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Summary of Macro Models and Chain of Events
Summary of Macro Models and Chain of Events
The purpose of this summary is to show you how the various models developed in
this module are connected. This compliments the study plan laid out in the
Study Guide and does not replace it.
Other factors that could shift the ZZ curve are investment spending, investor
confidence and consumer confidence.
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Expansionary fiscal policy Contractionary fiscal policy
An increase in G A decrease in G
A decrease in T An increase in T
G Z Y G↓ Z↓ Y↓
Or Or
T↓ YD↑ C Z Y T↑ YD↓ C↓ Z↓ Y↓
Other factors in the goods market: Other factors in the goods market:
An increase in investment spending A decrease in investment spending
(I) (I)
An increase in investor confidence A decrease in investor confidence
An increase in consumer A decrease in consumer confidence
confidence
I Z Y I↓ Z↓ Y↓
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The financial market model
Only the monetary policy, a change in the interest (repo) rate, is applicable.
This financial market model is based on the assumption that the quantity of money is
endogenously determined (or demand-determined money) — it is determined within
or by the model, and it is assumed that the demand for money determines the
quantity of money. Therefore, according to this interpretation, there is no
independent money supply curve since the quantity of money depends on the
money demand and the interest rate (the cost of credit).
The central bank cannot directly influence the quantity of money since the quantity of
money is endogenously determined by the demand for money. However, the central
bank can indirectly influence the quantity of money by influencing the interest rate,
which, in return, affects the cost of credit and loans and the demand for money. A
lower interest rate decreases the cost of credit, and as more credit is extended to
households and firms, the money demand and the quantity of money increase.
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The IS-LM model (in a closed economy)
The IS curve is derived from the goods market.
Therefore changes in the goods market and the financial market will affect the IS-LM
model. Thus, both the fiscal policy (G and/or T) and monetary policy (i) are applicable
Fiscal policy will have an impact on the goods market first and then on the financial
market.
Monetary policy will impact the financial market first, then the goods market, and
back to the financial market.
The impact on the goods market first The impact on the financial market
G Z Y MonetaryExpansion i
Y YD C i↓ Md↑ M↑
Y I
Impact on the goods market
Impact on the financial market i I Z Y
i=𝑖 Y I
Y Md M Y YD C
Taxes decreases
The impact on the goods market first The end result is that an
T YD C Z Y expansionary monetary policy
Y YD C increase the output and income
Y I level.
Then the impact on the financial market In the IS-LM model, the LM
i=𝑖 curve shifts downwards.
Y Md M
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Contractionary fiscal policy Contractionary monetary policy
A decrease in G An increase in the interest rate (i)
An increase in T
Government spending decreases Interest rate increases
The impact is first on the goods market The impact is on the financial market
G↓ Z↓ Y↓ first:
Y↓ YD↓ C↓ MonetaryContraction i
Y↓ I↓ i Md M
The impact is first on the goods market The end result is that a
T YD C Z Y contractionary monetary
Y YD C policy result in a decrease in
Y I output and income level.
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In the IS-LM model, the IS In the IS-LM model, the LM
curve shifts to the left. curve shifts upwards.
The demand for goods equation is extended to include a foreign sector by adding
exports and imports to the equation. An open model the demand for domestic
goods that determines the level of output and income.
Thus in an open economy, the demand for domestic goods or expenditure on GDP =
C + I + G – IM + X. Imports must be subtracted while exports must be added.
The NX curve shows the relationship between the level of output and income and the
trade balance.
For a given demand for goods, equilibrium in the goods market is reached where the
domestic level of output and income is equal to the demand for domestic goods.
Given this equilibrium level of output and income, there is a corresponding trade
balance position which can be either
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Trade balance Trade deficit Trade surplus
(NX = 0) (NX < 0) (NX > 0)
on the equilibrium level of output and income and the trade balance.
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A rise in domestic demand An increase in foreign Depreciation of the real
(e.g. an increase in government demand exchange rate
spending) (an increase in exports)
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E IM NX
which affects the trade
balance positively.
E X Z Y
E IM Z Y
Y IM NX
Summary of the impact of the nominal interest rate (i) on the goods market Impact of
the nominal exchange rate (E) on the goods market
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Impact of the nominal interest rate (i) on the goods market
The change in the interest rate determines the impact on the exchange rate. Why?
Say, for instance, the central bank decreases the interest (repo) rate. A decline in the
interest rate causes a depreciation of the nominal exchange rate. The depreciation of
the nominal exchange rate results from the decrease in the domestic interest rate
relative to the interest rate in the rest of the world. This causes domestic bonds to be
less attractive, and a capital outflow occurs. This capital outflow reduces the domestic
currency demand (it increases the demand for foreign currency), and the exchange
rate depreciates. The depreciation of the exchange rate reduces the price of exports
and increases the price of imports, which positively impacts the trade balance. The
negative effects are that the imports bill is now higher and an increase in exports will
increase the demand for goods and the level of output and income, which will increase
imports.
i↓ Capitaloutflow E↓
E↓ X↑ NX↑
E↓ IM↓ NX↑
Y IM↑ NX↓
We assume this effect is outstripped, and overall, the trade balance improves (NX↑)
The opposite is also true: An increase in the interest rate causes an appreciation of
the exchange rate.
The increase in the interest rate causes an increase in capital inflows; the nominal
exchange rate increases, and the domestic currency appreciates (prices are
assumed to be fixed in the IS-LM model; therefore, a nominal appreciation of the
domestic currency will lead to a real appreciation of the domestic currency).
i Capitalinflow E
An appreciation of the domestic currency increases the price of exports, and the net
exports position worsens. Simultaneously, an appreciation decreases the price of
imports, and the net exports position worsens.
Chain of events in the IS-LM model for an open economy and diagrams:
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Expansionary fiscal policy Expansionary monetary policy
An increase in G A decrease in the interest rate (i)
A decrease in T
Government spending increases The interest rate decreases
The impact on the goods market first The impact is on the financial market
G Z Y MonetaryExpansion i
Y YD C
Y I Impact on the goods market
i I Z Y
Impact on the financial market Y I
i=𝑖 Y YD C
Y Md M
Impact on the exchange rate and
Since the central bank sets the interest trade balance
rate, the interest rate will be unchanged The decrease in the interest rate
causes an increase in capital
(i = 𝑖) and therefore, the exchange rate is
outflows; the nominal exchange rate
also unchanged.
decreases, and the domestic currency
depreciates (prices are assumed to be
The increase in the level of output and
fixed in the IS-LM model).
income will increase the demand for
money and the quantity of money i Capitaloutflow E
Y Md M
A depreciation of the domestic
currency decreases the price of
Impact on the exchange rate and
exports, and the net exports position
trade balance
improves. Simultaneously, a
The increase in output and income level
depreciation increases the price of
results in an increase in imports and a
imports, and the net exports position
deterioration of the trade balance.
improves.
Y IM NX
E X NX
E IM NX
AND/OR
The impact of a decrease in the
Taxes decreases interest rate on the level of output and
income is strengthened by the impact
The impact on the goods market first of a depreciation – thus, overall, the
level of output and income increases.
T↓ YD↑ C Z Y
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What will be the impact on the
Impact on the exchange rate and financial account of the balance of
trade balance payments? The decrease in the
The increase in output and income level domestic interest rate relative to the
results in an increase in imports and a interest rate in the rest of the world
deterioration of the trade balance. leads to a decrease in the demand for
Y IM NX domestic bonds, which creates a
capital outflow and thus a
deterioration of the financial account
The IS curve shifts to the right; the interest rate will be unchanged,
and therefore, the exchange rate is also unchanged
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Expansionary monetary policy in an open economy
A decrease in the interest rate (i)
The impact is first on the goods market The impact is on the financial market
G Z Y first:
Y YD C MonetaryContraction i
Y I
Impact on the goods market
Then the impact on the financial market i I Z Y
i=𝑖 Y I
Y Md M Y YD C
Since the central bank sets the interest Impact on the exchange rate and
rate, the interest rate will be unchanged trade balance
(i = 𝑖) and therefore, the exchange rate
is also unchanged. i Capitalinflow E
The decrease in output and income level
results in a decrease in the demand for An appreciation of the domestic
money and the quantity of money. currency increases the price of exports,
Y Md M and the net exports position worsens.
Simultaneously, an appreciation
decreases the price of imports, and the
net exports position worsens.
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Impact on the exchange rate and E X NX
trade balance E IM NX
The decrease in the level of output and The impact of an increase in the
income results in a decrease in imports interest rate on the level of output and
and an improved trade balance. income is strengthened by the impact of
Y IM NX an appreciation. Thus, overall, the level
of output and income decreases.
The exchange rate is unchanged.
E X Z Y
Since exports are unchanged and E IM Z Y
imports decrease net exports increase.
The trade balance (net exports) Y IM NX
improves.
The decrease in the level of output and
income leads to a second-round
AND/OR decrease in imports and an increase in
the trade balance. However, we
Taxes increases assume that the negative effect
resulting from the appreciation
Impact is first on the goods market overwhelms this effect and the trade
T YD C Z Y balance deteriorates overall.
Y YD C
Y I
Then the impact on the financial market
i=𝑖
Y Md M What will be the impact on the financial
account of the balance of payments?
Impact on the exchange rate and The increase in the domestic interest
trade balance rate relative to the interest rate in the
The decrease in the level of output and rest of the world leads to an increase in
income results in a decrease in imports the demand for domestic bonds, which
and an improved trade balance. creates a capital inflow and thus an
Y IM NX improvement of the financial account
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Contractionary fiscal policy
A decrease in G
An increase in T
The IS curve shifts to the left; the interest rate will be unchanged,
and therefore, the exchange rate is also unchanged
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THE IS-LM-PC MODEL
The IS-LM-PC model integrates our knowledge about the goods market, financial
market, labour market, price setting by firms in an imperfect market and the Phillips
curve.
When unemployment was low, inflation was high (or positive). When unemployment
was high, inflation was low, even sometimes negative ‒ there was a short-run trade-
off between unemployment and inflation, and policymakers could use this trade-off in
policymaking.
For example, at a low unemployment rate of 2%, the inflation rate was 4%, but at a
higher unemployment rate of 4%, the inflation rate was only 1%. If policymakers were
to accept a higher inflation rate, they could achieve lower unemployment.
Later studies by Friedman and Phelps (using USA data from the 1970s) showed that
the apparent trade-off between the inflation rate and the unemployment rate
disappeared. This break down of the original Phillips curve's negative relationship is
that the wage setters or workers changed how they formed their expectations about
inflation because there was a change in inflation behaviour.
From the 1970s, the rate of inflation became more persistent. As inflation became
more persistent, workers and firms started changing the way they formed
expectations. They started assuming that if inflation had been high last year, inflation
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was likely to be high this year as well and therefore, the unemployment rate does not
affect the inflation rate as such but rather the change in the inflation rate.
This negative relation between the change in inflation and the unemployment rate is
often called the modified Phillips curve, or the expectations augmented Phillips curve
For low unemployment, the change in inflation is positive. For high unemployment, the
change in inflation is negative ‒ high unemployment leads to decreasing inflation, and
low unemployment leads to increasing inflation.
The natural rate of unemployment is the unemployment rate at which the actual
inflation rate is equal to the expected inflation rate (un π = πe).
The natural rate of unemployment is influenced by factors that affect wage setting
(the catchall factor z) and the mark-up set by firms (m).
Suppose the inflation rate in the previous year is a good prediction of the expected
rate of inflation this year, then we can think about the Phillips curve as a relation
between the actual unemployment rate (ut), the natural unemployment rate un, and
the change in the inflation rate (πt – πt-1), where πt is the expected rate of inflation
this year and πt-1 the previous year's inflation rate.
The change in the inflation rate (πt – πt-1) depends on the difference between the
actual unemployment rate this year (ut) and the natural unemployment rate (un).
The natural rate of unemployment is the rate of unemployment required to keep the
inflation rate constant.
To build and work with the IS-LM-PC model, we must rewrite our Phillips curve in
terms of output. Since we are concerned about the determination of output In this
module.
The relationship between unemployment, employment and output are central to the
IS-LM-PC model.
If we know what the natural rate of unemployment is, we can derive the natural level
of employment and, from the natural level of employment through a production
function, we can derive the natural level of output or the potential output level.
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As the natural unemployment rate changes, the natural level of employment and
natural level of output (potential output) will also change.
For a given labour force, the natural rate of unemployment determines the level of
employment, and that, given the production function, the level of employment
determines the level of output. Thus, associated with the natural rate of
unemployment is the potential level of output.
The difference between actual output and potential output is called the output gap.
The following relations between output and employment (known as Okun's law) are
important. :
The positive relation between output and the change in inflation is drawn as the
upward sloping PC curve, where output (Y) is measured on the horizontal axis. The
change in inflation (πt – πt-1) is measured on the vertical axis.
When output is equal to potential (or when the output gap is equal to zero), the
change in inflation is equal to zero. Thus, the Phillips curve crosses the horizontal
axis at the point where output is equal to potential.
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In the short run, the output gap can be at potential, positive or negative.
In the short-run, the equilibrium level of output and income can deviate from the
natural level of output and income. In other words, a negative or positive output gap
may exist and not necessary at potential.
This short-run deviation from the natural level of output and income may be due to
fiscal policy, monetary policy, consumer confidence or investor confidence.
A non-constant inflation rate will eventually prompt the central bank into action,
resulting in an adjustment to the medium-run where output is equal to the natural
level of output, unemployment is equal to the natural rate of unemployment, inflation
is constant, and the real interest rate is equal to the so-called "natural rate of
interest".
Y is larger than Yn, meaning that output Y is lower than Yn, meaning that output is
is above potential and inflation is below potential and inflation is
increasing. At output level Y, the change decreasing. At output level Y, the change
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in inflation is positive, and there is an in inflation is negative, and there is a
upwards pressure on inflation. downwards pressure on inflation.
To influence the output level and the To influence the level of output and the
change in the inflation rate, policymakers change in the inflation rate, policymakers
use the real interest rate (r). use the real interest rate (r).
Since the inflation rate increases, Since the inflation rate decreases,
policymakers will at a certain point react policymakers will, at a certain point, react
to this increasing inflation by increasing to this decreasing inflation by decreasing
the interest rate in order to decrease the interest rate in order to increase
output back to potential output. If output output back to potential output. If output
is equal to potential output and the output is equal to potential output and the output
gap is equal to zero, there is no pressure gap is equal to zero, there is no pressure
on inflation. on inflation.
Top figure: The central bank decided to Top figure: The central bank decided to
increase the interest rate in reaction to decrease the interest rate in reaction to
this high inflation. The LM curve shifts this low inflation. The LM curve shifts
upwards, and over time there is an downwards, and over time there is a
upward movement along the IS curve downward movement along the IS curve
from a to a1 and output decreases. from a to b and output increases.
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Bottom figure: As output decreases, the Bottom figure: As output increases, the
economy moves down the PC curve from economy moves up the PC curve from
point a to a1, and at point a1, the policy point a to b, and at point b, the policy rate
rate is equal rn, output is equal to Yn, and is equal rn, output is equal to Yn, and at
at this point, inflation is by implication this point, inflation is by implication
constant. This is the medium-run constant. This is the medium-run
equilibrium position. equilibrium position.
The IS curve shifts to the left The IS curve shifts to the left from
from IS to IS1 IS to IS1
Y YD C Y YD C
Y I Y I
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Impact on the financial market Impact on the financial market
i=𝑖 i=𝑖
Y Md M Y Md M
The question states that output The question states that output
is lower than potential. is lower than potential.
If u > un; Y < Yn output gap is If u > un; Y < Yn output gap is
negative inflation↓ negative inflation↓
The level of output is now back to The level of output is now back to
its natural level. The real interest its natural level. The real interest
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rate needed to maintain the natural rate needed to maintain the natural
output level, which is now lower output level, which is now lower
than before, means that investment than before, means that investment
spending is even higher than spending is even higher than
before the contractionary fiscal before the contractionary fiscal
policy. policy.
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