economy
• The Open Economy: a Concept
• Exchange Rate and its Determinants
• Foreign Exchange Market and Exchange Rate
• Nominal and Real Exchange Rate
• Net Exports and Capital Flows
• Fixed and Flexible Exchange Rate Systems
• Balance of Payments and its Structure
• Macroeconomic Policy in the Open Economy

1
 The Open Economy: a Concept
The open economy is an economy that interacts with other
economies of the world. It implies the «openness» of all
macroeconomic markets – goods, financial and resource.
Nations interact with each other through three main channels:

International Trade Financial Factors of Production

the exchange of Relationships Movements
goods and services the exchange of the exchange of
(exports and assets (purchases and economic resources
imports), that is sales), known as that provoke
net exports capital flows factor payments

The possibility to choose

to buy domestic to buy domestic to use economic
goods and services financial assets resources at home
or foreign or foreign or abroad
2
 Key Macroeconomic Variables
in the Open Economy

• Exchange rate (e)

• Prices (domestic P & foreign PF)
• Interest rates (domestic i & foreign iF)
• GDP (domestic Y & foreign YF)
• Balance of Payments (current account, capital
account, official reserves account)
 The Exchange Rate: the Concept
In order to buy goods and assets nations should
change their domestic currencies in the foreign
exchange markets, where the exchange rate of
the domestic currency is determined.
The exchange rate is the price of one country’s currency relative
to another country’s currency. It can be measured as:
The foreign currency price The domestic currency price
of one unit of one unit
of the domestic currency of the foreign currency
(the British variant): (the European variant):
for example, for example,
1.25$ = 1£ 70₽ = 1$
is the exchange rate for pound is the exchange rate for ruble
In our lecture course we will use the British variant. 4
 The Exchange Rate Determination:
the Demand for the Domestic Currency
The exchange rate is formed on the base of the interactions between
the demand for and the supply of the domestic currency.
The demand for the domestic currency (e.g. British pound – £)
comes from foreigners, who wish to buy:
domestic goods and services (i.e. produced in the UK);
domestic financial assets (i.e. to invest in the UK).
A demand curve for the domestic currency is generally downsloped,
indicating that the lower is the price of the domestic currency (the
rate of exchange), the greater is the quantity of the domestic
currency demanded.
The reason: foreigners receive more units of the domestic currency
for each unit of their own (foreign) currency in exchange and can
buy more goods and assets exports for foreigners becomes
cheaper, and it becomes more attractive to invest in this country.
5
 The Exchange Rate Determination:
the Supply of the Domestic Currency
The supply of the domestic currency (e.g. British pound – £)
comes from national economic agents (people in the UK), who
wish to buy:
foreign goods and services;
foreign financial assets (i.e. to invest abroad).
A supply curve of the domestic currency is generally upsloped,
indicating that the higher is the price of the domestic currency
or the exchange rate, the greater is the quantity of the domestic
currency supplied.
The reason: the greater is the amount of the foreign currency
national economic agents can exchange for one unit of the
national currency, the cheaper will be foreign goods, and the
more attractive are investments abroad.
6
The Foreign In order for the US to pay for its imports of
goods and services and securities from UK, it
Exchange must supply dollars, which are then converted
Market into pounds by the foreign exchange market.

Goods and services & Securities

Demand for £ Supply of $

United Foreign United
Exchange
Kingdom Market States
Supply of £ Demand for $

Goods and services & Securities

In order for UK to pay for its imports of goods and services

and securities from the US, it must supply pounds, which are
then converted into dollars by the foreign exchange market. 7
 The Exchange Market The Increase in the Demand for
the Domestic Currency
Equilibrium e
($/£) D2 S
The Equilibrium Exchange Rate D1
e D S B
($/£) e2
e1 A
A
eE D£ = S£
£1 £2 Quantity of
pounds (£)
The Increase in the Supply of
the Domestic Currency
Quantity of e
£E pounds (£) ($/£) D S1
S2
The increase in the demand for the domestic A
e1
currency leads to the rise in both the exchange
e2 B
rate and the quantity of currency supplied.
The increase in the supply of the domestic
currency leads to the fall in the exchange rate 8
and to the rise in the quantity of currency demanded £1 £2 Quantity of
pounds (£)
 Changes in the Exchange Rate

Suppose, the exchange rate of pound is

$1.25 = 1£

The rise in the exchange rate The fall in the exchange rate
means the means the
increase in the
decrease in the
international value
international value
of the domestic currency (i.e.
its relative price to other of the domestic currency
currencies) that is called that is called
appreciation depreciation
$1.3 = 1£ $1.2 = 1£
9
 Ruble Exchange Rate Dynamics, 1999-2020
75
70
65
60
55
50
45
40
35
30
25
20

Exchange rate for $ Exchange rate for € 10

Source: Bank of Russia
 The Determinants of the Exchange Rate
Domestic currency appreciates (e )

when the demand for the domestic
currency increases
that happens, if there is:
an increase in exports
(= foreigners wish to buy more
domestic goods and services);
capital inflow (= foreigners
wish to buy more domestic
assets and to invest more in the
domestic economy).
when the supply of the domestic
currency decreases
that happens, if there is:
a decrease in imports
(= domestic economic agents
wish to buy fewer foreign goods
and services);
a decrease in the desire of
domestic economic agents to buy
foreign assets or to invest abroad).

11
 The Appreciation of the Domestic Currency
on the Graphs

The Increase in the Demand The Decrease in the Supply

for the Domestic Currency of the Domestic Currency
e e
($/£) D2 S ($/£) D S2
D1 S1
B e2 B
e2
e1 A
e1 A

Quantity of Quantity of
pounds (£) pounds (£)

12
 The Determinants of the Exchange Rate
Domestic currency depreciates (e )
when supply of the domestic when the demand for the domestic
currency increases currency decreases
that happens, if there is: that happens, if there is:
an increase in imports a decrease in exports
(= domestic economic agents wish (= foreigners wish to buy fewer
to buy more foreign goods and domestic goods and services);
services); a decrease in the desire of
capital outflow (= domestic eco- foreigners to buy domestic
nomic agents wish to buy foreign assets or to invest in the
assets and to invest more abroad). domestic economy.

13
 The Depreciation of the Domestic Currency
on the Graphs

The Increase in the Supply The Decrease in the Demand

of the Domestic Currency for the Domestic Currency
e e
($/£) D S1 ($/£) D1 S
S2 D2
e1 A A
e1
e2 B e2 B

Quantity of Quantity of
pounds (£) pounds (£)

14
The Determinants of the Exchange Rate

Hence, to understand the factors that influence the

exchange rate, we ought to analyze the determinants
of net exports and capital flows.

15
The Exchange Rate and Net Exports: Exports
Changes in the exchange rate affect:
exports – the willingness of foreigners (U.S. citizens) to buy
goods produced in the domestic economy (U.K. economy);
imports – the willingness of domestic citizens (people in the UK)
to buy goods, produced in the foreign economy (U.S. economy).
The lower is the exchange rate of the domestic currency (pound),
that is the cheaper is the domestic currency, the larger is British
exports, because foreigners in exchange receive more units of the
domestic currency (pounds) for each unit of their own currency
(dollar), and can buy more British goods and services for the
same amount of their currency.
And equivalently, since foreigners get more units of the domestic
currency (pounds) for each unit of their own currency (dollar),
they pay less for each unit of British goods.
16
 The Exchange Rate and Exports
Example. Suppose, the U.S. citizen wants to buy a bottle of Scotch
whiskey in the UK, which costs £40. When the exchange rate of
pound is 1.25 dollars per pound, he must pay 40 1.25 = 50 (doll.),
while when the exchange rate of pound is 1.15 dollars per pound,
he must pay only 40 1.15 = 46 (doll.).

The country’s exports increases, when the exchange rate of

the domestic currency is low, and the domestic currency is
cheap (or weak).

17
The Exchange Rate and Net Exports: Imports

The higher is the exchange rate of the domestic currency (pound),

i.е. the more expensive is the domestic currency, the larger is
the willingness of domestic citizens (people in the UK) to buy
goods produced in other countries, because for each unit of the
domestic currency (pound) they will get more units of the
foreign currency (dollars), and can buy more foreign (U.S.)
goods and services for the same amount of currency.
And equivalently, for each unit of foreign (U.S.) goods domestic
citizens (people in the UK) will pay less, because in exchange
they will get more units of the foreign currency (dollars) for
each unit of the domestic currency (pound).

18
 The Exchange Rate and Imports
Example. Suppose, an Englishman wants to buy jeans in the United
States, which costs $50. When the exchange rate of pound
is 1.25 dollars per pound, he must pay 50 1/1.25 = 40 (pounds),
while when the exchange rate of pound is 1.15 dollars per pound,
he must pay 50 1/1.15 43.5 (pounds).

The country’s imports increases, when the exchange rate of the

domestic currency is high, and the domestic currency is
expensive (or strong).

19
 The Nominal and the Real Exchange Rate
To analyze the determinants of net exports, we must distinguish the
nominal and the real exchange rates. The exchange rate, which is
formed in the exchange market by interaction of the demand for and
the supply of a currency, is the nominal exchange rate.
The Nominal Exchange Rate (e) represents the
relative price of two currencies.
The Real Exchange Rate ( ) is the relative price of goods
produced in two countries.
For the British variant of the nominal exchange rate
the real exchange rate is:
= e P/PF

real nominal domestic foreign

exchange rate exchange rate price level price level
For a particular good the real exchange rate shows the relative price
20
of
a unit of foreign good, expressed in terms of the units of domestic goods.
Construction of the Real Exchange Rate (of pound)

Price of U.K. Price of U.K. goods,

goods, measured in measured in foreign
pounds currency
Р е×Р
Real
exchange rate
Price of foreign ε
goods, measured in
foreign currency
РF

21
The Nominal and the Real Exchange Rate
Example. If a car in the UK costs ₤30,000 and ¥2,5 million in
Japan, and the nominal exchange rate is 125¥ = 1₤,
then the real exchange rate is 1.5.
It implies, we can buy 1.5 of Japanese car for one U.K. car:

125 ¥/₤ × ₤30,000 for the U.K. car

𝛆= = 1,5
¥2,5 million for the Japanese car
.

1 Jaguar The real exchange 1.5 Lexus

rate is 1.5 Lexus

for 1 Jaguar
22
 The Determinants of the Real Exchange Rate

The real exchange rate reflects the competitiveness of the domestic

goods on the world goods markets, i.e. the terms of trade.
The higher is the real exchange rate, the less competitive are the
domestic goods and the worse are the terms of trade for the
domestic economy.
The real exchange rate is influenced by:

Nominal Exchange Rate Foreign Price Level

e PF
Domestic Price Level
P
23
 The Price Level and the Real Exchange Rate
The real exchange rate is primarily influenced by the changes in the
relative price levels of domestic and foreign goods (P/PF).
Among the determinants of the price level are:
the level of aggregate expenditures (consumption and investment
spending, government purchases, net exports), i.e. aggregate
demand that depends greatly on the fiscal and monetary policy:
the larger is the sum of expenditures, the higher is the pressure
on prices to rise and the lower is the competitiveness;
resource prices: the rise in nominal wages or natural recourses
prices leads to higher costs that initiates firms to decrease output
and to increase prices that results in the rise of the real exchange
rate and the loss of the competitiveness.
the level of productivity: high productivity leads to the decrease
in prices and to the rise in the competitiveness; 24
 Changes in the Exchange Rate and Inflation
Percentage changes in the real exchange rate can be defined as:
D (%) = Dе (%) + [ΔP(%) – ΔPF(%)] =
= Dе (%) + (p – pF)

a change a change a rate a rate

in the real in the nominal of domestic of foreign
exchange rate exchange rate inflation inflation
(Note: the formula above is acceptable only under small (< 10%)
rates of changes in the variables included).
The higher is the rate of domestic inflation
and/or the lower is the rate of foreign inflation,
the lower is the competitiveness of the domestic goods
in the world goods markets,
that is, the lower is the desire of foreigners to buy these goods. 25
 The Determinants of Net Exports: Exports
Since net exports is the difference between exports and imports,
it is determined by the factors that influence these two flows.
Exports is determined by:
• foreign income (YF): the wealthier are foreigners, the larger
amount of goods they would demand from the given
domestic economy;
• real exchange rate ( = e P/PF): the higher is (that is, the
higher is the nominal exchange rate e, or the higher is the
level of domestic prices P, or the lower is the level of foreign
prices PF), the smaller amount of goods foreigners would be
eager to buy from the given economy;
• tastes and preferences for the goods produced by the
domestic economy: the higher is the willingness of foreigners
to consume these goods, the greater is the country’s exports.
Thus, Ex = Ex (Y F , e , P , P F , tastesF ) 26
 The Determinants of Net Exports: Imports
Imports is determined by:
• domestic income (Y): the wealthier are the domestic economic
agents, the more goods they can afford to buy from other countries;
• real exchange rate ( = e P/PF): the higher is (that is, the
higher is the nominal exchange rate e or the higher is the level of
domestic prices P or the lower is the level of foreign prices PF), the
greater amount of foreign goods the domestic economic agents
would be eager to buy;
• tastes and preferences for foreign goods: the higher is the desire of
the domestic economic agents to consume these goods, the greater
is the country’s imports.
Hence I m = I m (Y , e, P , P F , tastes)

and net exports is

NX = NX (Y F , Y , e, P , P F , tastesF , tastes) 27
 Changes in Exports on the Graphs
Foreigners demand more To buy domestic goods foreigners
domestic goods & services need domestic currency

An increase in net exports and An increase

hence in aggregate demand for in the demand for
domestic goods & services the domestic currency
AD-AS Model Exchange Market
Price Exchange rate
level (P) SRAS of the domestic S
currency (e)
P2 B e2 B
P1 e1 A
A
AD2 D2
AD1 D1
Y1 Y2 Real output (Y) Quantity of national
currency (Q)
A rise in real output and in price level Domestic currency appreciates
 Changes in Imports on the Graphs
Domestic agents demand more To buy foreign goods domestic
foreign goods & services agents need foreign currency

A decrease in net exports and An increase

hence in aggregate demand in the supply of
for domestic goods & services the domestic currency
AD-AS Model Exchange Market
Price Exchange rate
level (P) SRAS of the domestic S1
currency (e) S2
A
P1 e1
A
P2 e2 B
B
AD1 D
AD2
Y2 Y1 Real output (Y) Quantity of national
currency (Q)
A fall in real output and in price level Domestic currency depreciates
 The Determinants of Capital Flows:
the Interest Rate Differential
The major reason for capital to move from one country to another is
the rate of return on investment, which is expressed by the
interest rates. Thus, the key determinants of capital flows are:
domestic interest rate (i): the higher is this interest rate, the more
profitable and thus attractive are the domestic assets for
foreigners, and the larger is capital inflow in the domestic
economy;
foreign interest rate (iF): when it is high, foreign assets are more
attractive, and hence the greater is capital outflow from the
domestic economy to the rest of the world.
$ /$ $/$ The difference between the domestic interest rate
and the foreign interest rate (i – i ) is called the %%
F

interest rate differential.

30
 The Determinants of Capital Flows
expected changes in the nominal exchange rate (ee): if the rise in
the domestic nominal exchange rate is expected, foreign assets
become less attractive for the domestic agents, since the purchase
of foreign assets now will bring the yield on them not earlier than
at the end of the one-year period, and besides in foreign currency;
the rise in the nominal exchange rate of the domestic currency
means that domestic agents – owners of foreign assets – will lose,
when exchanging relatively cheap foreign currency for more
expensive domestic currency.
Thus, the expected rise in the country’s nominal exchange rate,
ceteris paribus, stimulates capital inflow. And vice versa.
Hence the functions of:

Capital Inflow Capital Outflow

е
е
CF = CF ( i , i F , e ) CF = CF ( i , i F , e )
31
 Domestic or Foreign Bond:
That is the Question
Example. Suppose the interest on the domestic bond = 10%, while on
the foreign bond iF = 8%, and a depreciation of the domestic currency
by 3% is expected. In order to determine, which bond – domestic or
foreign – to buy, let’s compare the rates of return on both assets:
on the domestic bond it equals 10% (i = 10%), while on the foreign
bond it equals 11% (8% as the rate of return on the foreign bond plus
3% as the expected income, received from the exchange of the foreign
currency for the national currency).
And vice versa, if an appreciation of the domestic currency is
expected, say, by 3%, the purchase of the domestic bond is more
reasonable, because the rate of return on the foreign bond for domestic
financial investors is only 5% (8% 3%). While foreign financial
investors, if they buy the bond of this country, will receive the rate of
return equal to 13% (10% + 3%) instead of 8%, that they will earn,
purchasing their own (foreign) bond.
 Capital Inflows on the Graphs
Foreign saving is used to To buy domestic assets
buy domestic assets foreigners need domestic currency

An increase in the supply An increase in the demand

of loanable funds for the domestic currency
Loanable Funds Exchange
Real Market Exchange rate Market
interest FS1 of domestic S
rate (r) FS2 currency (e)
r1 A e2 B
r2 B e1 A
D2
FD D1
Quantity of Quantity of national
loanable funds (F) currency (Q)
Real interest rate falls Domestic currency appreciates
 Capital Outflows on the Graphs
A part of national saving is To buy foreign assets domestic
used to buy foreign assets agents need foreign currency

A decrease in the supply An increase in the supply

of loanable funds of the domestic currency
Loanable Funds Exchange
Market Market
Real Exchange rate
interest FS2 of national S1
rate (r) FS1 currency (e) S2
B A
r2 e1
r1 A e2 B

FD D
Quantity of Quantity of national
loanable funds (F) currency (Q)
Real interest rate rises Domestic currency depreciates
 Exchange Rate Systems: the History
History knows the following exchange rate systems (or regimes):
the gold standard system implying the free exchange of national
currency for gold, and gold stands behind all the international
transactions between countries;
the fixed exchange rates regime (the Bretton-Woods system, which
was adopted in 1944), when the U.S. dollar was chosen the reserve
world currency, which was attached to gold, and other currencies
were tightly attached to dollar, and the fixed exchange rates were
maintained by the central banks via interventions in the exchange
market; in the early 1970-s the U.S. dollar was twice devaluated
the collapse of the fixed exchange rates system;
the floating (flexible) exchange rates system (from March 1st, 1973):
exchange rates are assumed to be set by relations between supply of
and demand for currency in the exchange market without central
banks’ interventions; national currencies are no longer attached to
gold). In practice there is no «clean float». Instead, a «managed» or
35
a «dirty floating» is used.
 The Fixed versus the Flexible
Exchange Rate System
Macroeconomists are primarily concerned with two types of
the exchange rate regimes:

The Fixed The Flexible

Exchange Rate System
A system, in which the rates of
exchange between the domestic
and the foreign currency are fixed,
and the central bank can’t allow the
exchange rate deviate from the level
that it proclaimed to maintain.
Exchange Rate System
A system, in which the rates of
exchange between the domestic
and the foreign currency floats
freely, and is determined
by the market demand for and
supply of a currency.

36
 The Fixed Exchange Rate System:
the Central Bank’s Interventions

Under the fixed exchange rate system pegging the rate of exchange
of the domestic currency to the certain fixed level is obtained by
the Central bank’s interventions in the foreign exchange markets.
The Central bank’s interventions are the purchases and sales
of the foreign currency in exchange for the domestic currency.
They are based on the operations with the official reserves, and
are also called the official financing.

37
 The Fixed Exchange Rate System:
the Central Bank’s Interventions

When there is an excess demand for When there is an excess supply

the domestic currency, in order not
to allow the rise in the exchange
rate, the CB intervenes and
increases the supply of the domestic
currency via purchasing the foreign
currency. The result is the increase
in both the supply of money (MS )
and the official reserves (reserves of
the foreign currency) (OR ).
of the domestic currency,
in order to prevent the
exchange rate from falling, the
CB decreases the supply of the
domestic currency (MS ) via
selling the foreign currency.
Thus, the official reserves
(reserves of the foreign
currency) fall (OR ).

38
 The Fixed Exchange Rate System:
the Central Bank’s Interventions
Among the assets of the central bank are reserves of foreign currency
that it holds. The liabilities is the stock of money in the economy.
The CB’s intervention (for example, Bank of England), in which it buys
foreign currency (say, for £1 million) and pays for it by issuing money
in circulation, increases both assets and liabilities by the same amount.
Balance Sheet of the Central Bank
Assets Liabilities
Reserves of Foreign Currency Money (National Currency)
(dollars) (pounds)
Effect of the CB's Intervention (assume e = $1,25/£1)
Assets Liabilities
Change in Official Reserves: Change in Money Stock:
+ $1,25 million (= £1 million) + £1 million
The opposite happens, when the central bank
sells foreign currency. 39
The Central Bank’s Interventions on the Graphs
The Increase in the Demand The Increase in the Supply
for National Currency of National Currency
e e S1 = SCB
($/£) D2 S1 ($/£) D
D1 SCB S2
A=B
ē
ē A B

Quantity of Quantity of
pounds (£) pounds (£)
In order to maintain the exchange rate on the proclaimed fixed level

when there is an upward pressure when there is a downward pressure

on the exchange rate, the CB on the exchange rate, the CB
increases the supply of money decreases the supply of money
40
(of the domestic currency) (of the domestic currency)
 The Fixed Exchange Rate System:
Devaluation and Revaluation
Although exchange rates are pegged at fixed values,
occasional adjustments in these values are allowed.

The official decrease of the The official increase of the

international value of the
domestic currency by the
Central bank (the exchange
rate, that it commits to
maintain), when it runs out
of foreign reserves,
is known as
devaluation.
international value of the
domestic currency by the
Central bank (the exchange
rate, that it commits to
maintain), when its foreign
reserves become so excessive,
that they cause domestic
inflation, is called
revaluation.

41
 The Flexible Exchange Rate System:
Depreciation and Appreciation
Under the flexible exchange rates
there is no need for the Central bank to intervene.
The increase in the supply of the domestic currency due to the
fall in net exports, or due to the net capital outflow leads to the
depreciation of the domestic currency, that in turn causes the
increase in net exports, and in the willingness of foreigners to buy
domestic assets, and therefore the domestic currency appreciates.
And vice versa, the rise in the demand for the domestic currency due
to the increase in net exports, or due to the net capital inflow
leads to the appreciation of the domestic currency, that in turn
causes the fall in net exports, and in the willingness of foreigners
to buy domestic assets, and the domestic currency depreciates.
Thus, the exchange rate is determined exclusively by the market forces.

42
 Lecture 14
The Open Economy
• Open Economy versus Closed Economy
• Exchange Rate and its Determinants
• Foreign Exchange Market and Exchange Rate
• Nominal and Real Exchange Rate
• Net Exports and Capital Flows
• Fixed and Flexible Exchange Rate Systems
• Balance of Payments and its Structure
• Macroeconomic Policy in the Open Economy

1
 The Balance of Payments

The balance of payments (BP) is a summary statement of all the

transactions of a nation with the rest of the world during a
year. Its main purpose is to inform government authorities of
the nation's international position and to help them formulate
monetary, fiscal, and commercial policies.
The balance of payments is divided into three major sections:
I. The Current Account, which shows flows of goods and
services, factor incomes and government grants.
II. The Capital Account, which shows flows of investments and
loans. (A statistical discrepancy may also be included here,
since it refers mostly to unreported capital transactions.)
III.The Official Reserves Account, which shows the changes in
the nation's official (i.e. government) reserves and liabilities
required to balance the current and capital accounts. 2
 The Current Account
The current-account balance includes:
the merchandise balance which shows the flow of goods between
the nation and the rest of the world (often called «visible trade») and
equals the balance between goods exports and goods imports;
the balance of services (or «invisible trade») that reflects the flow of
services (transportation, insurance, tourism, banking services, royalty
fees, etc., except lending operations);
The balance of goods and services is called the trade balance.
the balance of income, which includes income on assets, called
investment income (interest payments on bonds and dividends on shares),
and compensation of employees, i.e. reflects net factor incomes;
unilateral transfers (both private and government such as foreign
aid, gifts, grants, pensions):

Current-Account Balance = Merchandise Balance +

+ Services Balance + Income Balance + Unilateral Transfers
3
 The Capital and Financial Account
The capital and financial account reflects transactions involving assets,
either real or financial, that change ownership across international
borders. It includes:
▪ purchasing of real estate such as land and other real assets;
▪ purchasing of capital, that is direct investment;
▪ sales and purchasing of interest-bearing financial instruments (private
and government securities), that is portfolio investment;
▪ loans to and from foreigners;
▪ non-interest-bearing demand deposits, etc.
The purchase of home assets represents a payment from foreigners
received by a home country, and corresponds to capital inflow.
The purchase of foreign assets by home residents represents a
payment to foreign countries, and corresponds to capital outflow.
Capital-Account Balance =
= Foreign Purchases of Home Assets –
– Home Purchases of Foreign Assets =
= Capital Inflow – Capital Outflow 4
 Credits and Debits in the Balance of Payments
All transactions in the BP are recorded either as credits or as debits.
Credits Debits
• are all the transactions that lead • are all the transactions that lead
to the nation receiving payments to payments to foreigners
from foreigners (= earning (= spending of foreign currencies);
foreign currencies); • are entered with a minus sign (–)
• are entered with a plus sign (+) • include:
in current and capital accounts - imports of goods and services;
• include: - government grants and aid
- exports of goods and services; made to foreigners;
- investments and loans received - investments and loans made to
from abroad (= capital inflows) foreigners (= capital outflows)
When the sum of all credits exceeds the sum of all debits,
there is the balance of payments surplus;
When the sum of debits is greater than the sum of credits,
the nation has a deficit in its balance of payments. 5
 The Official Reserves Account
The official reserve account is the balance-of-payments
section that shows the change in the nation's official (government)
reserves and liabilities, required to finance the balance of
payments disequilibrium under the fixed exchange rate system as
well as under the «managed floating». It includes:
• reserves of foreign currencies held in the Central bank;
• reserves of gold (though now gold is not used in official financing);
• international means of payments (such as special drawing rights,
which are reserve assets created by the International Monetary Fund);
• the reserve position in the International Monetary Fund.

6
The Balance of Payments and Official Reserves
If the nation has a BP surplus
(BP > 0), it implies that at a
given rate of exchange, there is a
shortage of the national currency
(the quantity demanded exceeds
the quantity supplied: D > S)
and the excess of the foreign
currency. Monetary authorities
intervene and buy foreign
currency exchanging it for
national currency. As a result
there is an increase in both
official reserves and the supply
of national currency.
If the nation has a BP deficit
(BP < 0), it implies that at a
given rate of exchange, there is
an excess of the national
currency (the quantity supplied
exceeds the quantity demanded:
S > D) and the shortage of the
foreign currency. Monetary
authorities intervene and sell
foreign currency exchanging it
for national currency. As a result
there is a decrease in both
official reserves and the supply
of national currency.
7
 The International Reserves
of the Russian Federation, 2021

On April 1st, 2021 the International Reserves of

the Russian Federation accounted to $573 322 mln, of which:
Foreign exchange reserves $448 035 mln, of which:
- foreign exchange $435 984 mln;
- SDRs $6 885 mln;
- reserve position in IMF $5 166 mln.
Monetary gold $125 287 mln.
 International Reserves of Russia, 1998-2021
1998 – $12.9 bln: so low that CB’s interventions in the exchange
market and tight exchange rate policy were impossible.
2000 – $24 bln: started to rise due to the favorable conjuncture in the
world raw materials market (world oil prices jumped by 2.5 times).
2002 – $44 bln.
2003 – $77 bln. (the second place after China)
2004 – $124.5 bln.
2005 – $137 bln.
2006 – $214.7 bln. (the fifth place in the world)
2007 – $384.7 bln.
2008 – $455.7 bln. (reaching their maximum of $596,6 bln. in August
and falling to the minimum of $383,8 bln. in April, 2009).
2009 – $447.7 bln. The structure of foreign exchange of
2010 – $479.4 bln. Russia (September 2020): $ – 21.9%,
2011 – $498.7 bln. € – 29.0%, £ – 5.9%, CAD – 2.5%,
2012 – $537.6 bln. ¥ – 3.9%, AUD – 0.8%, CNY – 12.3%.
2013 – $509.6 bln.
2014 – $385.5 bln. 2017 – $432.7 bln. 2020 – $556.0 bln.
2015 – $368.4 bln. 2018 – $468.5 bln. 2021 – $595.8 bln. 9
2016 – $377.7 bln. 2019 – $554.4 bln.
 International Reserves of Russia,
1998-2021 (in bln USD)

10
Source: On Bank of Russia data
 Countries with the Largest
International Reserves, 2021
Country Billion USD
1 China 3 536,0
2 Japan 1 340,1
3 Switzerland 1 085,1
4 Russia 591,5
5 India 588,4
6 Taiwan 540,0
7 Hong Kong 519,7
8 Saudi Arabia 457,0
9 South Korea 443,1
10 Singapore 362,3
11 Brazil 354,8
12 Germany 267,0
11
13 Thailand 258,2
Countries with the Largest Gold Reserve,
December, 2020 (tons)

3662,4

2298,5

670,1

12
 The Balance of Payments
under Fixed Exchange Rates
The balance of payments total account must be zero:
NX + CF + OR = 0
in the case of the BP surplus (NX + CF > 0) there is an increase in
official reserves (OR ), which enters as debit (with a «minus»
sign), because it is accompanied by the increase in the supply of
national currency (MS ). It is an imports-like transaction.
BP NX CF OR 0
in the case of the BP deficit (NX + CF < 0) there is a decrease in
official reserves (OR ), which enters as credit (with a «plus» sign),
because it is accompanied by the decrease in the supply of national
currency (MS ) and can be associated with the «excess demand» for
national currency. It is an exports-like transaction.
BP NX CF OR 0
Thus, in both cases due to official financing 13
the balance of payments becomes equal to zero.
 The Balance of Payments
under Flexible Exchange Rates
The balance of payments condition then must be:
NX + CF = 0
Since the exchange rate is freely floating, and there is
no government intervention in the foreign exchange market,
that is, there is no official financing, a current-account surplus
is exactly matched by a capital-account deficit, and vice versa:
NX = – CF or – NX = CF

when NX > 0, then when NX < 0, then

capital outflow occurs, capital inflow occurs,
and a country is and a country is
a lender a borrower
14
 The Balance of Payments
under Flexible Exchange Rates
Let’s derive this relationship analytically from the national accounts
identity:
Y = C + I + G + NX
After subtracting (C + G) from both parts we get:
Y – C – G = C + I + G + NX – (C + G)
In the left side we get the sum of national saving
SNAT = I + NX
or rearranging:
(I – SNAT) + NX = 0

capital account balance current account balance

When NX > 0 (current account surplus), SNAT > I capital outflow
(– CF) = capital account deficit.
When NX < 0 (current account deficit), SNAT < I capital inflow
15
(+CF) = capital account surplus.
The U.S. Balance of Payments (in $ bln) 2016 2017
1. Merchandise exports +1,455.7 +1,550.7
2. Merchandise imports -2,208.2 -2,361.9
Merchandise trade balance (lines 1-2) -752.5 -811.2
3. Service exports +752.4 +780.9
4. Service imports -504.7 -538.1
Balance of services (lines 3-4) +247.7 +242.8
Trade balance (lines 1-4) -504.8 -568.4
5. Income receipts +814.0 +926.9
6. Income payments -640.8 -709.9
Balance of income (lines 5-6) +173.2 +217.0
7. Net U.S. unilateral transfer payments to foreigners -120.1 -114.8
Current-account balance (items 1-7) -451.7 -466.2
8. Capital-account balance -0.059 24.8
9. U.S. capital inflow
(= Increase in foreign holdings of U.S. assets ) +741.4 +1,587.9
10. U.S. capital outflow
(= Increase in U.S. holdings of foreign assets) -361.6 -1,237.0
Financial-account balance (items 9-10) +379.8 +350.9
11. Statistical discrepancy 74.1 92.2
12. Balance on current, capital & financial accounts (1-10) -2.1 +1.7
13. Official reserves balance +2.1 -1.7
14. Total (balance) 0 0
 Платежный баланс России, 2008-2015
(млрд.долл.США)
2008 2009 2012 2013 2014 2015
Счет текущих операций 103,9 50,4 71,3 33,4 57,5 67,7
Товары и услуги 157,2 95,6 145,1 122,3 134,5 111,1
Товары 177,6 113,2 191,7 180,6 189,7 148,4
Экспорт 466,3 297,1 527,4 521,8 497,8 341,4
Импорт -288,7 -183,9 -335,8 -341,3 -308,0 -193,0
Услуги -20,4 -17,6 -46,6 -58,3 -55,3 -37,3
Экспорт 57,1 45,8 62,3 70,1 65,7 51,7
Импорт -77,5 -63,4 -108,9 -128,4 -121,0 -89,0
Первичные доходы -46,5 -39,7 -67,7 -79,6 -68,0 -37,7
Оплата труда -14,4 -8,9 -11,8 -13,2 -10,1 -5,1
К получению 3,8 3,3 3,9 4,3 4,1 3,5
К выплате -18,1 -12,2 -15,7 -17,4 -14,2 -8,6
Доходы от инвестиций -32,1 -31,0 -56,8 -66,5 -58,0 -32,7
(проценты, дивиденды)
К получению 58,0 29,9 42,8 37,7 42,8 33,6
К выплате -90,1 -60,9 -99,6 -104,3 -100,9 -66,3
Вторичные доходы -6,8 -5,5 -6,1 -9,3 -8,2 -5,7
(чистые текущие трансферты)
 Платежный баланс России, 2008-2015
(млрд.долл.США)
2008 2009 2012 2013 2014 2015
Счет операций с капиталом -0,104 -12,5 -5,2 -0,4 -42,0 -0,3
Финансовый счет -139,7 -28,1 -25,7 -46,2 -131,8 -68,9
(кроме резервных активов)
Обязательства (приток капитала), 110,9 19,6 110,5 133,5 -27,9 -44,4
в том числе:
Прямые инвестиции 74,8 36,6 50,6 69,2 22,0 6,8
Портфельные инвестиции -27,9 8,7 19,3 0,7 -23,2 -12,9
Прочие инвестиции 64,1 -25,6 40,6 63,6 -26,7 -38,3
Активы (отток капитала) -250,5 -47,7 -136,2 -179,6 -103,8 -24,5
в том числе:
Прямые инвестиции -55,7 -43,3 -48,8 -86,7 -57,1 -22,1
Портфельные инвестиции -7,8 -10,6 -2,3 -11,8 -16,7 - -13,5
Прочие инвестиции -186,9 6,3 -85,1 -81,2 30,1 11,1
Чистые ошибки и пропуски -3,1 -6,4 -10,4 -8,9 8,0 3,3

Изменение валютных резервов 38,9 -3,4 -30,0 22,1 107,5 -1,7

Общее сальдо 0 0 0 0 0 0
 Платежный баланс России, 2016-2020
(млрд.долл.США)
2016 2017 2018 2019 2020
Счет текущих операций 24,4 32,2 115,7 64,8 33,5
Товары и услуги 66,2 83,2 165,0 128,5 74,4
Товары 90,3 114,6 195,1 165,3 91,9
Экспорт 281,6 353,0 443,9 419,9 332,2
Импорт -191,6 -238,4 -248,9 -254,6 -240,4
Услуги -24,1 -31,3 -30,1 -36,7 -17,4
Экспорт 50,5 57,5 64,6 61,9 46,9
Импорт -74,6 -88,9 -94,7 -98,7 -64,3
Первичные доходы -35,5 -42,0 -40,4 -53,5 -34,9
Оплата труда -1,8 -2,3 -3,3 -3,6 -1,1
К получению 3,7 4,1 4,1 4,0 3,6
К выплате -5,5 -6,4 -7,4 -7,6 -4,7
Доходы от инвестиций -33,7 -39,8 -37,1 -50,0 -33,8
(проценты, дивиденды)
К получению 36,7 42,4 48,7 49,7 40,5
К выплате -70,5 -82,2 -85,8 -99,7 -74,3
Вторичные доходы -6,3 -9,0 -8,9 -10,2 -5,6
(чистые текущие трансферты)
 Платежный баланс России, 2016-2020
(млрд.долл.США)
2016 2017 2018 2019 2020
Счет операций с капиталом -0,8 -0,2 -1,1 -0,7 -0,5
Финансовый счет -10,9 -11,9 -78,4 -3,9 -50,0
(кроме резервных активов)
Обязательства (приток капитала), 7,3 14,9 34,3 62,6 47,2
в том числе:
Прямые инвестиции 32,5 28,6 8,4 32,0 8,7
Портфельные инвестиции 3,0 9,2 1,8 17,5 11,1
Прочие инвестиции -28,2 -22,9 24,1 13,1 25,3
Активы (отток капитала) -18,1 -34,6 -42,0 -28,7 -36,2
в том числе:
Прямые инвестиции -22,3 -36,8 -31,4 -21,9 -5,3
Портфельные инвестиции 0,7 -1,3 -9,4 -4,8 -14,2
Прочие инвестиции 3,5 3,5 -1,2 -2,0 -15,9
Чистые ошибки и пропуски -4,5 2,6 2,1 -1,5 2,8

Изменение валютных резервов -8,2 -22,7 -38,2 -66,5 13,8

Общее сальдо 0 0 0 0 0
 Macroeconomic Policy in the
Open Economy
The model that allows to examine the ends of
Robert
macroeconomic policy in the open economy
Marcus
Mundell was proposed in early 1960-s by the professor Fleming
of the Columbia University Robert Mundell
(Nobel prize, 1999) and the Deputy Director of the Research
department of the International Monetary Fund Marcus Fleming, who
extended the Keynesian model of the closed economy on the
conditions of the open economy.
Hence their analysis preserves all the assumptions of the Keynesian
approach (rigid prices, rigid nominal wages, identity of aggregate
income and aggregate output, etc), and examines the macroeconomy’s
behavior in the short run and from the demand-side.

21
The Mundell-Fleming Model: Major Assumptions
the behavior of the small open economy is examined – of the
economy that cannot affect the level of the world interest rate and
takes it as given;
capital mobility is perfect: all financial assets in the world are
perfect substitutes;
prices are rigid (that is, there is no inflation), hence, the nominal
interest rate coincides with the real interest rate (i = r).
expectations are static: the expected exchange rate immediately and
one-to-one reacts on the current exchange rate changes. Therefore,
the only determinant of capital flows between countries is the size of
the rate of return on assets, i.e. the relation between the domestic
interest rate (i) and the foreign (world) interest rate (iF);
Therefore, internal and external macroeconomic equilibrium is restored,
when the domestic interest rate returns to its initial level, and again
becomes equal to the level of world interest rate (i = iF). 22
 Macroeconomic Policy in the Open Economy:
Restoration of Equilibrium under the Fixed Exchange Rate
When the domestic interest rate becomes higher than the foreign
interest rate (i > iF), there would be capital inflow and
an increase in the demand for the domestic currency,
needed to foreign financial investors to buy domestic financial assets.
Excess
FS e S1 Demand
r 1 SCB
FS 2
A
r2 ē A B
r3=r1=rF B
D2
FD D1
F Q
In order to prevent an appreciation of the domestic currency
in the situation of the excess demand for the domestic currency
the Central bank buys foreign currency and
increases the supply of the domestic currency
 Macroeconomic Policy in the Open Economy:
Restoration of Equilibrium under the Fixed Exchange Rate
When the domestic interest rate becomes lower than the foreign
interest rate (i < iF), there would be capital outflow and
an increase in the supply of the domestic currency,
needed to domestic financial investors to buy foreign financial assets.
Excess
r e S1=SCB Supply
FS2 S2
FS1
B A=B
r3=r1=rF ē
r2 A

FD D
F Q
In order to prevent a depreciation of the domestic currency
in the situation of the excess supply of the domestic currency
the Central bank sells foreign currency and
decreases the supply of the domestic currency
 Macroeconomic Policy in the Open Economy:
the Fixed Exchange Rate: Fiscal Policy
The increase in government purchases (G) leads to higher aggregate
demand (AD) and thus to higher output (Y), that increases the demand
for money (M/P)D, that in turn raises the interest rate (i=r). The higher
interest rate causes partial crowding out of domestic investment (I),
but implies the higher rate of return on domestic financial assets
(i > iF) that makes them more attractive to foreigners provoking
capital inflow. Wishing to buy domestic financial assets foreigners
increase their demand for the domestic currency (D). It gives the
upward pressure on its exchange rate.
In order not to allow the exchange rate to rise over its proclaimed fixed
level, the central bank makes an intervention in the foreign exchange
market and buys foreign currency paying for it with the domestic currency.
It leads to the increase in the official reserves (OR) and in the supply of
the domestic currency (MS) that lowers the interest rate (i=r) to the
level of the foreign interest rate and increases domestic investment (I)
to the initial level. The internal crowding out effect disappears
output (Y) increases with the full multiplier effect. 25
 Macroeconomic Policy in the Open Economy:
the Fixed Exchange Rate: Fiscal Policy
Keynesian Cross Money Market Exchange Market
AE AE=Y
i MS1/Р MS2/Р e S1
A'=C AEP(G2,I1)
AEP(G2,I2) SCB
B
I AEP(G1,I1) i B
I A 2
G C
ē А C
i3=i1=iF A (M/Р)D(Y2)
(M/Р)D(Y1)
D2
450 D1
Y1 Y3 Y2=Y4 Y (M/Р)1 (M/Р)2 (M/Р) Q

G AD Y I AD Y (to Y3)
(to Y2) (M/P)D domestic financial assetsD (= capital
i (to i2) inflow) D CB buys foreign currency in Y
exchange for the domestic currency OR ; MS
i (=r) (to i3= i1= iF) I AD Y (to Y4) 26
Macroeconomic Policy in the Open Economy:
the Fixed Exchange Rate: Fiscal Policy

Fiscal policy is extremely effective:

the fiscal expansion is accompanied by the monetary expansion,
and there is no crowding out of the domestic investment,
therefore output grows with the full multiplier effect
of the increase in government purchases:
ΔY = ΔG × multĀ

The result: output becomes higher,

the interest rate returns to the initial level
that is equal to the foreign interest rate,
the exchange rate stays unchanged.

27
 Macroeconomic Policy in the Open Economy:
the Fixed Exchange Rate: Monetary Policy
The increase in the supply of money (MS) lowers the interest rate (i=r)
that stimulates investment (I) and thus aggregate demand (AD) and leads
to higher output (Y), but at the same time makes national financial assets
less profitable to foreigners (i < iF), while foreign financial assets
become more attractive to domestic agents provoking capital outflow.
The desire to buy foreign assets increases the supply of the domestic
currency (S) in order to exchange it for the foreign currency. This gives
the downward pressure on the exchange rate of the domestic currency.
To prevent the fall of the exchange rate below its proclaimed fixed level,
the central bank intervenes and sells foreign currency in exchange for
the domestic currency, thereby withdrawing it from circulation. This
results in the decrease both in official reserves (OR) and in the supply of
the domestic currency (MS).
The decrease in the supply of the domestic currency causes the fall in the
domestic investment (I) and hence in aggregate demand (AD) and output
(Y). Because in order to maintain the fixed exchange rate the money
supply must be reduced by the exactly same amount as it initially 28 has
been increased, output will return to its initial level.
 Macroeconomic Policy in the Open Economy:
the Fixed Exchange Rate: Monetary Policy
Money Market Keynesian Cross Exchange Market
i MS1/Р MS2/Р AE e
AE=Y S1=SCB
S2
AEР(I2)
i3=i1=iF A=С B A=C
AEР(I1) ē
i2 B
I
A=С
(M/Р)D
450 D
(M/Р)1 (M/Р)2 (M/Р) Y1=Y3 Y2 Y Q

MS i I AD Y (tо Y2)
(tо i2) foreign financial assetsD (= capital outflow)
S CB sells foreign currency in exchange ΔY= 0
for the domestic currency OR ; MS
i (=r) (tо i3=i1= iF) I AD Y (tо Y1) 29
Macroeconomic Policy in the Open Economy:
the Fixed Exchange Rate: Monetary Policy

Monetary policy is fully ineffective:

the monetary expansion is followed
by the monetary contraction of the same size:
+ΔMS = –ΔMS ΔY = 0

The result: output is unchanged,

the interest rate returns to the initial level
that is equal to the foreign interest rate,
the exchange rate stays unchanged.

30
 Macroeconomic Policy in the Open Economy:
Restoration of Equilibrium under the Flexible Exchange Rate
When the domestic interest rate becomes higher than the foreign
interest rate (i > iF), there would be capital inflow and
an increase in the demand for the domestic currency,
needed to foreign financial investors to buy domestic financial assets.
r FS1 e S Excess
B Demand
FS2 е2
A
r2 е1 A
r3=r1=rF B D2
FD D1
F Q
Excess demand on the exchange market causes the appreciation
of the domestic currency (e ) that decreases the competitiveness of the
domestic goods on the world goods markets (= a real appreciation ε ):
under the higher nominal exchange rate domestic goods become
relatively more expensive for foreigners Ex , while foreign goods
become relatively cheaper to domestic economic agents Im NX
 Macroeconomic Policy in the Open Economy:
Restoration of Equilibrium under the Flexible Exchange Rate
When the domestic interest rate becomes lower than the foreign
interest rate (i < iF), there would be capital outflow and
an increase in the supply of the domestic currency,
needed to domestic financial investors to buy foreign financial assets.
S1 Excess
r S
F2 e Supply
FS1 S2
B
r3=r1=rF е1 A
r2 A е2
B
FD D
F Q
Excess supply on the exchange market causes the depreciation
of the domestic currency (e ) that increases the competitiveness of the
domestic goods on the world goods markets (= a real depreciation ε ):
under the lower nominal exchange rate domestic goods become
relatively cheaper for foreigners Ex , while foreign goods become
relatively more expensive to domestic economic agents Im NX
 Macroeconomic Policy in the Open Economy:
the Flexible Exchange Rate: Fiscal Policy
The increase in government purchases (G) provokes the rise in aggregate
demand (AD) and thus in output (Y), that leads to higher demand for
money (M/P)D and hence to the rise in the interest rate (i=r). The higher
interest rate causes partial crowding out of the domestic private
investment (I), but because i > iF domestic financial assets become
more attractive to foreigners (= capital inflow). In order to buy
domestic financial assets foreigners increase the demand for the
domestic currency (D), that leads to its higher exchange rate (e), i.e. the
domestic currency appreciates. Since the exchange rate is floating, the
central bank does not intervene, and there is no official financing.
The higher exchange rate makes domestic goods relatively more
expensive to foreigners that suppresses exports (Ex), while it makes
foreign goods relatively cheaper to domestic agents that encourages
imports (Im). Thus, net exports (NX) falls (crowds out), that causes the
fall in aggregate demand and in output. This decreases the demand for
money (M/P)D. The interest rate falls to the level of the foreign interest
rate, that reduces domestic investment to its initial size. Because of the
33
complete crowding-out of net exports, output returns to its initial level.
 Macroeconomic Policy in the Open Economy:
the Flexible Exchange Rate: Fiscal Policy
Keynesian Cross Money Market Exchange Market
AE AE=Y i e
A'=C AEP(G2, I1,NX1)
MS/Р
S
AE (G , I ,NX )
B NX AEP(G1,I1,NX1)
P 2 2 1

I =AEP(G2,I1,NX2) B
I i2 C e2
A=D
G e1 A
i3=i1 =iF A=D
(M/Р)D(Y2)
450 (M/Р)D(Y1) D1 D2
Y1=Y4 Y3 Y2 Y (M/Р) Q

G AD Y I AD Y (to Y3)
(to Y2) (M/P)D
domestic financial assetsD (= capital inflow)
i (to i2) ΔY= 0
D e (= appreciation)= ε Ex ; Im
NX AD Y (М/P)D i (=r) (tо i3=i1=iF)
I AD Y , hence tоtal fall from Y2 to Y4 34
Macroeconomic Policy in the Open Economy:
the Flexible Exchange Rate: Fiscal Policy

Fiscal policy is ineffective

due to the complete external (NX) crowding-out effect:
+ΔG = –ΔNX ΔY = 0.

The result: the level of output is unchanged,

but its composition changes (higher share of G and
lower share of NX), the interest rate returns to the
initial level that is equal to the foreign interest rate,
the exchange rate rises
(= an appreciation of the domestic currency).

35
 Macroeconomic Policy in the Open Economy:
the Flexible Exchange Rate: Monetary Policy
The increase in the supply of money (MS) leads to the fall in the interest
rate (i=r). On the one hand, the lower interest rate stimulates domestic
investment (I), but on the other hand, makes national financial assets
less profitable to foreigners (i < iF), while foreign financial assets
become more attractive to domestic financial investors, that provokes
capital outflow. Since domestic agents now need extra foreign currency,
they increase the supply of the domestic currency (S) wishing to get the
foreign currency in exchange. It leads to the fall in the exchange rate of
the domestic currency (e), i.e. its depreciation.
The lower exchange rate of the domestic currency makes domestic goods
relatively cheaper for foreigners, and foreign goods – relatively more
expensive for domestic agents. Thus, exports (Ex) rises, while imports
(Im) falls. The increase in net exports (NX) causes the increase in
aggregate demand and in output (Y). Because the demand for money
(M/P)D rises, the interest rate (i=r) increases and returns to the level of
the foreign interest rate, that in turn returns domestic investment (I) to the
36
initial level. Aggregate demand rises for the complete amount of net exports.
 Macroeconomic Policy in the Open Economy:
the Flexible Exchange Rate: Monetary Policy
Money Market Keynesian Cross Exchange Market
i MS1/Р MS2/Р AE AE=Y e
C AEP(I1, NX2) S1
AEP(I2, NX1) S2
i3=i1=iF A C B AEP (I1, NX1)
I A
NX e1
i2 B A
I e2 B
(M/Р)D(Y3)
(M/Р)D(Y1)
450 D
(M/Р)1 (M/Р)2 (M/Р) Y1 Y2 Y3 Y Q

MS i I AD Y (tо Y2)
(tо i2) foreign financial assetsD (= capital outflow)
S e (= depreciation) = ε Ex ; Im NX Y
AD Y (tо Y3) (M/P)D i (=r) (tо i3=i1= iF)
37
I AD Y , hence total rise from Y to Y )
Macroeconomic Policy in the Open Economy:
the Flexible Exchange Rate: Monetary Policy

Monetary policy is extremely effective:

the monetary expansion is accompanied by
the increase in net exports, and output grows with
the full multiplier effect of the rise in net exports:
ΔY = ΔNX × multĀ.

The result: output becomes higher,

the interest rate returns to the initial level
that is equal to the foreign interest rate,
the exchange rate falls
(= a depreciation of the domestic currency).

38
 Lecture 15
Economic Growth
• Concept of Economic Growth
• Measures of Economic Growth
• Types and Sources of Economic Growth
• Labour Productivity and Economic Growth
• Economic Growth and Government Policy
• Contradictions of Economic Growth

1
 Economic Growth versus Business Cycle

The business cycle is the characteristic of the economic behavior

in the short run, while the economic growth characterizes the
behavior of the economy in the long run.
In the short run during the business cycle:
the main input that stands behind aggregate supply is labour;
the assumption is that capital stock and technology are unchanged;
output is determined by aggregate demand.
Now we would analyze economic growth, based on capital
accumulation and technological advances.
Economic growth models are supply-side and dynamic, because in
the long run output is determined by the changes in all the factors
of production, and the time factor is of essential importance.

2
 The Importance of Economic Growth Theory
The economic growth theory helps:
to explain the differences in the level of economic development
between countries, the rates of economic growth and the standards
of living;
to study the determinants and factors of economic growth;
to examine the long-run factors of both the level and the growth
rate of real GDP per person;
to prove that productivity is the key determinant of a country's
standard of living;
to discover the factors that determine a country’s productivity;
to analyze what governments might do to provide the long-run
economic growth and to raise the economy’s growth rate, to
increase production possibilities, the economic welfare and the
quality of life. 3
 Economic Growth: the Concept

Economic growth is a steady long-run increase in the real GDP

over time. Thus it is:
a tendency real GDP must not obligatory increase every
year, we estimate only the trend of the economic development;
long-run since we consider the increase in GDP in the long
run, it is the rise not in actual GDP (Y), but in the potential
(= full employment) GDP (Y*), the increase in the production
possibilities of the economy;
real GDP (not nominal, which can rise due to higher prices and
can be observed even under the fall in real output).

4
The Aim and the Relevance of Economic Growth
The aim of economic growth is the rise in the standard of
living and in the economic welfare. The larger is the economic
potential and the higher are the rates of economic growth, the
higher will be the standard and the quality of life.

«The consequences for human welfare involved

in questions like these are simply staggering:
Once one starts to think about them, it is hard
to think about anything else».
Robert Lucas

5
 Economic Growth on the Graphs
Graphically economic growth can be presented in the following ways:
Output Trend Production Possibilities AD-AS Model
Frontier
Real GDP Investment Goods Р LRAS LRAS
1 2

TREND
Y3* PPF2 P1 A
Y2* I3 PPF1 D
I1 P2 B
Y1* A
I2 B AD

1900 1950 2000 Years C1 C2 C3 Consumption Y*1 Y*2 Y

Goods

A movement along PPF1 (from A to B) generates Double pleasant

increasing opportunity costs (C at the expense effect: a rise in output
of I ), which disappear if economy moves to is accompanied by a
higher PPF2 (from A to D), where both C and I fall in prices
 Measures of Economic Growth
• Real GDP is used for the evaluation of the level of economic
development of the country,
but …it is an absolute measure, which cannot reflect exactly the
welfare and the well-being, since an increase in output can be
accompanied by the changes in the size of population.
• Real GDP per capita (= real GDP divided by population), that is
the more exact measure, because it can be used for the evaluation of
the economic welfare, standard of living, since it reflects the value
of all the amount of goods and services produced in the economy
not in general, but that is accounted in average per a person.

7
Economic Growth and Living Standards
around the World, 0 – 2000

8
 Economic Growth over Two Millennia

From the end of Roman Empire to approximately 1500s there

was no per capita economic growth in Europe.
From 1500s to 1700s the per capita output growth became
positive at the level of 0.1% per year.
Even during the Industrial Revolution the growth rate were by
today’s standards very low.
In the history of mankind the per capita output growth is
a recent phenomenon.
 Measures of Real GDP
Real GDP can be estimated on the base of:
national data; ▪ exchange rate; ▪ purchasing power parity.
The last measure is most frequently used for comparison of the level
of economic development and of the welfare level across countries.
To compare GDP across the world, a common set of prices for all
countries is used and measured in the international dollars (that are
the US dollars of a particular year).
Adjusted real GDP numbers are measures of purchasing power across
countries, also called purchasing power parity (PPP) numbers.

10
 Countries with the Highest GDP, 2019
(absolute figures in millions of Int$) (IMF)
Rank Country GDP, $ bln
1 United States 21 345
2 China 14 217
3 Japan 5 176
4 Germany 3 964
5 India 2 972
5 United Kingdom 2 829
6 France 2 762
8 Italy 2 026
9 Brazil 1 960
10 Canada 1 739
11 South Korea 1 657
12 Russia 1 610
13 Spain 1 429
14 Australia 1 417
11
15 Mexica 1 241
 GDP by PPP Across the Countries, 2019
Rank Country GDP, PPP ($ bln) Share in World Economy, %
1 China 27 331 18.67
2 United States 21 345 15.20
3 India 11 468 7.74
4 Japan 5 750 4.13
5 Germany 4 467 3.21
6 Russia 4 390 3.12
7 Indonesia 3 736 2.58
8 Brazil 3 481 2.49
9 United Kingdom 3 162 2.24
10 France 3 062 2.19
11 Mexica 2 616 1.90
12 Italy 2 455 1.77
13 Turkey 2 362 1.70
14 South Korea 2 320 1.65
15 Spain 1 924 1.38
Source: International Monetary Fund, 2020 12
 Economic Growth Around the World
There is great variation in the standard of living across countries at a
point in time and within a country across time – for example,
between the United States and India today, and between the United
States of today and the United States of 100 years ago.
This great variation in the standard of living across countries is
explained by great variation in both:
the level of real GDP per person (at present, the level of real GDP
per person in the United States is about 75 times that of Burundi,
about 35 times that of Ethiopia, more than 17 times that of
Bangladesh, 9 times that of India, 4 times that of China, 2.3 times
that of Russia, about the same as Hong Kong and Switzerland, and
about 1.8 times lower than in Luxembourg and Kuwait, 1.5 times
than in Singapore and 1.1 times than in Norway.
the growth rate of real GDP per person (for example, East Asia is
growing very quickly, while Africa is growing slowly). 13
GDP per Capita Worldwide (PPP Int.$), 2020 (IMF)
1 Luxembourg 112 875 30 Japan 41 637
2 Singapore 95 603 36 Lithuania 38 605
3 Qatar 91897 50 Greece 29 045
4 Ireland 89 383 51 Turkey 28 294
5 Switzerland 68 340 53 Russia 27 394
6 Norway 64 856 56 Kazakhstan 26 589
7 United States 63 051 76 China 17 206
8 Brunei 61 816 86 Brazil 14 563
9 United Arab Emirates 58 466 96 Ukraine 12 710
10 Hong Kong 58 165 110 Vietnam 10 755
11 Denmark 57 781 128 India 6 284
12 Netherland 57 101 140 Bangladesh 5 139
16 Taiwan 54 020 143 Kenia 4 993
17 Germany 53 571 167 Zimbabwe 2 583
18 Sweden 52 477 176 Afghanistan 2 073
19 Australia 50 845 185 Mozambique 1 279
25 France 45 454 188 Congo, Dem. Republic 978
26 South Korea 44 292 189 Central African Republic 972
27 United Kingdom 44 288 191 Burundi 783
 The Role of the Growth Rates
The ranking of countries by real GDP per person changes over time.
The cause: countries have different speed of economic growth, i.е.
diverse annual rates of real GDP growth per capita.
Even small differences in growth rates can make enormous
differences in a country's level of income (output) after many
years. This is due to compound growth. That is, each year's
growth is based on the previous year's accumulated growth:
Yt = Y0 × (1 + ga)T

level of GDP per initial level of average annual rate of

capita over T years GDP per capita per capita GDP growth

15
 The Role of the Growth Rates

Hence, the average annual growth rate ga is a geometric average

from growth rates for a given period of time:

Yt
ga T 1
Y0
The importance of the rate of economic growth can be
illustrated by the following example:
Suppose economies A and B have the same Y0 = 10 000,
but gA = 3% and gB = 4%. Over 50 years YtA 44 000,
while YtB 71 000 or by 1.6 times higher. The level of
71 000 country A will reach only over 66.5 years.

16
 Economic Growth in Eight Leading Countries,
1870-2018
Average
GDP per Capita, in 1990 year US dollars
annual growth
(by PPP)
rate, %
County 1870 1913 1950 1973 2000 2018 1870-2018
Australia 5 217 8 220 11 815 20 527 36 603 49 831 1,5
Canada 2 702 7 088 1 622 22 058 36 943 44 869 1,9
France 2 990 5 555 8 266 20 441 33 410 38 516 1,7
Germany 2 931 5 815 6 186 19 074 33 367 46 178 1,9
Japan 1 580 2 431 3 062 18 226 33 211 38 674 2,2
Sweden 2 144 4 581 10 742 21 509 34 203 45 542 2,1
United
Kingdom 5 829 8 212 11 061 19 168 31 946 38 058 1,3
United States 4 803 10 108 15 240 26 602 45 886 55 335 1,7

Source: Maddison Project Database, 2020

17
Long-run Growth: Sweden and Argentina

18
 The Great Divergence

19
A significant increase in income inequality across countries in XIX-XX century.
GDP Growth Rates, Different Countries (PPP), 1800-2015
1800-2015 1800-2015 average Period of
Country 1800 2015 growth annual growth doubling (years)
Qatar 1097 132877 12012,76% 2,26% 31,07
Singapore 1021 80794 7813,22% 2,05% 34,09
Kuwait 1097 82633 7432,63% 2,03% 34,48
United Arab 998 60749 5987,07% 1,93% 36,27
Emirates
Luxembourg 1453 88314 5978,05% 1,93% 36,28
South Korea 576 34644 5914,58% 1,92% 36,38
Hong Kong 1007 53874 5249,95% 1,87% 37,45
Norway 1278 64304 4931,61% 1,84% 38,03
Taiwan 996 42948 4212,05% 1,77% 39,59
Japan 1050 36162 3344% 1,66% 42,11
Sweden 1414 44892 3074,82% 1,62% 43,1
Latvia 751 23282 3000,13% 1,61% 43,4
Germany 1639 44043 2587,8% 1,54% 45,28
USA 2128 53354 2407,24% 1,51% 46,26
Spain 1518 32979 2072,53% 1,44% 48,41
France 1803 37599 1985,36% 1,42% 49,02
Greece 1371 25430 1754,85% 1,37% 51,03
GDP Growth Rates, Different Countries (PPP), 1800-2015
1800-2015 1800-2015 average Period of
Country 1800 2015 growth annual growth doubling (years)
Russia 1430 23038 1511,05 1,3 53,62
Italy 2225 33297 1396,49 1,27 55,08
Brazil 1109 15441 1292,34 1,23 56,59
China 985 13334 1253,71 1,22 57,2
Mexica 1379 16850 1121,9 1,17 59,54
Great Britain 3431 38225 1014,11 1,13 61,82
Ukraine 763 8449 1007,34 1,12 61,98
Netherland 4235 45784 981,09 1,11 62,6
India 1052 5903 461,12 0,81 86,4
Pakistan 1021 474 364,54 0,72 97,03
Mozambique 390 1176 201,54 0,51 135,02
North Korea 579 1390 140,07 0,41 170,17
Zimbabwe 869 1801 107,25 0,34 204,5
Burundi 418 777 85,89 0,29 240,38
Central African 424 599 41,27 0,16 431,3
Republic
Liberia 797 958 20,2 0,09 806,96
Somali 694 624 -10,09% -0,05% –
 Growth Rates in Different Countries, 2020

1,9
-11,8
2,0

0,0

-2,0

-1,5
-1,9
-4,0

-4,1
-4,2
-4,3
-5,0
-6,0

-5,3
-5,4
-5,8
-6,0
-7,1
-8,0

-7,6
-8,0
-9,0

-10,0
-9,8
-9,8
-10,3
-10,6

-12,0

Source: International Monetary Fund, 2020

 10000
20000
30000

15000
25000

0
5000
12660 Int.$
12390
10820
10100
9010
8830
8680
8970
8600
9320
10520
11350
12140
13330

Source: International Monetary Fund, 2020

14720
16210
18110
20200
21680
20120
21270
22780
24280
26040
25730
24060
24100
26000
27320
Russian Real GDP per Capita (PPP), 1990-2020

28180
27390
 -8
-3
2
7

-18
-13
-14,5 12 %
-8,7
-12,6
-4,1
-3,6
1,4
-5,3

Source: Goscomstat, 2021

6,4
10
5,1
4,7
7,3
7,2
6,4
8,2
8,5
5,2
-7,8
4,5
4,3
3,4
1,3
0,7
-2,8
-0,2
1,5
2,3
1,3
Growth Rates of Real GDP in Russia, 1992-2020

-4,1
 «The Rule of 70»
For simplification of calculations economists often use «the rule
of 70»: if a variable grows with an annual rate of х%, the level of
this variable will double approximately in 70/х years.
According to this rule ga
Yt Y0 2
The conclusions from «the rule of 70»:
output grows faster in less developed countries, because they have
the lower initial level of output (the «catch-up effect»);
higher rates of economic growth, ceteris paribus, can afford to a
less developed country «catch up» with a country that has the
higher level of output (idea of «convergence»).
Historical examples: Japan, four «dragons» of South-Eastern Asia.
NumericalRate of Period of GDP GDP Level over 70 Years
Example Growth Doubling Compared to Initial Level
Economy 1 1% 70 years 2 times higher
25
Economy 2 4% 17.5 years 16 times higher
The Initial GDP & the Growth Rate

26
 Average Annual GDP per Capita Growth Rates
Country 1960-1970 1970-1980 1980-1990 1990-2000 2000-2015 1960-2015
South Korea 5.86 7.92 8.58 5.5 3.24 5.54
Taiwan 6.49 7.35 6.3 5.18 3.09 5.26
Singapore 6.75 6.83 4.31 4.37 2.5 4.89
China 1.63 3.95 9.14 9.52 8.63 6.24
Hong Kong 6.16 6.05 5.86 1.86 3.29 4.43
Japan 9.32 3.1 3.89 0.74 0.94 3.34
Spain 7.48 2.47 2.49 2.35 0.96 3.46
India 1.43 0.94 3.32 4.01 5.56 3.29
France 4.43 2.98 1.65 1.45 0.61 2.15
Canada 3.25 2.85 2.09 2.08 0.92 2.12
United 2.22 1.91 3.14 2.5 1.4 2.04
Kingdom
United States 2.87 2.35 2.66 2.48 0.8 2.00
Argentina 2.76 0.78 -1.66 2.87 4.63 1.23
Burundi 1.99 1.78 1.01 -3.75 0.09 0.17
Zimbabwe 3.18 -1.92 -0.48 -0.36 -0.15 0.18
Somali -1.14 -2.88 1.82 -4.28 0.54 -0.53
Niger 0.98 -1.59 -4.58 -0.48 1.25 -0.92
27
Congo 1.83 0.98 1.03 -1.69 0.36 -1.83
Advanced Economies: Catching-up with a Leader
Real GDP per Capita (PPP)
60 000

50 000

40 000

30 000

20 000

10 000

США Великобритания Франция Германия Италия Япония

Источник: Maddison Project Database, 2020
 The “Tigers”of Southeast Asia:
Catching-up to United States
Real GDP per Capita
80 000
70 000
60 000
50 000
40 000
30 000
20 000
10 000
0

Южная Корея Тайвань Гонконг Сингапур США

Источник: Maddison Project Database, 2020
Countries with Emerging Economies: Catching up?
Real GDP per Capita
60 000

50 000

40 000

30 000

20 000

10 000

США Китай Аргентина Индия

Бразилия Южная Корея Чили Россия
Источник: Maddison Project Database, 2020
 Types of Economic Growth
Resource widening Resource deepening
(or extensive) (or intensive)
is based on the increase in the is induced by the increase in the
quantity of available resources by quality (productivity) of
simple addition of factors of resources, the use of technological
production; progress;
determinants of growth: use of determinants of growth:
greater amount of labour force, increase in labour skills; use of
equipment, agricultural lands; advanced equipment and
construction of new plants and technology; use of advanced and
factories; discovery of new mineral more effective methods of
deposits; foreign trade, etc; management by firms and by
labour skills and labour the government in regulating
productivity, equipment quality and economy;
technology stay unchanged; the essential role of technical
output and income per labour unit and technological advances;
and per capital do not change. increase in factor productivity.
31
 The Production Function
In the long run real GDP is determined by the production function.
A production function establishes the relationship between the
quantity of inputs used in production and the quantity of output
from production:
Y = AF (L, K, H, N)

output technological physical human natural

knowledge labour capital capital resources

32
 Factors of Production
Labour (L): the number of workers in the economy;
Physical capital (K): the stock of equipment and structures that
are used to produce goods and services;
Human capital (H): the knowledge and skills that workers
acquire through education, training, and experience;
Natural resources (N): inputs provided by nature's bounty, such
as land, rivers, and mineral deposits. They come in two forms:
renewable and non-renewable.
Technological knowledge (A): understanding about the best ways
to produce goods and services. The difference from human capital
in that technological knowledge is society's understanding of the
best production methods («know how»), while human capital is
amount of understanding of these methods that has been
transmitted to the labor force.
33
 The Production Function
Y = AF (L, K, H, N)
If an economy has more workers, there is an increase in L, and Y
would increase.
If an economy has more equipment, there is an increase in K, and Y
would increase.
If workers become more educated, there is an increase in H, and Y
would increase (note: the number of workers and the amount of
equipment is unchanged).
If a country has better land, N is larger and therefore Y is larger.
Finally, if it is discovered that it is more productive to produce using
new technology, there is an increase in A, and Y should increase.
The most widely used in macroeconomic models production functions
have the property of the constant returns to scale, which implies that
the change in all inputs for some amount will lead to the exactly
same change in output, i.e. for any positive number х it is true that:
хY = AF (хL, хK, хH, хN) 34
 The Role of Labor Productivity
If we assume х = 1/L, we get:
Y/L = AF (1, K/L, H/L, N/L)
On the one hand, Y/L is output per worker (quantity of goods and
services that a worker can produce per hour), that is average
labour productivity, which depends on physical capital per worker
K/L, human capital per worker H/L, natural resources per worker
N/L, and the state of technology A.
On the other hand, Y/L is real GDP per worker, that is the measure of
the standard of living.
Hence, a country's standard of living depends directly on the
productivity of its citizens, because an economy's income is equal
to an economy's output.
Labour productivity growth is a key dimension of economic
performance and an essential driver of changes in living standards.
Conclusion: the way we work – the way we live. 35
 GDP per Worker in Different Countries
in 1970 & 2015 (in 2010 USD)
Country 1970 2015 Growth,% Country 1970 2015 Growth,%

South United
8 368.6 67 163.3 703 37 300.3 79 139.9 112
Korea Kingdom

Singapore 10 062.8 80 191.5 697 Belgium 47 252.2 99 877.3 111

Ireland 30 735.2 135 614.9 341 Sweden 43 088.7 89 925.9 109

Finland 31 216.9 83 281.8 167 France 43 336.3 89 229.7 106

Japan 26 880.7 67 815.2 152 Denmark 46 344.9 89 475.5 93

United
Norway 50 442.1 111 765.6 122 57 688.7 109 916.9 91
States

Spain 36 215.5 79 693.3 120 Germany 43 689.9 80 671.4 85

36
Source: OECD Economic Outlook
Real GDP per Worker in the US

37
 Sources of Economic Growth

The major sources of economic growth are:

increased stock of capital due to net investment;
technological advances due to research and development;
improved skills due to investment in human capital
that is education and training;
better resource allocation, management and utilization.

38
 Economic Growth and Government Policy
Physical capital, human capital, natural resources, and technological
knowledge determine productivity. Productivity determines living
standards. If a government wishes to accelerate economic growth, to
raise the productivity and standard of living of its citizens, it should
pursue policies that:
encourage saving and investment. If society consumes less and
saves more, it has more resources available to invest in the
production of capital. Additional capital increases productivity and
living standards.
r
I = S + (T – G) + (Im – Ex) FS1 FS
2

private public foreign sector r

1
saving saving saving r2
FD
F
 Role of Investment and Saving

Stock of Output/Income
Capital

Changes in the
Saving/Investment
Stock of Capital

40
 International Evidence on Investment Rates
and Income per Person (for about 100 countries)
Income per person in 2011 (logarithmic scale)

Investment as percentage of output (average 1961-2011) 41

 Policy Measures to Stimulate
Saving and Investment
To encourage private sector saving:
Decrease the tax rate on incomes from saving.
Impose taxes on real incomes from saving rather
than on nominal incomes.
Replace the income tax with a sales tax.
To increase home investment:
Expand government expenditures on
infrastructure (= public capital).
To stimulate home investment:
Decrease the tax rate on firms profits.
Introduce investment tax credit.
Give tax holidays for firms starting new business
42
 Government Policy and Economic Growth

Government policy instruments that can encourage economic growth:

profit taxes subsidies investment tax credit personal taxes

decrease increase decrease

in the tax rate in the amount paid implementation in the tax rate

increase in net investment rise in the disposable income

increase in the stock of physical capital increase in the supply of labor

increase in the production possibilities of the economy

= increase in the potential level of output
 Government Policy and Economic Growth
on the Graph

P LRAS1 LRAS2
SRAS1
SRAS2
A
P1 PPF2
P2 B
PPF1
AD
Y*1 Y*2 Y Consumption Goods

Result: increase in potential output Y* accompanied

by the fall in the price level Р
 Economic Growth and Government Policy
encourage investment from abroad, by Capital Inflow
removing restrictions on the ownership of r
FS1 FS
domestic capital and by providing a stable 2

political environment. In addition to using

domestic saving to invest in capital, countries r1
r
can attract investment by foreigners both 2
foreign direct investment (capital investment FD
that is owned and operated by a foreign F
entity) and foreign portfolio investment (capital investment that is
financed with foreign money but is operated by domestic residents).
Though part of firms’ revenues, created with the help of foreign
capital, moves abroad (foreign firms’ profits from direct investment
and dividends and interest payments from portfolio investment),
financial resources from the rest of the world:
- increase the economic potential of the home country;
- make the level of labor productivity and wages higher; 45
- give the chance to use the most advanced technology.
Capital Outflow from Russia, 1994-2019 ($ bln)

In 2018 it increased
to $67.5 bln, in 2019
decreased to $26.7 bln,
and in 2020 increased 46
to $48.4 bln.
 Economic Growth and Government Policy
encourage education that is investment in
human capital. According to the statistical data, in
the United States each year spent on education
increases the worker’s wage by 10%. Education
not only increases the productivity of the
recipient, it may provide a positive externality.
An externality occurs when the actions of one person affect the
well-being of a bystander. An educated individual may generate
ideas that become useful to others.
Therefore so harmful for
poor countries is
brain drain
when their educated workers
emigrate to rich counties.
47
Effect of Education on the Standard of Living

48
 Trends in the Level of Education
in Different Regions of the World
Absence of Secondary Higher Average
Regions and Years School Primary Education Education Number of
Education Education Years of
Education
Developed
Countries (24)
1950 9.2 60.1 25.0 5.7 6.10
1960 7.7 54.2 31.2 7.0 6.72
1970 6.2 45.8 38.2 9.8 7.64
1980 5.4 34.6 44.5 15.5 8.74
1990 5.4 27.6 44.4 22.6 9.55
2000 3.4 19.4 49.2 28.0 10.52
2010 2.4 13.7 51.7 32.2 11.30
Developing
Countries (122)
1950 61.1 29.9 8.1 0.9 2.02
1960 54.6 32.9 11.1 1.3 2.50
1970 45.0 35.9 17.2 1.9 3.35
1980 37.2 32.3 27.1 3.4 4.37
1990 30.8 31.3 32.3 5.6 5.28
2000 22.9 29.5 39.6 8.0 6.33
2010 17.4 26.9 45.2 10.5 7.20
 Economic Growth and Government Policy
protect property rights and establish political
stability. Property rights refer to the ability of
people to exercise control over their resources.
For individuals to be willing to work, save and
invest, and trade with others by contract, they
must be confident that their production and
capital will not be stolen and that their
agreements will be enforced.
Even a remote possibility of political instability
creates uncertainty with regard to property rights
because a revolutionary government might
confiscate property — particularly capital;

50
 Doing Business Across the World, 2018
Country Country Country
New Zeeland 1 Ireland 17 Mexico 49
Singapore 2 Canada 18 Luxembourg 63
Denmark 3 Latvia 19 Greece 67
South Korea 4 Germany 20 Ukraine 76
Hong Kong 5 Austria 22 China 78
United States 6 Malaysia 24 India 100
United Kingdom 7 Poland 27 Argentina 117
Norway 8 Spain 28 Brazil 125
Georgia 9 France 31 Bolivia 152
Sweden 10 Switzerland 33 Zimbabwe 159
Macedonia 11 Japan 34 Central African Republic 184
Estonia 12 Russia 35 South Sudan 187
Finland 14 Kazakhstan 36 Venezuela 188
Taiwan 15 Belarus 38 Eritrea 189
Lithuania 16 Italy 46 Somalia 190
51
Source: World Bank
 Doing
Business
Indicators
 Economic Growth and Government Policy
control population growth. Though the population growth leads to
the increase in the number of the labour force and to the increase in
aggregate output, the rapid growth in population tends to spread
other factors of production more thinly (less capital per worker, etc)
that can reduce the per capita level of output that implies the decrease
in the standard of living. The control over the rates of population
growth is especially important for the underdeveloped countries.

53
Population Growth Rates and Economic Growth

54
 Economic Growth and Government Policy
encourage research and development. Most of the increase in the
standard of living is due to an increase in technological knowledge
which comes from research and development. After a time,
knowledge is a public good in that we all can use it at the same time
without diminishing another's benefits. Technological knowledge as
well as investment in human capital provides positive externality.
Research and development might be encouraged with grants, tax
breaks, and patents to establish temporary property rights to an
invention. Alternatively, the desire to do researches, to invent, and to
make innovations might be encouraged by maintaining intellectual
property rights.

55
 Government Expenditures on R&D as % of GDP
in Different Countries in 2000 and 2015

4,5
4
3,5
3
2,5
2
1,5
1
0,5
0

2000 2015 56
 Controversies of Economic Growth
In order to increase the stock of capital there must be the increase in
investment and saving, but
this additional growth has an opportunity cost — society must
give up current consumption in order to attain more growth.
investment in capital may be subject to diminishing returns: as
the stock of capital rises, the extra output produced by an
additional unit of capital declines.
Thus, an additional increment of capital in a poor country increases
growth more than the same increment in an already rich country.
This is known as the catch-up-effect, because it is easier for a
relatively poor country to grow quickly.
However, because of diminishing returns to capital, higher saving
and investment in a poor country will lead to higher growth only
for a period of time, with growth slowing down again as the
57
economy accumulates a higher level of capital stock.
 The Price of Economic Growth

Economic growth can:

degrade the environment;
cause congestion;
lead to more hectic lifestyles, etc…

Still, most people would prefer to live

where real GDP per capita is high than where it is low.

58