This document was created by Sarthak Virdi, Divya Sethuraman, Aastha Malipatil,

Uravi Pania, Nidhi Agrawal and Sukarm Sharma

GDP is the measure of the economy’s total income and expenditure. How does it
measure both? For the economy as a whole, income + expenditure, because of Circular
flow of Income.

GDP measures two things at once i.e., the total income of everyone in the economy and
the total expenditure on the economy’s output of goods and services.

Income = Expenditure

Circular Flow of Income

Measuring GDP
GDP: The market value of all final goods and services produced within an economy in a
given period of time.

1. Gross: It includes both new investment and investment made for the purpose of
depreciation expenditure
- New Investment adds to the production capacity
- Depreciation is done to replace the worn-out assets

2. Net: Gross – Depreciation

3. Market Value: The market value- final value of all goods and services are taken, not
the intermediate value

4. Factor Cost: Total cost incurred in deploying all factors of production to generate
goods

5. Net Indirect Taxes: Indirect taxes – Subsidies

6. Market Price= FC + NIT

7. Basic Price = It comes in the middle of both market price and factor cost, as there are
different types of taxes so in NIT, the
 = FC + Production Tax (Stamp Duty) – Production Subsidy (Fertilizer Subsidy)

8. MP = BP + NIT

Exclude:
1. Second hand sale of goods
2. Transfer Payments
3. Resale of Shares and Bonds
4. Illegal
5. Goods used for private consumption

Include:
1. Housing: Housing can be rental or owned, owned is included as C, rental housing is
including because rent is one of the factor payments made

- Intermediate products are removed

- Products- Current products, not old production (Transfer payments not included
because of the same)
- Domestically produced- Irrespective of the nationality of who is producing it
- Annual Rate- multiply projections of one quarter * 4

Irregularities in Calculation
1. Seasonal randomness is corrected by seasonal adjustment: Because you're only making
quarterly calculations- seasonal changes could be problematic- for eg: Christmas
season could have higher output because of consumer sentiment
2. Statistical Discrepancy in collecting the data

Output Method: Value of Output (Sales + Change in Stock (Closing stock - Opening stock)-
Intermediate cost.

Factor Cost= Cost incurred for employing all factors of production

Basic Price= Factor cost + Production Taxes - Production Subsidies
Market Price: GDP is calculated at this = Basic Price + Product Taxes - Product Subsidies

We usually go from Factor cost to Market Price: FC + Indirect Tax - Subsidies

National Income (NNP at factor cost)= GDP at MP - Depn + NFIA - Net Indirect Tax (Indirect
Taxes - Subsidies)
Gross to Net= -Depn
Domestic to National = Net Factor Income from Abroad (Incomes you receive - income you
remit)
FC to MP= +NIT

Expenditure Method

GDP MP = Government Final Consumption Expenditure + Private Final Consumption

Expenditure + Net Exports (Exp - Imp) + Investment (Gross Domestic Capital Formation) +
Valuables (in the olden times they used to add valuables)

GDCF (investment)- 2 things

1. Inventory Investment= Change in Stock= Closing stock - Opening Stock

2. GFCF= Investment undertaken by different sectors (Business + Private + Public)

Income Method gives us NDP at FC

NDP at FC= Compensation of Employees + Operating Surplus + Mixed Income for Self
Employed (They dont get paid in wages, they are generating income)

COE= Wages and Salaries + Employers contribution to Social Security Scheme (Pensions are
excluded because they are earned in the old years)

Operating Surplus= Rent + Royalty + Interest + Profit (Dividend + Undistributed Corporate

Profits (Retained Earnings) + Corporate Tax)

NDP at FC + NFIA = NNP at FC

Different measures of GDP

Real GDP: Value of the total output accounting inflation (constant prices)
Nominal GDP: Value of the total output not accounting inflation

Real GDP= it reflects a change in the production quantity and Nominal GDp accounts for
change in the production quantity and prices, where prices are not relevant

GDP Deflator: Change in the price levels (Inflation): (Nominal /Real GDp)* 100
It can be used to find the inflation rate
Inflation- a situation when the economy’s overall price level is increasing : inflation in year 2 =
(GDP deflator in year 2 - GDP deflator in year 1)/(GDP deflator in year 1) x 100

Problem:
 1. GDP is a measure but it is not full and exact measure- it measures the ability of
obtaining of life but not ability to maintain life- More income meaning more inputs to
make life better

It doesn't measure:
1. Leisure: Population is overworking
2. Anything Produced at home: Childcare and Motherhood
3. Gratuitous acts
4. Quality of products
5. Does not include distribution of income among different strata of society
6. Illegal activities

1. Private Income (Private Households and Firms): NNP at FC - Govt Income and Savings
+ Transfer Income (From the government, something from the world, National Debt
Interest)
2. Personal Income (Households)= Private Income - Retained Earnings - Corporate Tax
(Dividend is not included because it accrues to the households)
3. Personal Disposable Income= Personal Income - Income Tax- Non Tax Payment (Fines
etc)

These formulas are an aggregate

Chapter 12:

1. How to calculate CPI and Inflation (219)

2. Fisher Effect- real interest rate - nominal interest rate (228)
3. Page 226

Chapter 12:
● Economic growth> standard of living> depends on how much goods and services >
productivity> factors of production.
● Focus on Long run economic growth.
● Productivity- qty of goods and services per unit of labour.
● Growth in productivity is key determinant of production and therefore living standards.
●

Physical Capital per worker is also called Produced factor of production: stock of equiment like
machinery.
Human capital per worker- skill and knowledge (education, training and experience) this is also
a produced factor of production.
Natural resources- inputs avaliable in nature-land,water etc. are natural resources absolutely
necessary- NO, there are countries which do not have natural resources, they engage in trade
like singapore are they a limit to growth, because they will eventually run out?-NO,
because technological progress (eg tin copper replaced by plastic and fiber optic cables) if
natural resources were actually scarce, they would have very high prices, but prices have been
stable.
Technological knowledge- best way to make use of existing factor of production to produce
goods and services. 3 kinds- proprietary(only known to firm), patent (proprietary for some time),
common knowledge( everyone knows like factory line)

Quantity of labour is also a determinant to the production function.

Production function.
Y= A F(L,K,H,N)
● Production function exhibits constant returns to scale i.e doubling of any factor will lead
to doubling of output.

In public policy, govt targets factor of production to increase productivity-

● Savings - to increase physical capital, society compromises on consumption today to
produce more in future. Diminishing returns(despite an increase in savings, which will
increase capital, the returns to the capital will fall over time). However this period (before
diminishing returns set in)operates for a long period so it is beneficial. Catch up effect-
boost in countries with lesser capital will be more compared to already capital rich
countries. Therefore increase in input for poor countries will cause higher increases in
output. For richer countries, diminishing returns will set in.(US and South Korea)

● Investments- FDI (foriegn direct investment is both owned and operated by foriegn
entities) and FPI( capital investment is not operated by foriegn entity)
● Investments from abroad increases GNP much more than GDP. Investment from
abroad, therefore, does not have the same effect on all measures of economic
prosperity. Recall that gross domestic product (GDP) is the income earned within a
country by both residents and nonresidents, whereas gross national product (GNP) is
the income earned by residents of a country both at home and abroad. When Ford
opens its car factory in Mexico, some of the income the factory generates accrues to
people who do not live in Mexico. As a result, foreign investment in Mexico raises the
 income of Mexicans (measured by GNP) by less than it raises the production in Mexico
(measured by GDP).
● Education : Brain Drain is a problem in poorer countries.
● Health and Nutrition- health of workers affect productivity. Robert Fogel linked heights
and wages to show that taller people have better wages. Problem in poorer countries
because of malnutrition.
● Property rights and Political stability- Affects savings and investment( we won’t invest in
unstable places) and to produce, you need property rights. Otherwise you won’t have
incentive to save and be productive.
● Free trade- exporting and importing, comparison of inward oriented and outward
oriented policies. When country opens up, it has higher economic growth. Trade is like
technology because you get other countries’ resources. Why are inward policies bad,
why are outward policies good. Also relate to natural resources point, it does not
hinder growth.
● Research and development- technology, knowledge is a public good, invest in creating
knowledge. How does govt encourage innovation?- patents, incentivises to do R&D to
make profit from it.
● Population growth- misconception that high population growth leads to more labour, but
this population growth has concerns ( malthus concern that natural resources will run
out, this got debunked because of technology ; second valid concern is that more labour,
the capital available per worker will be low. This capital can be physical or human)
therefore population control is necessary- done through hard law like one child policy,
incentive based approach like education, information like birth control awareness.
Benefit assumption- countries with bigger populations have more economic growth as
more people can come up with technological ideas etc.

Terms of Trade: trade improves welfare by pushing the indifference curve higher, therefore
maximizing their welfare. (refer notes sent by divya) Cic measures citizen welfare. Assuming
two situations; where economy is not trading, where it is.

Assuming prices are constant, v is constant

Isovalue line= p(x)*q(x) + p(m)*q(m) = v (total cost of consuming)
Take q(x) on LHS, we get
Q(x)= (1/px)*v - p(x)/P(m) * Q(m).

● First hypothetical: Assuming that the economy is not trading, Production possibility
frontier- maximum of different combination of x and m an economy can produce. Where
L1 meets production frontier, that is optimal point for production. However consumption
at this level might not be beneficial or desired.
● Community indifference curve- when isovalue meets community indifference curve, that
is desired. This is optimal consumption.
● Without trade, one is stuck at where isovalue meets ppf rather than community ic.
● Prices prevailing at point L1 where one is forced to consume, is called Domestic terms of
trade.
 ● Second Hypothetical- opening up.
● Supposing in international market, price of X is higher and price of M is lower, isovalue
line will change. L2 will be flatter (refer diagram), now there are new terms of trade-
international terms of trade. Now optimal point of production is e2, optimal consumption
is a different point. So since country is trading, the gap between Qm2 and Qm3 is filled
by importing.

Chapter 13: financial markets:

● Bond market- there is credit risk of default, so more interest rates. Tax treatment- for
federal bonds, full taxes for state bonds no.
● Stock market- stock prices are not the best indicators of economy
● Financial intermediaries- bank accounts- they connect borrowers to savers.
● Mutual funds- this is not necessarily better
● Important identities-
● Y = C + I + G, savings= investment
● So Y= C+S+G ; S= Y-C-G.
● Public and pvt savings= national savings.
● Public savings = T-G; Pvt savings = Y- C-T
● Adding we get national savings.
● Do q4 and 5 .
● Market for Loanable funds- graph of supply and demand. We determine interest rate
based on the supply and demand. Interest rate will be real interest rate.

● Policies affecting demand and supply of loanable funds.

● Saving incentives- will affect supply, shift to right, lower interest rate
● Investment investment- will affect demand, shift to right, higher interest rate.
● Deficit budget- will affect supply, as public savings will reduce, thus national savings will
reduce. Supply shifts to left, higher interest rate. This leads to a crowding out effect.
● Debt financing
Unemployment
Unemployment in the long Run: It deals with
What is the problem of unemployment
Natural Rate of unemployment
Cyclical rate of employment

Identifying Unemployment
1. Who are employed
2. Who are unemployed
3. Labout Force
4. Other Population

5. Employed: People who are engaged in their own business, normal employees, people
who are unpaid but part of family business, jobs people have been temporarily absent
from
6. Unemployed: Any who is not employed and is not available for work but hasn't been able
to find work + Those who have been laid off
7. Labour Force- The ability of people to work (Both Employed + Unemployed)
8. What is not in the labour force- anyone who is not willing to work (Students)
9. Labour Force + Who are not labour force= adult population (15-65)
10. Unemployment rate= (Unemployed/ Total labor force)* 100
11. Labour force participation rate= (Employed + Unemployed / total population)* 100

Natural Rate of unemployment- normal rate of unemployment that generally prevails in the
economy
Cyclical rate of employment- Seasonal deviations from natural rate of unemployment

Section II

Why are these ratios not perfect measures?

1. When there are strict categories of unemployment, there are certain overinclusions and
underinclusions, people move in and out of the labour force, that is a primary reason for
imperfections. For eg: Some people who are unemployed also includes those are not
willing to work- Over Inclusions (When all laid off are included)
2. Under Inclusions: People may not show that they are employed because their source of
money is something illegal
3. Discouraged Workers: Excluded from all statistics, workers who have been trying to get
work for a long time but have not been able to find work and therefore given up.

Section III
Duration of unemployed: Most spells of unemployment are short in duration but unemployment
observed during a certain moment is long term
Because of this idea, unemployment in the economy is because of the few sections who are
perpetually employed (which is why the natural rate sustains).

Why are some sections perpetually unemployed? Because you have the concept of labor force,
the supply and demand should eventually match up in the economy, there are people who
demand labor, there must be a point where there should be an intersection point (the point
being wages) and the point being efficient wages. There is an excess supply of labour always,

Short spells- searching for a job best suited to them- Frictional Unemployment
Long spells- excess supply- Structural Unemployment

3 theories: Explain structural unemployment \

Job Search: How do you solve frictional unemployment?

People find appropriate jobs suited for themselves, what are the reasons?
1. There is a change in demand for labour among the firms only: Lay off people because
production has fallen
2. There is a change in demand for labour among the industries- Sectoral Shifts- it can be
because of change in demand for labour due to industrial shift or regional shift, alos
certain industries require more people to work ( for eg: Covid-Pharma)
3. Sector development: Service sector is developed and shift from Manufacturing sector
4. Unemployement Insurance: workers become complacent nd therefore the job process is
lengthier

Quicken the job search process:

1. Give them more information
2. Skill them better so that they are adaptable to changes

It can be done by the government or Public policy perspective when government is doing
it can be done privately: by workers skilling by the training agencies, ads etc, private job training
etc

Unemployment Insurance: Public policy view of unemployment- government gives insurance to

people who have been laid off- partial protection to people (not for fired, quitters and new
entrants in the market)
They put less effort in the job search because of the insurance given thereforethe job search
period increasing
Also this assurance makes you agree to bad terms given the unemployment insurance can rely
on.

Why is market wage above the equilibrium wage?

 1. The minimum wage rate is always above the equilibrium wage rate, because minimum
wage at eqlevel is not sustainable for a lifestyle
2. The pinch of lowering the minimum wage rate is felt by people in the lower households
and not by rich households

Union or COllective Bargaining

1. Union performs collective bargaining,
2. One of the things they can also do is going on a strike
3. They wil negotiate a wage higher than the equilibrium wage
4. This union negotiation effects-
a. They also contribute to the structural unemployment: Firms who employ these
workers, they won't be able to pay everyone higher wages, so they would have to
layoff certain number of workers
b. Outsiders of the firm- who are never part of the union- so the outsiders are
waiting to join the union cause it would lead to higher wages for them
c. Outsiders are part of the unemployed laborers, they don't even get a low paying
job
5. High Union wages reduce unemployment, and it is inequitable because some laborers
benefit at the expense of laid off insiders and outsiders, this negotiation creates excess
supply of laborurers
6. In case of firms like Amazon, unions are important because of the disproportionate
power balance between them

The theory of efficiency wages

1. Firms are paying higher than the eq level: Of their own accord, firms pay a higher
wage rate above eq level
a. Worker Health: Take less sick leaves
b. Worker Turnover: Turnover will be less
c. Worker Quality: Best quality workers
d. Worker Effort: a better wage, they will contribute on their own

Consumption

1. Long run: it is relevant to look so we can understand economic growth, a component of

GDP
2. Short run: A role to play in AD-AS

C = Y-T : This equation which is used in all models is too simple, it only takes Income as a
determinant, Income is not the only determinant of consumption

John Maynard Keynes - He only observed and didnt have any data
3 Ideas
 1. Marginal Propensity to Consume- It is always between 0 and 1, the change in
consumption due to change in income
a. They neither exhaust their whole income so it is not 1
b. They do not save the whole so not 0
2. The ratio of consumption to income falls with an increase in income- APC falls, Savings
is a luxury, an option for rich people
3. Consumption decisions are based on only on current income (not considering future
income)

C= Ci + cY

MPC is between 0 and 1, if you sub bigger and bigger values in Y, C increases proportionally-
slope of the line
APC falls: divide all terms by Y: APC= Ci + MPC (only constant)- slope of the line from the origin
to a point on the consumption line

Observational Household Data: When they looked at data from households, they consumed
more and saved more, houses with higher income tend to save one, Houses do not take market
rate into cognisance for increasing their consumption
Between 2 world wars, all three conjectures got proven.

Simon Kusneth

2nd conjecture found to be wrong:

1. He collected data on Income and Consumption across years. His data showed that even
if there was an economic recession or boom, there would be a stable C/Y at the end.
(LONG RUN DOESNT WORK)
2. If you extend the 2nd conjecture, post the second world war, there would be a high
increase in everyone’s income, people will only save and no consumption but this didnt
happen

Consumption Functions:
1. Short run: Falling APC
2. Long run: 45 degree line- Constant APC

Irving Fisher and Intertemporal Choice

The Intertemporal Budget Constraint

1. Consumption depends on a persons lifetime income, he will try and consume in such a
way that in his retirement years they would have some income
2. Earning period and Reduced earnings period: C1Y1 and C2Y2
3. Between these time periods, there is an ability for the consumer to save and borrow
 4. Saving means you are increasing your ability to consume in the future, Borrowing
against your future income therefore decreasing your income in the future
5. In the first period, if the consumer is saving: S = Y1 - C1 (pos- saving) negative-
borrowing
6. Any saving and borrowing can happen in the first period, he is gonna die in the second
period
7. Second period: all consumption happens = C2 = (1+r)S +Y2
8. C2= (1+r)(Y1-C2)+Y2
9. C1+C2/1+r= Y1+Y2/1+r
10. Interest rate is 0, for both saving and borrowing, r is 0, therefore Consumption across
both periods would be equal to income in both periods
11. Discounted by a factor of 1+r in the secod period because his savings is appreciated in
the second period, consumption is cheaper in the second period than in the first period,
consumption in the second period for the consumer because he has more income funds
consumable in the 2nd period. Wealth is worth less in the 2nd period, getting discounted
by 1+r, wealth that you earn through Y2 can never appreciate as it cant be saved
12. Future consumption is dependent on what is saved out of current income
13. The slope of this equation is 1+r
14. 1/1+r is the factor by which 1st period consumption needs to be forgone in order to
increase your second period consumption

Preferences

One unit reduction of first period consumption is given up for increase in second period
consumption
Optimisation: Budget constraint is tangential to the IC: SLope of IC = Slope of Budget
constraint
MRS= 1+r (The consumer chooses his optimal consumption accounting for his income in both
periods)

How Changes in income affect consumption?

The change in income can mean an income change in either of the two periods, it will change
consumption in both the periods. Therefore, the constraint Y1 or Y2 is gonna change, the shift
of the line is happening (1+r), slope is not changing, if income increases in any periods, there is
increase in consumption in both periods, there is a rightward shift in budget contraint.
2. The consumer can borrow and lend across the periods, the timing of when he gets the new
income is irrelevant to how much I consume today, as they take into account both incomes.

How changes in real interest rate affect consumption?

In LCH, one Standard of Living is to be maintained throughout the life & consumption is
smoothened out. There are T years till the end of your life, expected to earn an income until the
time you work, and thus the income line is horizontal. Same income earned each year. Post
retirement, dissavings. Income is transferred from the periods where income is high to where
income is low. Savings happen when you work and dissavings when you work. In the Long run,
in Modigliani, wealth varies proportionately. Until you retire, wealth rises and falls after
retirement.

Milton friedman (PERMANENT INCOME HYPOTHESIS)

People experience random and temporary changes in their income throughout their life, and
thus their consumption is also random. Both agree that consumption depends on lifetime
income, but Milton says that consumption is a combination of your permanent and transitory
income.
Permanent income is the income expected to persist across your lifetime, while transitory is not
expected to persist. If you are better educated, then you can expect your income from a job to
persist, but not what you win from a lottery.
The expectation of the income being permanent/ transitory is what matters. Persistence is
based on how long you expect the income to last. He says that consumption should depend
on permanent income.
- Consumption changes are random
- Permanent and transitory income
- Consumption should depend on permanent income, because consumers smoothen out
transitory income throughout their life by way of savings and borriwings
If you win 10k in a lottery, all of that is not consumed, and is saved. You spend some of it
throughout your life. Consumers would rather save transitory income. Because consumers feel
this income won’t persists, they want to save it.
- C = MPC(Permanent Income)
- APC = MPC(pY)/ Current Income
- APC is dependent upon the ratio of permanent and current income, if perm>current,
APC rises and if perm<current APC falls.
- In households with a high permanent income, current=permanent and APC is constant.
But income includes transitory income and thus APC cant be constant in the short
run. High income in households is mainly because of transitory income and we
 know that all of transitory income wont be consumed and will be saved. C remains
the same and current income rises, thus APC falls in the short run.
- In the long run, because year-to-year fluctuations are of transitory income,
changes to income are permanent in nature, and the pY and Current income
become equal and the APC is constant.

Robert Hall

RANDOM WALK HYPOTHESIS

People base their consumption on what they expect to earn. Consumers view the changes in
their income with rational expectations and they use all available information to make forecasts
about their future income. If you have rational expectations, then there won’t be changes that
you don’t expect. Only random/ unexpected changes will cause a change in income.

Changes in income only reflect a surprise. Because you already expected a change, it won’t
affect your consumption. Since these changes are unexpected, consumption bhevaiour is
random and can’t be expected.

Implications - if you want consumers to change income on the basis of economic policy, then
the change in income has to be a shock. If there is to be a tax change, which consumers
already know of, then they would have incorporated that change into their income and thus it
wont affect consumption.

Laibson -
Challenges the idea of rationality
Some people think they’re not saving enough, some think they should be saving.
There is an insufficiency of savings and thus people aren’t as rational.

Pull of instant gratification - people are more patient in the long run.
MONETARY SYSTEM

Money is a set of assets used to buy goods and services

- Medium of exchange
- Unit of account - recording debts
- Store of value - consumption/ purchasing power can be transferred to a future period
- Liquidity - the ability of any asset to be converted into a medium of exchange.

Money & Wealth - wealth includes stocks and bonds, but money doesn’t because they are not
mediums of exchange.

Earlier there was barter system, which is not feasible because of double coincidence of wants.
Commodity money has intrinsic value of its own, the item can be used in itself (gold).
There was gold backed currency, which meant that currency had to be backed by gold, but
exchanges occurred with currency. This was the gold standard. Gold was used because it can
be measured easily, its value and can be checked for impurity. But it is scarce, and thus people
moved to fiat money. This does not have value of its own, but is decreed to be used by the
government. Only because the government says so, it won't be used for it also depends on
acceptability by the society. In prison, cigs are used. Some kind of societal conventions do play
in.

Money in the economy has two components - Currency (notes and coins with the public)
and Dmeand Deposists (they are like money in the pocket, you can withdraw on demand)
Money supply/ stock - C + DD in the economy at a given point of time
Money is a set of assets and when calcualtiing supply, some can be excluded.

Central Bank - an institution that oversees the banking system and controls quantity of
money supply in the economy. The decisions it makes to control the money supply are called
the monetary policy. It also regulates banks by telling them how mch money they should have in
their reserves, what should be the IR. It is also a lender of last resort.
Qty of MS - regulated through OMOs (Open Market Operations)
- By conducting OMOs, it can conveniently control MS. through government bonds, the
purchase and sale of government bonds in the open market. When the government sells
the bonds, it is basically that money supply is reducing in the economy. The public keeps
the bond and gives away money. The money supply reduces because MS includes
currency with the public. When these bonds are bought back, the government gives
money to the public and MS rises in the economy. Easy because it doesnt affect banks
or their IR.

Banks constitute money supply and make the monetary policy difficuly, for they have the DD
part of MS. the Central Bank uses fractional reserve banking to solve this problem.

Assume one bank is opened, and that it does not lend, is only a depository institution. For that
bank, all deposits are a liability, for they are owed to the public. Reserves are the deposits that
are not loaned out. Since this is a 100% reserve system, deposits = reserves & assets =
liabilities. This does not affect money supply, say Currency = 100, and all of it is deposited,
reserves rise but currency falls and thus total MS does not change.

But the situation is different when banks start to give loans. Loan is an asset for the bank.
Assume this bank has a loaning capacity. Any bank that has loaning capacity will affect MS. the
fraction of reserves to be held is determined by the Central Bank.

Fractional Reserve Banking

You deposit 100, liability = 100. But reserve Ratio (fraction of deposts to be held as reserves, as
mandated by the Central Bank) i s 10%. 90 can be loaned out. What happens to the MS,
when the bank makes the loan it increases the MS by giving loans. When the borrowers
hold 90 in currency that has been loaned out by the bank, the MS rises by 90. Money is
not created out of thin air, the bank owes the created money to its depositors, for it has come
from the deposits. There is a change in asset valuation.

Multiplier - the amount of money generated by banks with each dollar of reserves. Gives
the addition to the money supply in the economy.
- Money creation doesn’t stop at 90. The + 90 comes back to the bank as deposits in the
bank by people. This is then used to loan out by keeping 9, thus giving a +81 to the
economy.
- Money creation happens at every level. Second, third, fourth rounds of lending. Ths
happens till the extent of the reciprocal of reserve ratio. If RR is 10%, money multiplier is
1/ 10%, which is 10. The initial 100 becomes 1000.
- Reserve ratio in India is the sum of CRR and SLR.

Bank Capital & Leverage Ratio

- The only thing that was available to give loans/ create reserves was deposits. But the
bank has other liabilities too that can further generate money supply. The bank can
 borrow (debt) & its own owners will invest (equity/ capital). The bank can now do
just more than lend, it can also put money in stocks and bonds.
- Bank capital is the capital supplied by the owners as funds. Also called owners’ equity.
The bank decides how much to allocate to assets on the basis of a risk-return analysis.
They will lend to companies only if they have confidence, or the Central Bank itself can
regulate the use of these funds.
- Leverage - many business rely on leverage/ the use of borrowed money to
supplement existing funds for the purpose of investment.
- Leverage ratio - total assets/ bank capital if you have this ratio as 20, this means for
every 1 bank capital you have 20 assets. But this also tells you how much yu have
borrowed, if you have 1 capital and 20 assets, then it means you have borrowed the 19.
The leverage ratio is thus an indicator of debt. This can either be deposits or
borrowed money, the former is also an indirect form of debt.

-
- Deposit and debt are unchanged. Suppose that the bank’s assets were to rise in value
by 5 percent because, say, some of the securities the bank was holding rose in price.
Then the $1,000 of assets would now be worth $1,050. Because the depositors and debt
holders are still owed $950, the bank capital rises from $50 to $100. Thus, when the
leverage rate is 20, a 5-percent increase in the value of assets increases the owners’
equity by 100 percent.
- Suppose that some people who borrowed from the bank default on their loans, reducing
the value of the bank’s assets by 5 percent, to $950. Because the depositors and debt
holders have the legal right to be paid before the bank owners, the value of the owners’
equity falls to zero. Thus, when the leverage ratio is 20, a 5-percent fall in the value of
the bank assets leads to a 100-percent fall in bank capital. If the value of assets were to
fall by more than 5 percent, the bank’s assets would fall below its liabilities. In this case,
the bank would be insolvent, and it would be unable to pay off its debt holders and
depositors in full.
- This is why the government has capital requirements. In 2008-09.
- Any change in the asset gets reflected in the capital because liabities are not changing.
There are securities too. Banks thought they had 100 worth of assets, but they were
actually worth 70, for the securities invested were mortgaged loans. The bank loan
is dependent upon the property value which was fraudulently inflated. The bank
had a capital of 10, it owed the debtors 90. 100-90=10. The real value of the asset
became 70. You owe 90, and you had 70.

Reserves can be changed by

-Changing the reserve ratios
-The amount of money lent to banks by the Central Bank (discount rate, a high discount
rate discourages holding reserves and thus money creation capacity falls).
- there can be bidding where banks decide the IR, but they will borrow only when the IR
is low.

In the Indian context, the rate at which the CB lends to commercial banks is called Repo
Rate. in Term option facilities (USA), the IR is determined by bids. Here, the Cnetral
Bank determines the IR.

If the Reserve ratio is increased, the money that can be leant by banks falls and money
supply falls.
CRR - the reserves mandated by the CB that banks keep with the central bank.
SLR- assets that banks must keep with themselves.
Reverve Repo Rate - the Central bank pays an interest rate for banks to keep reserves
with the Cnetral Bank. If RRR rises, banks find it more lucrative to keep money with the
Cnetral Bank, and thus reduce lending. This is linked to CRR because what the
banks keep with the Central Bank is CRR.

Controlling MS
Omos to control money supply
Central banks can lend to banks
Ratio requirements can be changed
Reverse Repo Rate - linked to CRR

Limitaions of Monetary Policy

The Central Bank cannot control how much money people want to deposit and the CB
can only control the IR of the banks, an thus ir can’t change the behavior of households.
The CB cannot also control how much banks want to lend. If they want to lend less, they
will do so.
MONEY AND INFLATION

Inflation and Money Growth - Long run

Inflation is not inevitable, there can be deflation too. When the overall price levels rise,
you need more money and the demand for real money balances will be high. If there is
defltion, the value of money will keep on increasing. Then if you have borrowed money
in the past, you will have to pay back more. An extraordinarily high rate of inflation is
called hyperinflation.

The determinant of whether an economy experiences inflation determining through the

quantity theory of money. Classical theory of money/ inflation. The point of it is to show
when would an economy experience inflation, for inflation is nit the norm. The classical
theory applies to the long run.

It is the idea that the quantity of money available determines the vale of money &
price level and the growth of MS determines inflation.

Value of money & price level - inflation is about the value of money, the goods are the
same. Inflation is an economy wide phenomenon, which concerns the value of money.
The price level can be understood as a price of basket of goods and services and people
have to pay more for the goods and services when there is inflation. Higher price level
means low value of money because the same money will buy you less.
P = price level = the number of dollars needed to buy g & s. Suppose 1 basket costs $1.
If you have $1, you can buy 1/P value of goods and services. 1 dollar can be
expressed as 1/P in terms of the value of goods and services. How much goods
and services a dollar can buy. Say P=2, the value of each dollar is ½. When P=3,
value is ⅓. As price rises, the value of money keeps on falling.

What determines the value of money is money supply and money demand. Money
demand is how much people want to keep with themselves. Money demand is affeceted
by overall price levels, because if price levels rise you will need more money to buy the
same g & s and your demand for real money balances will rise. Money supply is fixed by
the Central Bank. In the Long run, what balances money supply and demand is
Price level, in the shirt run it is done by Interest Rates.
With a fall in price levels, less money is demanded. In the long run the price level
determines money demand, but in the short run it will be the interest rate.

Effects of monetary injection

Increase in money supply by the central bank.

Increase in the supply of money, increases price level and reduces value of money.
Growth in the quantity of money thus is the primary determinant of inflation. The
quantity of money directly affects the price level and thus it inversely affects the
value of money. As MS increases, inflation increases.

Adjustment process - how does the economy move from a to b. A monetary injection
creaetes an excess money supply, and the MS>MD. People try and get rid of this excess
money, by putting it into banks, lend it out/ invest into bonds. This then increases
demand for goods and services. G & S are dependent on Factors of production and they
are not altered by a high MS. Merely increasing MS does not affect the output & thus
due to high demand and a constrained supply, price levels rise. The price level moves
from 2 to 4 which then reduces value of money.
People might demand more themselves or put money into the bank which will be loaned
out and more people will demand.

Classical dichotomy and Monetary Neutrality

Changes in money supply lead to changes only in the price levels, and thus only nominal
variables are affected. Real variables are measured in physical units. Since production
has remained constant, the change in monetary variables (MS) affects only the nominal
variables (price levels). Monetary neutrality is facilitated by the idea of classical
dichotomy, which separates the economy into real and nominal variables.

Is this realistic in the short run? There will be confusion and mistakes in the short run.
Monetary changes will affect real variables in the short run. MN holds only in the long
run. This is the criticism, and the main difference between the long run and the short run.

Quantity Theory of Money and the Quantity equation

MV = PT

The quantity of money in the economy is related to the transactions in the economy. If
you need more money, for each transaction, you will demand more money.
The QOM is related to the dollars echanged for the transactions.
T is the number of times a good or a service is exchanged for money, P is the price level
for this exchange.
PT is the number of dollars exchanged for these transactions.
M is MS. V measures the rate at which money circulates in the economy or the number
of times a dolar changes hands in the economy.

If the quantity of money changes, with V remaining the same, either P or T should
change.

The problem here is that it is difficult to find the number of transaction happening and
thus T is substituted by the output produced. Output is the income generated, and thus it
can also be called income velocity of money.

MV = PY (but the difference is that if a second hand car is sold, it will counted as T but
not in Y, but roughly the amounts are the same). Y is real GDP, PY is nominal GDP
because P is the GDP deflator.

M is measured by C + DD.
MONEY DEMAND FUNCTION

Real balance of money measures the purchasing power of money. The M dollars can
buy M/P goods and services. The quantity of money people choose to hold is linked to
Y. in the short run this will translate into a relation with the IR. M/P is dependent on your
income, you demand a fraction of your income. K tells you how much you want to hold
for every dollar of income. With high levels of income you will have a high demand for
real money balances because you need more money to carry out transactions.
Velocity is inversely related to the amount money people want to hold.

It is assumed that the velocity of money is constant, because the same has been shown
to be true by data examined over the long run. Any change in M will not affect V and will
only affect the nominal GDP. Y being the real GDP depends on real variables and is
not affected by M (monetary neutrality), a change in M would thus affect the Price
Levels. Monetary changes to the economy thus affect the price level.

CHAPTER 17

To calculate velocity, nominal GDP is to be divided by the money in the economy.

MV=PY
V=PY/M
This is called the quantity equation of money because it relates the quantity of money to
the level of output in the economy.

A change in the quantity of money changes only the prices, which is that it affects only
the nominal variable, because the real output does not depend on prices, rather it
depends on FOP. QOM is regulated by the central bank. Money supply change is thus
seen only in inflation.
Inflation tax -

when the government increcases MS, the value of money falls as a consequence of
rising price levels. Because there is inflation, with a rise in price levels the value of
money falls and this is a kind of a tax created because you need to pay more money for
each basket of goods and services. Inflation tax is the revenue the government
creates by raising the money supply. The government transfers purchasing power
from the consumers to itself. By printing money, it takes away purchasing power
from the people.

Most inflations start because the government prints money. This is done by governments
because they are backed into a corner as their tax revenue is low & they need to cover
their costs/ spending requirements. The other solution could be cuting down on
spending.

Fisher Effect

NIR = RIR + Inflation

Economic forces determine the two terms on the RHS. real interest rate depends on the
supply and demand of loanable funds, and the level of inflation depends on money
supply. In the long run, growth in money supply would affect Inflation, but the real
variable RIR will not be affected (monetray neutrality), and only NIR will be affected.

The adjustment process of the Nominal interest rate in response to the inflation rate is
the Fsher effect. This may not hold in the short run, because inflation may be
unexpected. If there is an accidental rise in the inflation rate, then the NIR will not
reflect it. If it stays high, people will expect it and thus in the long run NIR reflects
it. This is based on the idea that actual inflation and expected inflation move
together in the long run.

Costs of Inflation

Fall in purchasing power - inflation fallacy

When inflation occurs, wages increase too. They are the price of hiring labor and they
too rise in case of inflation and thus purchasing power does not actually reduce.

Shoeleather costs
Inflation - money has to be constantly deposited into banks to make sure interest is
eanred and money does not lose its value. This cost is not distributed to the society and
is a deadweight loss.

Menu Costs
If inflation causes changes in prices, then menus will have to be revised.

Relative prices & Misallocation of Resources

When people see changes in nominal prices, they might not look at the broader context
and realize that the same is happening across the economy.

Inflation induced tax distortions

Inflation can distort tax burden on people, where taxes are based on nominal income
and thus the burden on people can be high if there real incomes are not rising.

Confusion and inconvenience

Makes difficult long term plans
 Deflation along with an equal RIR can produce a zero NIR which would reduce the
shoeleather costs/ menu costs.
AD AND AS

Economic fluctuations

Irregular - not always predictable

Most Macreconomic quantities change together
As output falls unemployment rises

Output = GDP = Expenditure

Classicalists believed in the dichotomy, real and nominal variables. Changes in nomical
variables affect only other nominal varibales. What keynes says is that only in the long
run, does monetary neutrality exist. In the short run, changes in nominal variables do
affect real variables.

AD and AS is a short run model here, not the long run. Upward sloping AS is in the short
run. Whenever AD and AS intersect, that determines the pirce and output level. In the
short run AD, AS curve, you have prices and output, real and nominal variables together,
thus disporivng monetary neutrality for the short run.

A one on one relation between prices and demand cannot explain AD (market demand).
Three theories to explain the behavior of AD -

Wealth effect - price reduces, purchasing power rises. Output increases.

Interest Rate Effect - Price falls, then demand for money falls. People need lessmoney
to buy the same basket of g & s. Where money demand and money supply intersect,
that determines the intersect rate. Now that money demand has decreased, interest rate
falls. People can now borrow easily and they can invest/ borrow more. In the maket for
loanable funds, supply has increased because people put more money into the financial
sector because they need less money with themselves & this causes a low interesat
rate. This kicks up investment.

Exhange Rate Effect - if price falls, IR falls and you would want to invest abroad. You
now convert your currency into foreign currency. This increases supply of the domestic
currency and demand for the foreign currency which leads to a high foreign exchange
rate. This increases net exports, because exports become expensive and imports
become cheaper.

The AD curve can shift if -

- If G increases Taxes, disposable income falls and C falls
- Consumer sentiment - regarding future expectations \
 - Stock market booms increases household wealth and AD rises
- Interest rate changes can affect investment
- If government expenditure increases, AD will increase
- Changes in other countries, because countries are dependent on each other for trade.

AS
In the long run, nominal variables cannot affect real variables. In the AS curve, the AS is a real
variable while prices are nominal. A change in the latter cannot affect the former. This is why the
AS is upward sloping in the log run, because it remains constant for a given price. It can shift
because of change in labour, capital, natural resources and technology.
- Labor - increasing population, skill increases, then shift to right
- Capital - if amount of capital increases, to the right
- Natural resources - discovery of NR, shift to the right
- Technology - cannot shift left, only to the right.

Technological knowhow keeps on increasing and to keep up with a rising AS, the
Central Bank keeps increasing the AD & this is why certain level of inflation exists.

AS slopes upwards in the short run (there is a change in the actual price level from the
expected price level)
- Sticky wage theory - prices rise, wages might not be able to keep up witht the same and
this makes production cheaper. Thus supply increases. Prices decrease, wages are high
and will take time to be lowered. Makes production more expensive and AS falls.
- Sticky price theory - firms might not change their prices immediately because of say
menu costs, and the firm’s prices have not risen, it becomes expensive to produce.
Supply falls.
- Misperception theory - sellers only look at the prices of their goods, not relative prices.
Price levels in the economy rises overall, but they only look at what is happening to their
product. They dont look at the fact that in the long run, the same will also affect labor
costs/ other costs.

AS as a vertical line is based on natural rate of output. The natural rate out of output
corresponds to a natural rate of unemployment.

If expected price level increases, AS shifts to the left, when the expected price level
decreases, AS shifts to the right in the short run.
Suppose the government starts printing money and this will increase the AD in the economy.
This increases price levels. After some time, expectations would catch up and this becomes the
expected price level and thus the AS shifts back to the natural rate of output. This is because
when expected price level rises, AS shifts back.

For a falling price level

Changes in AD will self-correct, but changes in AS will not. To match the changes in AD, AS
changes. But the same does not happen in case of AS.

Wage Price Spiral/ Stagflation

Output falls, prices rises. If AS shifts back, the price levels are rising and they continue to do so
because when people expect high prices, AS shifts back. Corrected by the fiscal policy and
monetary policy by increasing AD.
EFFECT OF FISCAL AND MONETARY POLICY ON AS AND AD

LPT - where money supply and money demand intersect that determines the interest rate. If the
central bank wants to reduce IR, will increase MS. this reduces IR and endus up increasing AD.

Fiscal Policy - either expenditure can be raised on taxes can be reduced. AS cannot be
affected.

An increase in G/ fall in taxes would shift AD to the right.

Effect of G changes -
- Government expenditure multiplier - leads to a multiplier effect on consumption. The
formula for the multiplier is 1/1- MPC.
- Crowding out effect - government expednitre can cause increase in interest rates and
this can reduce AD.

Automatic stabilizers

- But Active S can be helpful to control the level of output, in case of recession/ deflation.
- The argument agasint it is that there can be a time lag, like laws need to be passed in
order for the fiscal policy to be passed.
- Taxes and government expenditure - taxes are proprtionate to the level of income and
rise when income is rising and fall when income is falling
- If output is low, G will be high because of welfare schemes or unemployment insurance
EXTRA- IMPORTANT POINTS
- AD AS MODEL IS FOR SHORT RUN!!!
- Basically, output and unemployment have an inverse relationship- 3rd fact about
economic fluctuations
- AD AS MODEL is going AGAINST monetary neutrality because you are
explaining short run fluctuations so here on Y axis we take a nominal variable -
price level and X axis real variable- output of g and s
- AD AS NOT SAME AS MARKET DEMAND(see Sarthak’s notes)
- Components of GDP affect AD, here we take G as fixed by fiscal policy , so
changes to Consumption C, Investment I and NX net exports affect AD

WHY AD IS DOWN SLOPE- MOVT ALONG AD CURVE (all explanations start with FALL in
price lvl)
- Wealth effect, interest rate effect, exchange rate effect
- Wealth effect- fall in price level P, value of money 1/p rises, so
consumer is wealthier so chooses to inc C, C inc so AD rises
- Int rate effect- fall in price lvl, fall in qty of money dd with oneself, so you
put more in savings and bonds so there is fall in int rate, fall in int rate
makes cost of borrowing for invst cheap, so Invest I inc ,so AD rises
- Exchange rate effect- fall in (domestic) price lvl leads to fall in
domestic int rate(see wealth effect), int rate goes both ways so those with
govt bonds get lower return on that, so will get rid of those bonds to buy
foreign bonds with better return, exchange own currency for foreign
bonds, so increase supply of f domestic currency, more domestic
currency wrt to foreign currency, so domestic currency depreciates wrt to
foreign currency- becomes cheaper for foreign currency to buy from our
country so our exports inc, it becomes hard for us to import- so NX falls,
so AD rises

WHY AD SHIFTS - due to changes in C I G NX at every price lvl

- For C- stock market boom/crash, taxation, savings
 - For I- say want to increase I by buying equipment, investment tax credit, changes in
money supply ( inc in money supply reduces int rate- liq pref will do next), so
- For G- inc in G- right shift in ad
- For NX- if another country’s economy is in recession, then domestic country’s NX falls
for every price lvl, so AD shifts to left

WHY LR AS is Straight Line- because in LR due to classicalists saying monetary neutrality,

price lvl does NOT effect output of g and s supplied
LR AS signifies natural rate of output with normal rate of unemployment

WHY LR AS SHIFTS- LR AS due to shifts in production from natural rate of output due to
changes in factors of production- labour,capital, natural resources, tech
Labour- changes in immigration, unemployment(min wage laws, unemployment insurance)
Capital- any inc/dec in physical/ human capital
Natural resources- new minerals, bad weather, availability of imports(oil)
Tech- better tech always shifts LR AS to right, intl trade equal to new tech, regulations in
production tech

LR AD AND AS- in long run, down slope AD keeps shifting to Rt because of increase in money
supply and vertical LR AS keeps shifting to right bcoz better tech so now with rt shift of ad and
LR AS constantly, we always have inflation and growth in output in the long run

WHY SR AS SLOPES UP- sticky wages, sticky prices, misperceptions

ALL 3 THEORIES SAY SAME THING- change from natural rate of output occurs when actual
price level changes from expected price level

WHY SR AS SHIFTS- same as shift factors of of LR AS but ALSO VERY IMP

SHORT RUN AS shifts- because of change in expected price levels,

if expected price levels increase, AS shifts to LEFT

CHANGES IN AD shifts SELF CORRECT because SR AS CHANGES ACCORDINGLY

LEFT WARD SHIFT IN AS say due to inc in cost of production- WAGE PRICE SPIRAL
AND STAGFLATION , correction to wage price spiral is by correcting AD by policy
makers

WHEN YOU HAVE TO SHIFT AD IN A FACT SITUATION

- First look at how to shift ad with fiscal measures or monetary measures(for
monetary measures use LPT)
- Take into account consumption theories- and critique the stabilzation that you
show by also including points relevant to the facts
- Subjective points about AUTOMATIC STABILIZERS include
SOME TERMS
Expansionary fiscal policy/ helicopter/ easy money policy- trying to increase in AD by
monetary means by increasing money supply
You can also increase AD by fiscal policy means- increase G or cut T

PHILLIPS CURVE

Short run trade off between unemployment and inflation. To have a downward sloping it would
mean that to reduce unemployment, inflation would have to rise. The AD is moved in the AD
and AS curve to derive the curve.

Long Run Phillips curve is vertical at the natural rate of unemployment, because in the long run
output is constant and the rel variable cannot be affected.

Unemployment = natural rate of unemployment - a(actual inflation - expected inflation)

In AS, in the short run expectation of the price level also causes changes. The same is in the
case of Phillips curve, being the expected inflation level.

The government prints money, you move up the Phillips curve an people in the long run begin
expecting a high price level and thus the actual and the expected inflation levels match up and
you go back to the natural rate of unemployment at a higher level of inflation.
Natural rate hypothesis that the Phillips curve ultimately goes back to the natural rate of
unemployment. In the long run, the actual and the expected inflation levels catch up and you
move back to the natural level of unemployment.

Supply Shocks in the Phillips Curve

They cause shifts because in that case both the price and the output change and a movement
cannot explain the same.
This makes the trade off worse, because both inflation and unemployment have increased. A
leftward shitft in the supply curve will shift the Phillips curve to the right and a leftward shift in the
Supply curve will move the Phillips curve to the left.

Sacrifice ratio - the amount of output to be given up in order to reduce on eunit of inflation. The
general sacrifice ratio is about 5.

Rational Expectations

We might be able to reduce the costs of disinflation, to a very low amount o even to zero if we
change people’s expectations. If inflation expectations are reduced, then people will start
expecting the same and this would cause a leftward sheft in the Phillips Curve.

In the short run, there is definitely trade off, but there cn be exceptions
- People might not believe the government
- Although the costs might not be reduced to zero, they can be reduced and thus the
Rational expectations theory stands
IS LM

The Great Depression dsiproved the Classical model, to show AD causes low output and high
unemployment, which in turn can cause low national income.

Price levels are constant. IS LM shows what is happening in both goods and services market
and the money market, and what happens to the interest rate. IR connects both these markets.

The model of the IS curve is premised on the Keynesian cross. It can be derived using the
Loanbale funds model. Keynesian cross takes planned expenditure and actual expenditure into
account. PE is how expenditure is planned by the government and the households. Planned
and actual can deviate because of inventory changes. If actual < planned, then there will be
some unsold output that will be part of your inventory. C is a function of income, and investment,
taxes and government expenditure are to be assumed to be fixed. The equilibrium is that point
were planned and actual expenditure equate with each other. Because there are fixed variables,
the C line doesnt start from 0 and starts from the Y axis, with the slope being MPC. Actual
expenditure line is the 45 degree line.

Adjustment possess -
- If actual > planned expenditure, then firms are selling less than what they produce and
they will reduce output till the point where actual and planned match.

The keyneisan cross shows how income is determined for a given planned investment and a
given fiscal policy. It can be used to understand what happen when one of the constant
varibales chnages.
If the government increases its purchases, then planned expenditure rises while the actual
remains the same. At the new equilibrium there has been an increase in planned expenditure
and a shift in the income level. The change in income is larger than the change in G because of
government multiplier. The same happens for a change in taxes, with a tax multiplier working.
Cutting back taxes is an indirect way of increasing consumption.

Tax multiplier = -MPC/ 1-MPC

Investment has an inverse relation with the interest rate. Investment graph is thus downward
sloping with the interest rate on the Y axis. To derive the curve, look at what happens in the
Keynesian cross, as IR falls I rises and causes an increase in planned expenditure. To
derive the change, the starting point of the analysis has to be interest rate in the
Keynesian Cross. For the loanable funds model, the starting point will be income. In
loabnable funds, income chnages and this causes a change in savings. If income rises,
national savings rise. Because savings = Y-C-G. This means that the supply of lonabale
funds is increasing despite anything happen to the interest rate, thus there will be a shift.
The increase in national savings is thus shown as a raightward shift in the supply of

lonabale funds.

The IS curve will show a relation between IR and Y. since a fall in IR has led to an increase in Y,
this means that there is an inverse relationship between the two and the curve is downward
sloping.

FOR THE LOANABLE FUNDS MODEL INCOME IS THE STARTING POINT AND FOR THE
KEYNESIAN CROSS, THE INTERSAT RATE IS THE STARTING POINT.
IS is drawn for a given fiscal
policy where only the IR are changing. What happens when the fixed variables change, like a
change in government spending?here the IR is constant but G has changed. This causes a
change in Y.

There can be a loanable funds explanation for the same too. Show the effect of
Theory of LP

Interest rate is determined by Money supply and Money Demand. Real balance of money
demand is being balanced by the Interest Rate. previously we took money demand to be a
function of income, but now IR is to be incorporated. This is because IR impacts demand for
money because it is the Opportunity Cost of Holding money.

For the LM curve, LP derivation, the starting point is a change in income. Say income changes,
it affects money demanded. If income increases, money demanded rises and it shifts to the
right. This increases the IR. the increase in income causes the increase the IR and this is why it
is upward sloping. For LM, M was constant. This means that LM is drawn for a fixed amount of
money supply. If MS shifts, LM shifts. If money supply decreases then this increases the IR and
income has not changed. This means that there is a leftward shift in LM.

To use the quantity equation to derive LM, a chnage in interest rate is the starting point

Real balances of money demanded should be a function of both money demanded and the
interest rate. Velocity is dependent on the interest rate is the main argument, because
people repsond to a higher IR by holding less money an at the same time Y is rising and
thus the velocity of money should rise to hold a higher Y with a higer IR. the same number
of dollars should change hands more times if the Y is increasing. Thus they say that velocity is
not constant and this equation too yields an upward sloping LM curve.

P is fixed because short run. IR increases, real balances of money demanded fall. MV rises and
PY rises, with M and P being the same, the relation between v and y being direct.
IS LM AND AD AS

The curves change because of the monetary/ fiscal policy or chocks. IS is drawn for a given
fiscal policy and changes in the same can affect the IS curve. An increase in government
purchases would affect the Keynesian curves. This is because planned expenditure has G as
one of the components. This changes Y at the given interest rate. For the same IR, Y rises and
thus it shifts upwards. Thus causes the interest rate to rise. The national income will increase by
the extent of the multiplier in the Keynesian cross, but the increase in the IS-LM graph will be
less. This is because with a higher Y money demand will increase and there is a rising interest
rate and this will incorporate the crowding out effect.

Monetary policy changes can affect the LM curve. A change in Money Supply will be shown in
the LPT graph showing a higher supply of funds and a low interest rate and a lower income.
When MS rises, IR falls for every level of income and this leads to a shift in the LM curve and
because of the falling IR, Y rises and there is a higher output.

Monetary transmission - a change in the monetary policy can affect income. How chnage in
Monetary Policy can affect the level of income and people’s spending.

IS-LM SHOCKS
Because of factors other than the government policy, like a change in demand for g&s in the
economy, a stock market boom, change in consumer confidence/expectations. If there is a
stock market boom, wealth increases and the propensity to consumer rises. Any event that
changes consumption/ investment can be a shock. Political instabillity. A change in investor
confidence can affect investment, a higher ocnfidence will lead to high levels of investment.

If money supply remains the same, exogenous shocks like credit card restrictions can affect the
ISLM. this increases demand for money and there is a rightward shift in LPT and IR rises. This
leads to a situation where IR rises for a given level of income and the LM curve shifts to the
right.
More Internet transactions/ ATMs will reduce the demand for money and a leftward shift in the
LPT, a lower interest rate and a leftward shift in the LM curve.

INTERACTION BW MONETARY AND FISCAL POLICY

A change in fiscal policy, which changes taxes. Taxes rise, this affects income. The Central
Bank would want to react to this which it can do in 3 ways, which can have impact on the fiscal
policies -
- If G rises, IS shifts to the right.
- The central bank can either hold MS constant, the IR constant or the Income constant.
- IS rises, if M held constant then there will be no shift in LM. No LM shock happening
too. The result will be only a rightward shift in IS, a rise in Y and IR. The crowding out
effect still happens because MS is held constant. This reduces the demand for
investment and there will be a fall in investment.
 - If IR is held constant, then after G rises, a rightward shift in IS. to hold the IR constant,
the Central Bank will increase the Money Supply and IS will intersect LM at the same
interest rate at a higher level of output.

- No crowding out effect happens in this case, income rises. The change in interest
rate that would have been, has been cancelled out because of a higher money
supply.

- if income is to be held constant, a rightward shift in IS will have to be matched by a leftward

shift in LM. this leads to a higher IR.