Bismi ALLAH Arrahman Arraheem Class Notes of Principles of Macroeconomics Econ.102

Bismi ALLAH Arrahman Arraheem
Class Notes of Principles of Macroeconomics
Dr. Usamah Ahmed Uthman
Associate Professor of Economics
Department of Finance & Economics
King Fahd University of Petroleum& Minerals
Dhahran 31261
Saudi Arabia
Econ 102
Web Site
College of Industrial Management
Department of Finance & Economics
Principles of Economics II (Macroeconomics)
Dr. Usamah Ahmed Uthman
: B24/296
Office Hours
:2:25 –3:15 PM,Sun. &Tues. (or by appointment)
:Economics by Lipsey, et al, 12th Ed.
Course Outline
Chapter 21
Chapter 22
Chapter 23
Chapter 24
Chapter 25
Chapter 26
Chapter 27
Chapter 28
Chapter 29
Chapter 31
Chapter 32
Chapter 37
What Macroeconomics Is All About?
The Measurement of National Income
National Income Determination – Part 1
National Income Determination – Part 2
Applications to the Multiplier Theory
Output and Prices in the Short Run
Output and Prices in the Long Run
The Nature of Money and Monetary Institutions
Money, Output, and Prices
Monetary Policy
Government Debt and Deficits
Exchange Rates and the Balance of Payments
First Exam Chapters 21,22,23,24
Second Exam Chapters 24,25,26,27,28,
Quizzes and participation
Final Exam (Chapters 22,24,26,28,29,31,32, and 37) 40%
NOTE: Professor reserves the right to change the contents and
weights of course requirements.
FIRST MAJOR EXAM, Wednesday, 8 Jumada I,1437 (17 February, 2016, 6:30- 8:15 PM
SECOND MAJOR EXAM, Wednesday, 27Jumada II, 1437 (5 April, 2016),7:00- 8:45 PM
Welcome to Economics
Dear Students of ECONOMICS
Assalam Alikum WA Rahmat ALLAH wa Barakatuh
It is my pleasure to teach economics to another patch of KFUPM students. Economic issues and events are
with us all the time, at the personal, family, business, government, and international levels. There is almost
no issue, problem or, event in the world that does not have an economic dimension either in terms of cause,
consequences, or both. Economics Science tries to explain past and present events and tries to predict
future ones. It tries to help us draw policies at every level of society. For these reasons the study of
economics should be both necessary and enjoyable by everyone.
How to Study Economics?
You should try to understand the concepts much more than memorizing statements. This is how you can
grasp and retain what you learn in your courses. Try to read ahead of class if you can, but definitely after
class, and may be more than once, with a pencil in your hand. Some memorization is definitely
required in the study of any science. To make sure you have retained in your mind what you read,
it is strongly advisable that you re-write what you have read more than once.
Our main material for the course of will be my Class Notes that you can find
by clicking on the link below:
After that, click on Teaching to find the Notes relevant to your course. Please download and print the Notes
immediately and bring them with you to every class period. All information you need about the course
policies are explained at the beginning of the Class Notes.
For students of ECON.101 and ECON.102, upon reading a chapter at least twice, please try to solve some
Study Guide, which you can find in any copying center on or around Campus. Try
to solve and understand the answers, and not memorize them. Most of my
quizzes come from the Study Guide.
For students of ECON.410, I will provide you with end –of-chapter problems.
Attendance, and coming to class on time are musts.
Good luck and have an enjoyable semester.
problems from the
Dr. Usamah Ahmed Uthman
Associate Prof. of Economics
Economics' two -major branches are:
Microeconomics: discusses individual economic units: the firm, the consumer, particular markets, such
as the oil market, the computers mkt, the tomatoes mkt.
Macroeconomics: discusses the behavior of aggregate economic Variables, such as total investment,
total consumption, govt. expenditures and taxation, unemployment, inflation, economic growth….. etc.
The two branches are related, i.e. macro events affect micro areas & vice versa.
Macro issues: What does macroeconomics discusses?
I) Long term economic Growth:
1) What causes economic growth?
2) How do govt. policies affect economic growth? Through:
a) Monetary policy, which regulates money supply and interest rates.
b) Fiscal policy, which regulates government expenditures and taxation.
II) Short term business cycles: are short term fluctuations in economic activity. To understand
business cycles we must understand inflation and unemployment.
* Economic indicators: are measures of the health of the economy, such as the rate of economic growth,
unemployment, the budget deficit., the public ( govt.) debt, the inflation rate, investment , the balance of
payments deficit….etc
* National product and national income: as NP rises, NI rises too.
* This means that the more goods and services are produced, there is more income generated for people.
This is because in the process of generating output, factors of production must be employed and paid for.
The value of NP = the sum of incomes to
the owners of the factors of production.
What are the factors of production? Who owns them?
Figure 21-1
The Circular Flow of Expenditure and Income
Slide 21.2
©1999 Addison Wesley Longman
You shall notice that:
total leakeages = saving (S) + taxes (T) + imports ( M)
total injections = investment (I) +govt expend.(G) + exports (X)
for macroeconomic equilibrium:
total leakages = total injection
= I+G+ X
* Nominal National income: is measured in the prices of current year, NI=PQ.
to change in P, Q, or both.
It can change due
* Real national income: is measured in the prices of some base year. This means we hold prices
constant. When prices are held constant, changes in (real) national income reflect only changes in
* The most commonly used measure of national income is the Gross Domestic Product (GDP). It is the
total value of all final goods & services produced at home.
* The Business Cycle refers to the continual ups & downs in economic activity around a long term
trend. This can be observed in many economic series. It is important to note that no two business
cycles are exactly the same, neither in duration, nor in magnitude.
* See FIG.21-3 below. Also, see EXTENSION 21-1 below for business cycle terminology.
Figure 21-2
National Income and Growth, 1929-1997
Slide 21.3
©1999 Addison Wesley Longman
Figure 21-3
A Stylized Business Cycle
Slide 21.4
©1999 Addison Wesley Longman
A recession, or contraction, is a downturn in economic activity. Common usage defines a recession as a
fall in the real GDP for two successive quarters. Demand falls off, and, as a result, production and
employment also fall. As employment falls, so do households' incomes. Profits drop, and some firms
encounter financial difficulties. Investments that looked profitable with the expectation of continually
rising demand now appear unprofitable. It may not even be worth replacing capital goods as they wear
out because unused capacity is increasing steadily. In historical discussions, a recession that is deep and
long-lasting is often called a depression. The most famous depression in modern history was the one
that took place during 1929-1933. The economic –financial crisis that started in 2008 has been called
a great recession.
When the economy is at a trough, there are lots of unemployed resources, the level of output is low in
relation to the economy's capacity to produce. There is thus a substantial amount of unused productive
capacity. Business profits are low; for some individual companies, they are negative. Confidence about
the economy in the immediate future is lacking and, as a result, many firms are unwilling to risk
making new investments.
The characteristics of a recovery, or expansion, are many: old equipment is replaced; employment,
income, and consumer spending all begin to rise; and expectations become more favorable, as a result
of increases in production, sales, and profits. Investments that once seemed risky may be undertaken as
the climate of business starts to change from one of pessimism to one of optimism.
Production can be increased with relative ease merely by reemploying the existing unused capacity and
unemployed labor.
A peak is the top of a cycle. At the peak, existing capacity is used to a high degree; labor shortages
may develop, particularly in categories of key skills; and shortages of essential raw materials are likely.
As shortages develop in more and more markets, a situation of general excess demand develops. Costs
rise, but because prices rise also, business remains profitable.
These terms are nontechnical but descriptive. The entire falling half of the cycle is often called a slump,
and the entire rising half is often called a boom. An economic boom is usually accompanied by
inflation, and a slump is usually accompanied by deflation. However, it is possible that a recession is
accompanied by inflation. In this case we say that the economy is in a state of stagflation.
*Potential GDP (Y*): is real GDP when resources are fully employed at normal rates of utilization
Output Gaps:
Positive GDP gap
Y (actual real GDP) >Y* is called inflationary gap
Negative GDP gap
Y <Y * is called recessionary gap
Figure 21-4
Potential GDP and the Output Gap 1965-1997
Slide 21.5
©1999 Addison Wesley Longman
Long term growth in real national income is reflected in the upward trend in real GDP
Short term movements around the potential reflect cyclical fluctuations.
* Sources of long Term growth: 1) a rise in labor productivity. This could be the result of better
education & technological advancements.
2) Increase in the amount of resources (Labor, land & capital) available to the economy.
* Economic Growth makes people better off on the average. It does not necessarily mean that
everyone will be better off.
Employment & Unemployment
* Employment: total # of people holding jobs
* Unemployment: total # of adults actively seeking jobs but cannot find them.
* Unemployment rate: No. unemployed/total labor force x100.
Types of unemployment
1) Frictional unemployment: the result of labor turnover as workers move from one job to another.
EX: If you are not happy with your job, you may quit and look for another job.
2) Structural unemployment: is the result of a mismatch between labor supply characteristics and
labor demand. EX: There may be too many civil engineers, while the economy is demanding more
accountants and computer programmers.
3) Cyclical unemployment: is the result of insufficient aggregate demand. If the economy is in
recession, some workers may lose their jobs.
Full employment is achieved when the economy is operating at potential GDP. This assumes that
unemployment is limited to frictional and structural unemployment.
Natural Unemployment: When unemployment is limited to frictional and structural types. Also
called The NAIRU: The Non- accelerating – inflation rate of unemployment. In other words, it is the
unemployment rate when inflation is not accelerating.
Income & employment: national income could rise because output per worker (labor productivity) is
rising, or because more people are working, or both.
Also, unemployment increases because economy is not doing well or because population growth rate is
faster than economic growth or both.
Figure 21-5
Labor Force, Employment, and Unemployment, 1925-1997
Slide 21.6
©1999 Addison Wesley Longman
* Unemployment is important because:
1) It causes economic waste. The time of unemployed labor implies forgone production & income
2) Unemployment is the cause of crimes & psychological problems.
For details on unemployment, see chap.31
* Inflation and the price level:
Economists develop price indexes to measure the general price level, and they use changes in the general
price level to measure inflation.
What is a price index? A price Index is a weighted average of the prices of a basket of goods and
- Definition: Inflation is a general rise in prices.
- The inflation rate is the percentage change in the general price level from one period to the next. i.e ,
the inflation rate is the % change in a price index from one period to the next.
Look at Extension 21-3below to see how the consumer price index is constructed.
This is very, very important.
Why inflation matters?
Inflation erodes the purchasing power of money (PPM) which is the amount of goods and services
that can be bought with money. Thus, the PPM is negatively related to the price level.
* Types of inflation:a) fully anticipated inflation: everyone in the economy has the same and correct forecast of the
inflation rate in the next period(s). In this case, there won’t be real changes in the economy i.e. workers
won’t increase supply of labor, producers won’t increase output & employment of resources.
b) Unanticipated inflation: When forecasts are incorrect. It harms those whose receive fixed
payments (e.g. wages, interest on saving, pension income…etc.) It benefits those whose payments are
fixed in monetary terms (borrowers, employees, retired people). Thus, inflation redistributes
incomes form some groups to the others.
c) Intermediate case: when forecasts are partially correct, but even if forecasts are correct, it may be
difficult to adjust for inflation because of binding contracts.
* Indexation: is linking payments to changes in the general price level. It is away to go around inflation.
Once again: Inflation is bad because:1) It erodes the purchasing power of money.
2) It redistributes income in a haphazard way between people.
3) It increases uncertainty about future revenues, costs, and rates of return of investments.
Figure 21-6
The Price Level and the Inflation Rate, 1950-1997
Slide 21.7
©1999 Addison Wesley Longman
Suppose we wish to discover what was happening to the overall cost of living for typical college students.
A survey of student behavior in 2012 shows that the average college student consumed only three goods
pizza, coffee, and photocopying-and spent a total of SR200 a month on these items, as shown in Table 1.
Expenditures Behavior in 2012
per Month
per Month
SR0.10 per sheet
140 sheets
SR 14.00
8.00 per pizza
15 pizzas
0.75 per cup
88 cups
Total Expenditures
By 2013, the price of photocopying has fallen to.0 5 halalh per copy, the price of pizza has increased to
SR8.50, and the price of coffee has increased to 80 halalh. What has happened to the cost of living? In
order to find out, we calculate the cost of purchasing the 2012 basket of goods at the prices that prevailed
in 2013, as shown in Table 2.
2012 Expenditures Behavior at 2013 Prices
SR0.05 per sheet
8.50 per pizza
0.80 per cup
per Month
140 sheets
15 pizzas
88 cups
Total Expenditures
per Month
SR 7.00
The cost of living has increased by SR 4.90, or 2.45 %
The base year (2012) figure is assigned an index number of 100. So, for 2013 the cost of living is 102.45
For example, in May 1998 the CPI in the United States was 162.8 on a base of 1982-1984 (the period in
which the original survey was done.) Thus, the price level had risen by 62.8 percent over the preceding 13
years, an average annual rate of increase of 3.82 percent.
The CPI is not a perfect measure of the cost of living because it does not account for quality
improvements or for the tendency of consumers to purchase more of things whose prices fall, and
less of things whose prices rise (i.e. the substitution effect). Also, it may not include new products.
Thus, from time to time the underlying survey of consumer expenditure must be updated in order to keep
up with changes in consumption patterns.
The Interest rate:Is the price for lending and borrowing money. In reality, there are many interest rates. However,
interest rates commonly move together. The height of the interest rate is affected by many factors (eg risk
of customer, govt. fiscal and monetary policies, foreign interest rates… etc.). The interest rate is a
procyclical variable, i.e. it rises during the upside of the business cycle, and decreases in during the
downside of the business cycle. A countercyclical variable behaves in an opposite fashion.
* The prime interest rate: The rate banks charge to their best business customers.
* Interest rate and inflation:Inflation reduces the real interest rate on loans. The nominal interest rate (stated in contracts) includes
an inflation component. Thus
i=r+ e
The nominal interest rate = the real interest rate + the expected inflation rate.
This is called the Fisher Equation.
Figure 21-7
Real and Nominal Interest Rates, 1950-1997
Slide 21.8
©1999 Addison Wesley Longman
* Why interest rates matter?
Interest is an income to many people from saving accounts and bonds.
The interest rate is a cost of borrowing money→ affects investments→ economy's growth
rate → standard of living in the long run.
It affects consumption & saving decisions.
In the short run the interest rate affects output and employment, & the business cycle.
Note: Interest is Riba, and Riba is a major sin. We have to discuss it because it is a
reality of the world that we should work to eliminate.
International Economy:
The exchange rate: is the price of one currency in terms of another. Or, the No. of units of a local
currency required to purchase one unit of a foreign currency (eg. SR3.75 = $1). So, according to this
definition if the exchange rate ↑→ local currency depreciates. If the exchange rate ↓→ local
currency appreciates.
Note: the definition can be reversed. However, the above definition is the standard one.
See Fig. 21-8, for the external value of the dollar. Why is it important to Saudi Arabia?
Figure 21-8
The External Value of the U.S. Dollar, 1970-1997
Slide 21.9
©1999 Addison Wesley Longman
Foreign exchange is the amount of foreign currency or claims on foreign currencies, such as foreign
deposits, bonds and stocks that a country has.
2) The balance of payments: is an accounting record of all transactions of the country with the rest
of the world in terms of goods, services & financial assets. There are several sub accounts in the balance
of payments accounts. For details see Chap.37.
Figure 21-9
U.S. Imports, Exports, and Net Exports, 1970-1997
Slide 21.10
©1999 Addison Wesley Longman
Chapter 22 – The Measurement of National Income
Three Approaches:
I) The Value- Added (output) Approach: the value of national output= the sum of values added by
different firms at successive stages of production. This means that the
Value added by the firm = value of the firm's sales – value of its purchases from other firms. This
difference is equal to firm’s income payments to its factors of production. So the Value added= W+ R +
Pr + i + T-Sub + Dep. In other words, this reflects a distribution of national income in the economy.
If the total value of sales of all firms in the economy are added up, we would be committing the mistake
of multiple counting, which overstates the value of national income. See Extension 22-1 for the value
added approach.
Because the output of one firm often becomes the input of other firms, the total value of goods sold by all
firms greatly exceeds the value of the output of final products. This general principle is illustrated by a
simple example in which Firm R starts from scratch and produces goods (raw materials) valued at $100;
the firm's value added is $100. Firm I purchases raw materials valued at $100 and produces semimanufactured goods that it sells for $130. Its value added is $30, because the value of the goods is
increased by, $30 as a result of the firm's activities. Firm F purchases the semi-manufactured
(intermediate) goods for $130, works them into a finished state, and sells the final products for $180. Firm
F's value added is $50. We find the value of the final goods, $180, either by counting only the sales of
Firm F or by taking the sum of the values added by each Firm. This value is much smaller than the
$410 that we would obtain if we merely added up the market value of the commodities sold by each firm.
Transactions at Three Different Stages of Production
Firm R
A. Purchases from other firms
B. Purchases of factors of production
(wages, rent, interest, profits)
A + B = value of products (sales) $100
Total value of all sales
Firm I
Firm F All firms
$230 Total inter-firm sales
180 Total value added
A topic for a term Paper: The value added by a firm represents its contribution to national income.
Measure the value added by a firm you may be working for, and find the breakdown of its payments to its
factors of production. Do the same for other firms in the same business sector and for several years. This
should indicate to you the relative importance of the firm to the sector, and the relative importance of the
sector to the national economy. Also, this should tell you something about the distribution of income
between different owners of factors of production.
II) The Expenditures Approach: GDP is the sum of aggregate expenditures on final domestic goods
and services. There are four components of expenditures:
a) Consumption: expenditures on final goods & services intended for immediate use during the year.
b) Investment: expenditures on goods that aren’t for immediate consumption:
i) inventory of raw materials, semi finished goods, and finished good. Inventories are recorded at market
value. Inventory is part of investment because it is not intended to meet immediate consumption and
there is tied up capital in it. Thus, there is an opportunity cost to hold inventory. Inventory reduction is an
act of disinvestment.
ii) Plant and equipment: the economy’s stock of capital is a major source of economic growth.
iii) Residential housing: its services extend over many years.
- gross investment = replacement investment + net investment
- Both investments are part of national income because in the process of producing each, factors of
production are employed.
c) Govt. purchases of goods and services: expenditures generated in the process of output produced
by the govt. involves hiring factors of production (e.g. schools, hospitals, roads, police and court
services…. etc.) Govt. output is recorded at cost, (compare to inventory). This may understate or
overstate govt. output depending on govt. efficiency.
d) Net exports: exports - imports
Imports: income generated by us to foreign producers. Thus, it must be deducted from national income.
All previous national income components include an import component.
Exports: income generated to us by foreign buyers, so it must be added to our income. THUS:
Aggregate Expenditures (AE) = GDP= Consumption +Investment +Govt. Purchases + (Exports –
AE= GDP = (C+ I+ G+ (X-M) )
TABLE 22-1
Components of GDP from the Expenditure Side, 1997
of Dollars
of GDP
Government purchases
Net exports
$ 8,079.9
(Source: These data are available at the Web site for the Bureau of Economic Analysis,
III) GDP from the Income Side (The Income Approach): it sums up the incomes to owners of factors
of production, plus some other claims on the value of output.
a) Factor Payments (or Payments to the Owners of the Factors of Production):
i) Wages (W): total employees compensation: salary, allowances, pension deduction, social insurance
deductions, unemployment insurance deduction. Wages include any income that is due to labor.
Rent (R): income to land services or anything that is rented, including rent on own -occupied
Interest (i): on bank deposits and corporate and government bonds. Interest is income from
lent capital.
Profit (Pr): income to owned capital. Dividends (distributed profits) and retained earning are
both included in national income.
b) Non-Factor Payments:
i) Indirect taxes (IT): are imposed on the production and sale of goods & services eg. Sales tax. If the
government does not collect indirect taxes it would have remained as firms’ profit. This has to be added
to GDP figures.
Subsidies (Sub): make income exceeds the market value of output. So, they have to be subtracted
from GDP figures. Eg. govt. subsidies to wheat and dates producers. Subsidies are not an earned
income, so, they have to be deducted.
Depreciation is the cost of used up physical capital; a deduction from profits to provide for
replacement investment. Depreciation reduces net profits but it is part of gross profits, so it has to be
added to GDP, thus
GDP=NNP + depreciation
Table 22.2
Components of GDP from the Income Side, 1997
of Dollars
of GDP
Compensation to employees
Rental income
Business income (including
net income of farmers and
unincorporated businesses)
Capital consumption allowance
Indirect taxes less subsidies
Statistical discrepancy
$ 8,079.9
GDP measured from the income side of the national accounts gives the size of the major components of
the income that is generated by producing the nation's output. The largest category, equal to about 58
percent of income, is compensation to employees, which includes wages, salaries and other benefits. The
capital consumption allowance (depreciation) is the part of the earnings of businesses that is needed to
replace capital used up during the year. This amounts to over 10 percent of GDP.
(Source: Economic Report of the President, 1998.)
* GDP (gross domestic product) is income produced at home.
GNP (gross national product) is income received at home+ net foreign income
GNP=GDP+ (income to foreign investment locally – income from our international investments)
Disposable national income (Y d ):- How much of national is left to persons (the owners of the factors of
production) to consume and save. It is the most important variable that affects consumption expend.
Y d = GDP - IT - Dep.- RE (retained earnings)- i (paid to financial institutions)+Sub.+ TR (transfer payments)
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Economics & Finance 2/14/2015 @ 11:42AM 798 views
Korean Wages Are Now Higher Than Japanese Wages, Perhaps For The First Time In 3,000
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This is something of a surprise actually, and it’s also an interesting indicator of just how fast economic growth can be. Average wages in South
Korea are now higher than they are in Japan. Underneath this is the slightly surprising detail that GDP per capita is still significantly lower in Korea
than it is in Japan. That means that, out of a smaller set of economic resources (that GDP, obviously), Korea is doing a better job of providing a
level of consumption for the workers than Japan is. And that is, in the end, what having an economy is all about. Enabling consumption by the
general population of the country.
Here’s the actual news itself:
The average wage of Korean workers has surpassed that of Japan in terms of purchasing power parity (PPP) for the
first time. In addition, Korea topped the list of OECD member countries in the pace of wage increases from 1990 to
2013. However, Korean ranked second among OECD counties in terms of wage inequality. Wages rose sharply but it
happened around large companies so wage inequality was deepening among workers.
Something that’s common to both countries is that there’s a distinct difference in wage levels between large companies and the smaller ones that
surround them. This is true in all economies by the way, but it’s especially marked in these two Far Eastern countries.
The thing is though, it’s not true that South Korea is a richer country than Japan. Here’s a listing of countries by nominal GDP per capita which is
the normal thing people look at and that’s much higher for Japan than it is for Korea. In the normal course of things we would thus expect Japanese
workers to have higher living standards than Korean ones. The gap closes a bit when we look at GDP adjusted for PPP (that is, taking account of
the differences in prices between the two places). But that gap still doesn’t close (although note that those references are to slightly older figures,
the quote is to near current ones).
So what’s happening here is that there’s two different things going on. One is that more of the Korean economy is actually going in wages than it is
in Japan. That makes sense as the Japanese economy has quite a lot of subsidies in it and wages, profits, subsidies to production and taxes on
consumption make up, with self employed income, the four parts of our income definition of GDP. But also there’s something else. Which is that the
general price level in Korea is lower making those wages go further. And it’s that that pushes Korean living standards (measured in this rather
crude manner of course) past Japanese. And the really surprising thing is that this might well be the first time in about three millennia that this has
been true.
I wouldn’t say that the 3,000 years is definitely true but if does accord with my understanding of the history of the area. And Angus Maddison’s
numbers show that this is almost certainly true too. As to the speed with which it has happened as late as 1980 South Korea’s GDP per capita was
only one fourth that of Japan. This has all happened in only the one generation, just in one working lifetime. Quite astonishing. There really might
be something to this freeish market capitalism stuff you know.
My latest book is “23 Things We Are Telling You About Capitalism” At Amazon or Amazon UK. A critical (highly critical) re-appraisal of Ha Joon
Chang’s “23 Things They Don’t Tell You About Capitalism”.
This article is available online at:
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Real And Nominal Measures:
Nominal vs. Real GDP:Nominal GDP = ∑P.Q is measured in current prices .It changes due to a change in P,Q, or both. This
makes it difficult to compare real GDP over the years. Thus, we have to fix prices using some price index.
Nominal GDP (at current Prices)
Implicit GDP deflator =
______________________________ X 100
Real GDP (at base year prices)
It is the most comprehensive price index as it includes all final goods & services in the economy. It
shows the changes to the overall general price level in the economy.
Extension 22-3
Data for a Hypothetical Economy
Quantity Produced
Year 1
Year 2
(dollars/bushel) (dollars/ton)
Table 2 shows nominal GDP, calculated by adding the money values of wheat output and of steel output
for each year.
Calculation of Nominal GDP
Year 1: (100 X 10) + (20 X 50) = $2,000
Year 2: (110 X 12) + (16 X 55) = $2,200
Table 3 shows real GDP, calculated by valuing output in each year at year 2 prices; that is, year 2 is
used as the base year for weighting purposes.
Calculation of Real GDP Using Year 2 Prices
Year 1: (100 x 12) + (20 x 55) = $2,300
Year 2: (110X 12) + (16 X 55) = $2,200
In Table 4, the ratio of nominal to real GDP is calculated for each year and multiplied by 100. This
ratio implicitly measures the change in prices over the period in question and is called the implicit GDP
deflator. The implicit deflator shows that the price level increased by 15 percent between year 1 and
year 2.
Calculation of the Implicit GDP Deflator
Year 1: (2,000/2,300) X 100 = 86.96
Year 2: (2,200/2,200) X 100 = 100.00
In Table 4, we used year 2 as the base year for comparison purposes, but we could just as easily have used
year 1. The measured change in the price level would have been very similar-but not identical in the two
cases. If we use year 1 as the base period, the implicit GDP deflator in year 2 is equal to (2,200/1,900) X
100 = 115.8, indicating an increase in prices of 15.8 percent from year 1 to year 2. The GDP deflator
measures the level of prices in a particular year relative to the level of prices in the base year.
Why does the measured change in prices depend on which year we use as the base year? If you look back
at Table 1, you will notice that the price of wheat relative to steel is higher in year 2 than in year 1. Thus,
if we use year 2 as the base period, the changes in the quantity of wheat will be weighted more heavily
{and the changes in the quantity of steel weighted less heavily) than if we use year 1 as the base period.
This difference in weighting explains the variation {15 percent as compared with 15.8 percent) in the
measured change in the implicit GDP deflator.
The GDP deflator can be used to calculate inflation from one period to the next:
Inflation rate in year 2 = GDP deflator in year 2- GDP deflator in year 1 X100
GDP deflator in year 1
For example suppose we calculated the GDP deflator in one year as 125 and in the next year as 135,
Inflation in year 2 would be:
135-125 X100 = 8%
The GDP deflator gets its name because it can be used to take inflation out of nominal GDP- that is, to
“deflate” nominal GDP for the rise that is due to increases in prices.
How do we choose the “right” base year? As with many other elements of national income accounting,
the choice involves some arbitrariness. The important thing is to be clear about which year you are using
as the base year and, for a given set of comparisons, to be consistent in your choice.
A Comparison of GDP Deflator and the CPI: Both indexes are used to measure inflation.
The Inflation rate is the % change in some price index from the one year to the subsequent year. However, there
are some differences.
The GDP deflator reflects the current level of prices relative to the level of prices in the base year. Because nominal
GDP is current output valued at current prices and real GDP is current GDP valued at base – year prices, the GDP
deflator reflects the current level of prices relative to the level of prices in the base year. The GDP deflator measures
the change in nominal GDP from the base year that cannot be attributable to change in real GDP. What does this
mean? It means that since nominal GDP can change due to a change in prices alone, change in quantities alone(real
change), or a combination of both, the GDP deflator tries to measure the change in GDP that is due to change in
prices alone.
The CPI measures prices of consumer goods that an average household faces. So a higher CPI results in a higher
cost of living. There are problems in measuring cost of living via CPI: 1) it ignores changes in quantities as prices
change. 2) It ignores the introduction of new goods 3) it does not reflect quality improvements in goods and
services. That’s why measuring the cost of living can be inaccurate.
Differences between CPI and GDP deflator:
1) CPI covers only a basket of consumer goods, while the deflator covers all output in the economy.
2) CPI compares what happened to the prices of a fixed basket of goods over the years. The GDP deflator
compares the price of currently produced goods and services to the prices of the same goods and services in
the base year. Thus the group of goods and services used to compute the GDP deflator changes
automatically over time. In other words, while the CPI compares what happened to the prices of a fixed
basket of goods over the years, the GDP deflator compares what happened to the prices of a changing
basket of goods over the years.
Output and Productivity: GDP may rise because of an increase in the amount of resources available to
the economy. Also due to a rise in output produced per unit of input.
* Labor productivity:Productivity per worker =
# of employed workers
Productivity per worker-hour =
total # of labor hours
* Omissions from GDP:- GDP statistics may not include all activities actually taking place in the
economy, such as:
1) Illegal activities such as the production of drugs, liquor, gambling, etc. use resources and generate
income to criminals. This is why they should be included in national income statistics. However, this
shouldn’t imply that their inclusion imply a rise in social welfare. Illegal activities harm society in 2
a) waste of resources in bad things
b) waste of resources in fighting crimes.
Illegal activities may be reported in national income when legal activities are used as a cover for illegal
2) Unreported activities: could be perfectly legal in themselves however people don’t report them to
avoid taxes.
3) Non-market activities: includes “do –it- yourself” works, voluntary works, housewives' works, value
of leisure.
4) Economic “bads” such as traffic congestions, pollution etc. (also when students park their cars in
the professors' parking lots).
The article below explains why GDP and per –capita income measures may not be good enough to
explain people’s well- being.
Culture & Society
Joseph E. Stiglitz
Joseph E. Stiglitz, a Nobel laureate in economics and University Professor at Columbia
University, was Chairman of President Bill Clinton’s Council of Economic Advisers and
served as Senior Vice President and Chief Economist of the World Bank. His most recent
book, co-authored with Bruce Greenwald, is Creating a Learning Society: A New Approach
to Growth, Development, and Social Progress.
OCT 13, 2014
The Age of Vulnerability
NEW YORK – Two new studies show, once again, the magnitude of the inequality problem
plaguing the United States. The first, the US Census Bureau’s annual income and poverty
report, shows that, despite the economy’s supposed recovery from the Great Recession,
ordinary Americans’ incomes continue to stagnate. Median household income, adjusted for
inflation, remains below its level a quarter-century ago.
It used to be thought that America’s greatest strength was not its military power, but an
economic system that was the envy of the world. But why would others seek to emulate an
economic model by which a large proportion – even a majority – of the population has seen
their income stagnate while incomes at the top have soared?
A second study, the United Nations Development Program’s Human Development Report
2014, corroborates these findings. Every year, the UNDP publishes a ranking of countries by
their Human Development Index (HDI), which incorporates other dimensions of wellbeing
besides income, including health and education.
America ranks fifth according to HDI, below Norway, Australia, Switzerland, and the
Netherlands. But when its score is adjusted for inequality, it drops 23 spots – among the
largest such declines for any highly developed country. Indeed, the US falls below Greece
and Slovakia, countries that people do not typically regard as role models or as competitors
with the US at the top of the league tables.
The UNDP report emphasizes another aspect of societal performance: vulnerability. It points
out that while many countries succeeded in moving people out of poverty, the lives of many
are still precarious. A small event – say, an illness in the family – can push them back into
destitution. Downward mobility is a real threat, while upward mobility is limited.
In the US, upward mobility is more myth than reality, whereas downward mobility and
vulnerability is a widely shared experience. This is partly because of America’s health-care
system, which still leaves poor Americans in a precarious position, despite President Barack
Obama’s reforms. Those at the bottom are only a short step away from bankruptcy with all
that that entails. Illness, divorce, or the loss of a job often is enough to push them over the
The 2010 Patient Protection and Affordable Care Act (or “Obamacare”) was intended to
ameliorate these threats – and there are strong indications that it is on its way to significantly
reducing the number of uninsured Americans. But, partly owing to a Supreme Court
decision and the obduracy of Republican governors and legislators, who in two dozen US
states have refused to expand Medicaid (insurance for the poor) – even though the federal
government pays almost the entire tab – 41 million Americans remain uninsured. When
economic inequality translates into political inequality – as it has in large parts of the US –
governments pay little attention to the needs of those at the bottom.
Neither GDP nor HDI reflects changes over time or differences across countries in
vulnerability. But in America and elsewhere, there has been a marked decrease in security.
Those with jobs worry whether they will be able to keep them; those without jobs worry
whether they will get one. The recent economic downturn eviscerated the wealth of many. In
the US, even after the stock-market recovery, median wealth fell more than 40% from 2007
to 2013. That means that many of the elderly and those approaching retirement worry about
their standards of living. Millions of Americans have lost their homes; millions more face
the insecurity of knowing that they may lose theirs in the future.
These insecurities are in addition to those that have long confronted Americans. In the
country’s inner cities, millions of young Hispanics and African-Americans face the
insecurity of a dysfunctional and unfair police and judicial system; crossing the path of a
policeman who has had a bad night may lead to an unwarranted prison sentence – or worse.
Europe has traditionally understood the importance of addressing vulnerability by providing
a system of social protection. Europeans have recognized that good systems of social
protection can even lead to improved overall economic performance, as individuals are more
willing to take the risks that lead to higher economic growth.
But in many parts of Europe today, high unemployment (12% on average, 25% in the worstaffected countries), combined with austerity-induced cutbacks in social protection, has
resulted in unprecedented increases in vulnerability. The implication is that the decrease in
societal wellbeing may be far larger than that indicated by conventional GDP measures –
numbers that already are bleak enough, with most countries showing that real (inflationadjusted) per capita income is lower today than before the crisis – a lost half-decade.
The report by the International Commission on the Measurement of Economic Performance
and Social Progress (which I chaired) emphasized that GDP is not a good measure of how
well an economy is performing. The US Census and UNDP reports remind us of the
importance of this insight. Too much has already been sacrificed on the altar of GDP
fetishism. Regardless of how fast GDP grows, an economic system that fails to deliver gains
for most of its citizens, and in which a rising share of the population faces increasing
insecurity, is, in a fundamental sense, a failed economic system. And policies, like austerity,
that increase insecurity and lead to lower incomes and standards of living for large
proportions of the population are, in a fundamental sense, flawed policies.
© 1995-2014 Project Syndicate
Bismi ALLAH Arrahman Arraheem
Projects in Macroeconomics
Project # 1
Estimating the Value Added and Factor Income Payments for the Highest –Valued Saudi Corporate
Get from the web the highest ten market -valued Saudi public firms by the end of 2015 and arrange
them in a descending order in terms of market value. (Start with the highest- valued firm). Mention
against each firm the nature of its activities (Ex: manufacturing, banking, agriculture, etc.) You are
required to do the following:
a) From the financial statements of each firm, estimate the value added by each. The value added by
a firm = value of the firm's sales – value of its purchases from other firms. This difference is equal to
the sum of its income payments to its factors of production plus non- factor payments. So the Value
added= Wages+ Rent + Profits + Interest + Taxes- Subsidies + Depreciation. Both are measures of
GDP at the macroeconomic level. The latter can be thought as a proxy for the other.
b) Arrange firms in a descending order in terms of value added. Mention against each the nature of
its activities.(Ex: Manufacturing, banking, agriculture, retail, …etc).
c) Does a higher market capitalization value necessarily mean a higher added value? Why, or why
d) Show the distribution of value added (factor incomes) for each firm. i.e the breakdown of
Value added= W+ R + Pr + i + T- Sub +Dep.
e) Arrange firms in terms of each component of the factor incomes. This means you have to make
a table for each component.
f) For each component of factor Incomes, find the total for all firms. EX.: Total wages paid by all
firms, total profits, total interest, etc.
g) Find the average wage per worker for each firm.
h) If the Saudi government were to apply a 5% value-added tax, how much each firm would be
paying. Assuming the list of top ten firms is representative of the whole private sector in the
Saudi economy, which sector do you expect to pay a higher value-added tax?
i) Alternatively, assume the government was to impose a 10% income tax on purely Saudi Firms
or the Saudi partner in each joint venture firm, calculate income tax to be paid by each firm (
including Zakat) and arrange firms accordingly. Which sector would you expect to pay more
income taxes?
j) Compare the government proceeds from the two taxes and explain the result.
k) Support your work by the suitable tables, graphs, charts, histograms, …etc.
Sources: Use the English page of each website.
(Capital Market Authority)
Project’s Groups ( 2nd Semester, 2015-2016)
Group # 1
Taha + Mashaal (Leader)
Assignment: Almaraii + NCB Bank
Group # 2
Hussien (leader) + Abdurrahman Alzahrani
Assignment: STC + Alrajhi Bank
Group # 3
Amer (Leader) + Hatim
Assignment: Saudi Electric + Jabal Omar
Group # 4
Waleed + Abdullah Aloqaili (Leader)
Assignment: Samba Bank + Maaden
Group # 5
Abdulaziz +Saleh +Mohannad (Leader)
Assignment: Riyad Bank +Safco
Chapter 23: National Income Determination: Part I
National Income accounting deals with measuring actual expenditures while the theory of national
income deals with how NI is determined.
Distinguish between actual & desired aggregate expenditure. EX: inventory is part of investment
expenditures. The actual level of inventories maybe >,<,= intended ( desired) inventory,
Actual Expenditures =Ca + Ia +Ga + (Xa-Ma)
Desired Expenditures= C+I+G+ (X-M)
Simplifying assumptions for this Chapter:
constant price level → no inflation
no government → G=0,T=0
closed economy → X=0 , M=0
* Autonomous (Exogenous) variable: is a variable that cannot be explained by the model. In the theory
of NI it is a variable not affected by national income. Autonomous expend. can and do change , but
such changes do not occur systematically in response to changes in NI.
* Induced (Endogenous) variable is one that can be explained by the model. i.e. is affected by NI.
* The consumption function relates desired consumption to the variables that affects it. In many
countries, consumption is the largest single component of aggregate expenditures.
1) the most important factor that affects C is personal disposable income. See previous chapter for
if T=0 → disposable income (Yd) = National income(Y)
Consumption Theories:
1) John Maynard Keynes: current income is the most important factor in affecting consumption.
2) Milton Freidman: the permanent income hypothesis states that consumption is mainly affected by
the expected long term income level. This implies that transitory changes in income don’t have much
influence on consumption.
3) Franco Modigliani: the life cycle hypothesis states the following:
a) at early stages of life C>Yd → people borrow
b) at middle stages of life C<Yd→ people save
c) at later stages of life (retirement) C>Yd→ people dissave (or consume from previous savings.)
Friedman & Modigliani are both Noble Prize Laureates in economics. See
TABLE 23-1
The Calculation of the Average Propensity to Consume (APC)
And the Marginal Propensity to Consume (MPC)
(Billions of riyals)
C= a + b Yd = 500 + 0.8 Yd
C/Yd Δ Yd
Δ C / Δ Yd
1.050 1,500
= 2,500
0.900 2,500
0.867 2,500
0.857 1,250
0.850 1,250
APC measures the proportion of disposable income that households desire to spend on
consumption; MPC measures the proportion of any increment to disposable income that households
desire to spend on consumption. The data are hypothetical. Economists call the level of income at which
desired consumption equals disposable income the break-even level; in this example it is $2,500 billion.
APC, calculated in the third column, exceeds 1-that is, consumption exceeds income below the breakeven level. Above the break-even level, APC is less than 1. It is negatively related to income at all
levels of income. MPC, equals 0.80 at all levels of Yd. Thus in this example 80 halalah of every
additional riyal of disposable income is spent on consumption, and 20 halalah is saved.
The average propensity to consume ( APC) = total consumption = C/ Y
total income
The marginal propensity to consume (MPC) = change in Consumption = Δ C
change in income
In other words, MPC is the slop of the linear consumption function.
Figure 23-1
The Consumption and Saving Functions
Slide 23.2
©1999 Addison Wesley Longman
The Saving Function:
The Average Propensity to Save (APS) = S/Yd
The Marginal Propensity to Save (MPS) =  S/  Yd
TABLE 23-2
Consumption and Saving Schedules
(billions of dollars)
Saving and consumption account for all household disposable income. The first two columns repeat the
data from Table 23-1. The third column, desired saving, is disposable income minus desired consumption.
Consumption and saving both increase steadily as disposable income rises. In this example, the breakeven level of disposable income is $2,500 billion; thus desired saving is zero at this point.
MPC+ MPS = 1
C=a + b Y d ; S = -a + (1-b) Yd
Where a: is autonomous consumption.
bY d is induced consumption, b is the slop of a linear consumption Function
The 45- degree Line: points on that line imply C= Y d (spending equals income)  no saving
* Consumption & wealth: a rise in wealth (a stock concept, a concept that has no time dimension)
increases the flow of consumption out of a given level of income. Moreover, it reduces the flow of
saving out of that income. A rise in wealth shifts the consumption function upwards while it shifts
the S- function downward. SEE Fig 23-2.
Figure 23-2
Wealth and the Consumption Function
Slide 23.3
©1999 Addison Wesley Longman
Figure 23-3
Consumption and Disposable Income, 1970-1997
Slide 23.4
©1999 Addison Wesley Longman
* Desired Investment Expenditures (I): Investment is the most volatile component of AE. The factors
that affect investment are: the real rate of interest, the level of sales, business confidence, and taxes.
1) The interest rate: affects investment as follows:
a) Inventory: represents tied- up capital in them. Thus the higher the interest rate, the higher is the cost
of capital, the lower is the desired inventory level. Also, there is a storage cost to carry inventory.
b) Residential housing: the interest component of the cost of housing could represent a very large
percentage of the total cost of a house.
c) Plant and equipment: firms finance some or all capital expansion by retained earnings. The higher
the interest, the less will be the desire to go for debt, and the more attractive is financial investment (the
less attractive is real investment.)
A rise in Interest rates increases the cost of any investment and reduces profits.
2) The level of sales:
a) Inventory levels change with the level of sales and the level of production.
b) If there is a surge in sales (demand) that firms believe is sustainable enough, they will invest in
plant & equipment. However, once that is completed, investment decreases. What if the increase in
demand is only transitory, how do firms meet the increase in demand?
3) Business confidence: is a psychological factor that could change in either direction for many different
reasons. It is a major source of investment volatility. Sometimes, it is the most important one.
4) Taxes: reduce profits and thus a cost that affects investments in plant & equipment. Governments give
special tax reductions to encourage both domestic and foreign investment.
* The role of profits in the economy.
1) They are signals that direct resources (and investment) into their best use (assuming perfect
2) Profits help to payback for the cost of existing investments.
3) Profits help to finance future investments.
4) Taxes and interest are deductions from profits. So Profits pay for taxes and interest.
In the Islamic system, interst is not allowed, and Zakat is not related to profits
* For simplicity: investments will be assumed to be autonomous. Thus I = I
This chapter assumes G=T=X=M=0 , thus
AE= a + by + I
In this simple economy, the marginal propensity to spend out of national income ( Z) is the same as
mpc (b ) ; (1-z) is the marginal propensity not to spend) is the same as the MPS.
TABLE 23-3
Desired Aggregate Expenditure
(Billions of riyals)
(C = 500 +0.8Y)
(I = 1,250)
(AE= C + I)
In a simple economy with no government and no international trade, desired aggregate expenditure
is the sum of desired consumption and desired investment. In this table government and net exports are
assumed to be zero, desired investment is assumed to be constant at $1,250 billion, and desired
consumption is based on the hypothetical data given in Table 23-1. The autonomous components of
desired aggregate expenditure are desired investment and the constant term in desired consumption
expenditure. The induced component is the second term in desired consumption expenditure (0.8 Y).
Figure 23-4
The Aggregate Expenditure Function
Slide 23.5
©1999 Addison Wesley Longman
TABLE 23-5
The Saving-Investment Balance
Desired Aggregate
Desired Consumption Desired Saving Desired Investment
National Income (Y) (AE = C +1)
(C = 500 + 0.8 Y)
National income is in equilibrium when desired saving is equal to desired investment. The data for Y,
AE, and I are from Table 23-3. The data for desired saving is from Table 23-2.
* Determination of equilibrium NI:
if AE>Y → pressure an income to rise. WHY?
If AE<y → pressure an income to decrease. WHY?
Equilibrium will be achieved where AE=Y
* At equilibrium:
AE = Y
& S= I
* To show this;
C + I = C + S. If C is deleted from both sides, I=S
If the economy is out of equilibrium, then Y-AE = S-I
(The income-expenditure gap) = (The saving – investment gap) .See the figure below.
Figure 23-5
Equilibrium National Income
Slide 23.6
©1999 Addison Wesley Longman
Changes in NI equilibrium: Equilibrium national income can change because of:
1) income changes
a shift in AE function because of a) a permanent rise in one of the components of AE due to a
parallel shift in AE, which is due to an increase in one , or more of the autonomous expenditures. b) A
rise in the propensity to spend  a change in slop of AE.
Figure 23-6
Movements Along and Shifts of the AE Function
Slide 23.7
©1999 Addison Wesley Longman
Figure 23-7
Shifts in the Aggregate Expenditure Function
Slide 23.8
©1999 Addison Wesley Longman
Shifts in The saving & investment functions:- See Fig. 23-8
A decrease in saving, or a rise in investment both would increase AE and GDP, but would they have
the same effect on the economy?
Figure 23-8
Shifts in Desired Saving and Investment
Slide 23.9
©1999 Addison Wesley Longman
1) If the saving function shifts ↓→ C ↑  production of consumer goods ↑  AE  →Y  → S
 again until S= S 0 = I
In the final equilib. Y, C both rise, but S is the same. The Production of consumer goods increases.
2) If the investments function shifts ↑ → AE ↑ → Y↑ → C↑& S↑→ in the final equilibrium Y , C,
I,S all rise and the production of both investment and consumer goods↑
The Multiplier Process A Numerical Example- See Extension 23-1 below.
Consider an economy that has a marginal propensity to spend out of national income of 0.80. Suppose that
autonomous expenditure increases by SR1 billion per year, because a large corporation spends an extra
SR1 billion per year on new factories. National income initially rises by SR1 billion, but that is not the end
of it.
Increase in
(millions of Riyals}
Total Round of spending
1 (initial increase}
11 to 20 combined
All others
Def. : The Multiplier is the magnitude by which national income changes, in response to an initial
change in aggregate expenditures.
Figure 23-9
The Simple Multiplier
Slide 23.10
©1999 Addison Wesley Longman
Deriving the Simple Multiplier:
At equilib.:
AE = Y
A + ZY = Y, where A is autonomous expenditures (a+I), and Z is the marginal propensity to spend out of
national income.
Y – ZY = A
Y ( 1- Z) = A , thus
Y = A/ (1- Z), where 1/ (1-Z) = K is the multiplier. We note that the magnitude of the multiplier is
inversely related to the MP- not-to- Spend (proportionally to the MP to spend). i.e if a higher
percentage of income is spent ( or less is saved), more income will be generated.
EX; Let Z= 0.7 , K = 1/ ( 1- Z) = 1/ ( 1- 0.7) = 10/3= 3.3
Let Z = 0.8 K= 1/ ( 1- 0.8) = 10/2 = 5
What does a value of K=3 mean? It means that for every additional riyal of autonomous expenditures,
equilibrium national income increases by 3 riyals.
Figure 23-10
The Size of the Simple Multiplier
©1999 Addison Wesley Longman
Slide 23.11
REVIEW: End of Chapter Questions
Ch. 21
micro, particular market
macro, inflation, unemployment
macro, industrial production
macro, subsidies affect national income, but micro prices
macro, recession
f) labor force expanding from population growth > a rise of employment =unemployment will rise
Ch. 22
a) yes, consumption
b) yes, consumption
c) no, it in the contrary , spending an investment
d) no , transfer of title
e) yes, inventories part of investments
f) no, ready counted when first sold
GDP not affected directly, but GNP is because income will go to foreigners not to “nationals”
GNP= GDP +Net Foreign income
(not affected but transfers income to foreign ownership)
Ch. 23
c) upward shifts of C, and AE while saving shifts down
d) AE, and I shifts downwards
e) Investments decrease (reducing production, selling inventories until it waves out)
f) If the government expending imports, export, (=consumption, I-gives investment C=1400+0.8y, I=400,
equilib. Y=?, what will happen if interest rate ↑ ?
AE=C+I →
1400+0.8y + 400 = 1800+0.8y
at equilibrium:
Y= 1800+0.8y → Y(1-0.8) = 1800 → Y=9000
C=1400 +0.8 (9000) = 8600
S=Y-C= 9000-8600 = 400
Chapter 24: National Income Determination: Part II:
Introducing Govt. & the Foreign Sector
* Definition: Fiscal policy is the govt. policy regarding govt. expenditures and taxation.
* When govt. is introduced into the model, Yd ≠ Y  Yd = Y-T, also C ≠ f(Y), but
C = f (Yd (Y)) → relationship between consumption & national income becomes indirect.
Net taxes = Taxes - Transfer Payments = T –TR
* Govt. spending includes govt. purchases (G) and Gov't transfer payments = G+TR.
Notice TR is part of the Gov't budget, but not a gov't purchase of goods & services. This is because
TR is income from government to individuals that is not in exchange for any factor of production. So, TR
is not part of G, but it affects AE & Y indirectly through Yd and C.
The budget balance = T-G > 0  a surplus
< 0  a deficit
= 0  a balanced budget
* The public(government) saving function: T- G = tY - G , where G an is autonomous variable, t (the
average tax rate) is also autonomous. The budget balance is positively related to national income (Y). t is
the slope, and a change in G shifts the function parallel to itself. A change in t, changes the slop of
the function, i.e rotates the function.
Figure 24-1
The Public Saving (Budget Surplus) Function
Slide 24.2
©1999 Addison Wesley Longman
Net exports = exports-imports = (X - M) = X-mY, where m is the marginal propensity to import.
Exports are assumed exogenous. See Fig. 24-2
If X changes → a shift in (X-M) function.
If M  → (X-M) ↓. M could change either because m, y, or both change.
Figure 24-2
The Net Export Function
Slide 24.3
©1999 Addison Wesley Longman
* Causes of shifts in (X-M):
(X-M) = f (Y h , Y f , (P h / P f ), ER)
Foreign income (Y f )  → X ↑ → (X-M) ↑
Relative domestic to foreign prices:(P h / P f ) ↑→ X↓ ,M↑→ (X-M) ↓
3) Different inflation rates: If home inflation > foreign inflation, home goods are relatively more
expensive, X decreases, M increases  (X- M) 
4) Exchange rate: # of domestic currency units to be paid for one foreign currency unit. If ER ↑  home
currency  imports becomes more expensive to us, exports cheaper to the foreigners
  ,   (  ) 
Note: For an economy to have positive net exports, the value of its output (GDP) must be greater
than what it uses domestically (or absorbs) of that output. Absorption of domestic output is (C+I +
G). So Net Exports= GDP- Absorption. However, if net Exports are negative, it must be that the
economy is absorbing more than what it produces.
For simplicity, in this chapter we assume both the price level and the exchange rate to be constant.
This issue is discussed in more detail in Chapter 37.
Figure 24-3
Shifts in the Net Export Function
Slide 24.4
©1999 Addison Wesley Longman
Calculating the Marginal Propensity to Spend:
If  Y= 1, t=0.1, mpc =0.8Yd, m=0.1, What is the marginal propensity to spend out of domestic
output (Z)? Notice that Consumption is a function of disposable income, Yd. So,
 Y d = Y – T = Y-0.1Y= 0.9 Y
 C = (mpc) (  Y d ) = (0.8)( 0.9) Y= 0.72Y ( What is  S ? )
Since all domestic expenditure components contain some imports of an average of 10% (m=0.1),
then that component must be deducted from the propensity to spend on Domestic output. Thus
Z = 0.72- 0.1= 0.62 (What does it mean?)
Thus the multiplier (K) = 1/ (1- 0.62)
Conclusion: We notice that a rise in savings, taxes, and imports (all are leakages) reduces Z, and thus
reduces the value of the multiplier and hence reduces equilib. national income.
* Equilibrium National Income: Two Approaches:
- I) The income- Expend. Approach. See Table 24-4
1) Desired consumption function: C = a + b Yd. Consumption depends on disposable income, which in
turn depends on national income. To find the relationship between C and Y, we have
thus Yd = ( 1- t) Y
d     = Y- tY = Y (1-t),
We have
C = a + b (1-t) Y
C / Y = (mpc) (1-t ) = ( C / Yd ) ( Yd /  Y )
assume a=500, mpc = C / Yd =0.8. Also assume t= 0.1. Thus d  0.9Y
 C  a  (0.8)( d )  a  (0.8)(0.9 )  a  0.72Y = 500+ 0.72Y
Figure 24-4
The Aggregate Expenditure Funnction
Slide 24.5
©1999 Addison Wesley Longman
Figure 24-5
Equilibrium National Income
Slide 24.6
©1999 Addison Wesley Longman
Thus: Equilib. is established where
Y = AE = C + I +G+ ( X- M)
The Saving –Investment Approach: Another app. is to show that equilib. is attained
where national saving = national investment.
To show this we have to discuss the national saving & national investment functions first.
The National Saving Function is the sum of private and public (govt.) savings functions:
= S + (T- G)
The slop of this function is the sum of the slops of private and public functions.
Figure 24-6
The National Saving Function
Slide 24.7
©1999 Addison Wesley Longman
Derivation of the slop:
Keeping in mind that C=a+ bY d  S= -a + ( 1- b) Y d  S = -a+ (1 –b)( 1-t) Y
And T- G = tY – G
Thus the slop of the national saving function:  (S + (T-G))/  Y = (1-b) (1-t) + t
So, if mpc= 0.8 & t = 0.1 , then mps=(1-mpc)= ( 1- b)= 0.2 of disposable income
The slop of the national saving function is = (0.2)(0.9)+ 0.1=0.28. What does it mean?
National Asset Formation (National Investment):
This is equal to investment at home plus net claims on assets the country owns abroad. The latter
comes from net exports and our net foreign investments. Thus:
National Asset Formation= I + (X –M)
Investment and exports have in common that both are not intended to meet current domestic
consumption. A country that has positive net exports adds to its foreign assets, and thus is a net
creditor. Negative net exports imply that the country is a net debtor.
When desired national saving = desired national asset formation, the economy reaches
S+ (T-G) = I + (X – M)
Figure 24-7
National Saving and National Asset Formation
©1999 Addison Wesley Longman
Slide 24.8
To show that one equilibrium condition follows from the other: That's to show that AE=Y implies
S+(T-G) = I+ (X-M), we have :
AE = C+ I+ G+ (X – M)
& C = Y-T- S. Thus
AE = Y- T- S + I + G + ( X- M)
At equilib. AE=Y, substitute for AE
Y= Y- T-S +I +G + ( X- M)
Cancel Y from both sides and re-arrange the terms, we get:
S+ (T –G) = I + (X- M)
From table 24-5, we can show that if the economy is out of equilib., then
The national saving – national asset formation gap = the income – expend. Gap
 S+ (T –G)  -  I + (X- M)  =  Y- AE 
Also, if we re- arrange terms further, we get
S+T+M = I+ G+ X
The Sum of Leakages = The Sum of Injections
Conclusion: There are three equivalent ways to express macroeconomic equilibrium.
Can you re-state them?
Fiscal Policy & National Income:- We know how the DIRECTION of fiscal policy affects the
economy. If the economy is in recession, fiscal policy has to be countercyclical, i.e it should be
expansionary, by raising government expenditures and/ or lowering taxes. If the economy is booming (
overheating), fiscal policy is again countercyclical, i.e it should be contractionary, lowering government
expenditures and/ or raising taxes. However, there are three more elements of policy; MAGNITUDE,
TIMING & MIXTURE. We are less certain about the last three. For example, how much should G or T
change? Which should change more? What expenditures should be increased or decreased? What taxes
should be increased or decreased? When is the best time to start implementing the policy, and at what
pace? What are the short run and long run effects?
See Fig. 24-8
Figure 24-8
The Effect of Changing the Tax Rate
Slide 24.9
©1999 Addison Wesley Longman
Does The Budget Deficit “Crowd Out” Private Investment?
Some economists argue that if the government budget is in deficit, (T- G < 0), the
government will be borrowing to finance the deficit. This implies that the government
shall be competing with the private sector for loanable funds, which may cause the
interest rate to rise, and thus may have a negative impact on private investment, in
addition to increasing the public debt. If that happens, government budget deficit is
said to “crowd out” private investment. However, this is a controversial issue; for
other economists argue that the deficit may actually “crowd in”, instead of “crowding
out” private investment, i.e it may cause it to increase, rather than decrease! This is
because there is a lot of private spending, they argue, that is dependent on
government spending. This issue is discussed in much more detail in Chapter 32.
Limitations of the Income - Expenditure Model:
The model is based on two basic concepts:
Equilibrium Y is where desired AE = actual Y
The multiplier measures the change in equilib. Y, that results from a change in the
autonomous part of desired AE.
The model, so far assumes the price level is exogenous to the model, and thus we have
been assuming the p-Level to be constant.
2) It assumes that equilib. Y depends only on aggregate demand (desired AE), and not on ( for
example) on the firms’ technical capabilities, the supply of resources. In other words, it assumes
that GDP is demand- determined.
3)It assumes the economy has some excess capacity (unemployed resources), which means that a rise
in AE , will generate a rise in real Y
These assumptions imply that equilib. income is determined by the demand side of the economy
alone. Income is said to be demand- determined.
Nevertheless, no matter what the p-Level is, the model continues to be useful to study the relationship
between AE and Y. The equilibrium conditions stated before still hold.
Deriving the Full Multiplier Model: Appendix Material; V.V. Imp.
  C    G  (    )
C= a + b d
d    
    t
d      t
X    X  m
G  G0
  0
At Equilibrium, we have:
AE= Y. Substitute for AE in the above AE function,
Y=C+I+G+ (X-M)
Substitute for C,I, G,X, & M from the above,
  a  b(    t )    G  ( X  m )
 (1  b  bt  m)  ao  bo    Go  o
Y=  1/( 1-b+bt+m)   ao  bo    Go  o 
Y=  the multiplier   Autonomous expenditures
 1/(1-Z) 
 A 
From the above, it is obvious that adding more leakages in the economy  a lower value of the
multiplier  a lower equilibrium national income.
Example from the text: Let
C=500+0.8 Yd
X-M =1200-0.1Y
a)Find equilibrium national income. What is the value of the multiplier? What is the value of
autonomous expenditures?
b) Is the government budget balanced?
c) Is foreign trade balanced?
C= 500+ 0.8(Y-T) = 500-+ 0.8 ( Y-0.1 Y) = 500 + 0.72 Y
At Equilib. AE=Y,
substitute for the above values of C,I,G,,X,& M
Y = 500 + 0.72Y + 1250 + 850 + 1200 – 0.1 Y
Y( 1-0.62)= 500+1250 + 850 + 1200
Y= (1/(1-0.62)) ( 3800) = (2.36) ( 3800) = 10000
Thus, the Marginal propensity to spend (Z) is 0.62, & the marginal propensity not to spend is 0.38.
Let  G=150,   ?
  (1/(1-Z)) (  G ) =(2.63)(150 ) = 394.5
Deriving the Tax Multiplier:
A change in taxes   d  C  
The change in disposable income = the change in taxes. Thus
d  
Since C= a  bd  in a closed economy, let Y=C+I G
C  (b)(  T )
Y= a+ bYd +I+G
Y= a+ b(Y-T) +I+G
Y= a+bY- bT +I+G
Y(1-b) = a- bT +I + G
Thus Y= (
) ( a-bT +I+G)
1 b
 1 
  
 b  
 (b)(
)  (mpc) (Expenditure multiplier, K)
1 b
1 b 
. Since b is less than one, it follows that the tax multiplier is
1 b
smaller than the expenditure multiplier,(
). What does it mean?
1 b
Example: If T  300  Yd  300  C  bd ,
Thus the tax multiplier is:
C  (0.8)( 300)  240
 Y  (C )( )  (240)
 (240)(
)  (240)(5)  1200 . Where K is the expenditure
(1  mpc)
1  .8
Alternatively, the change in Y can be calculated using the formula for the tax multiplier above.
The Balanced Budget Multiplier: If taxes increase by the same magnitude of the increase in govt.
expenditures, what would be the effect on national income? Would equal leakages and injections cancel
out each other in this case?
The change in national income will be the combined effect of the expenditures and tax multipliers:
   1    b  1  b
G   1  b   1  b  1  b
This implies that the balanced budget multiplier, in a closed economy is equal to1. Thus a balanced
budget policy increases national income by the same amount of G = T.
WHY? Can you explain?
Problem from Study Guide P. 338 (review session)
Given the following Info:
C=100+0.7 Yd
Yd = 0.8Y
G= 50
Find equilib. GDP, Z, (1- Z) _________________________________________________________
Yd = 0.8Y → Yd=Y-ty=Y(1-t)
at equilibrium: AE=Y
Y=(1/ 1- 0.46) (216)
Thus Equilib. GDP: Y= 400
(b) Z ( MP to Spend) = 0.56 -0.1=0.46
1-Z=0.54←MP not to Spend
Hence K (the Multiplier) = 1/ (1-Z) = 1.851
(c) Sum of autonomous exp= 216
(d) If
G  20,  y  ?
y 
(G )
1 Z
 (1.851)( 20)
Y  37.037
(e) If G increases by 20 & suppose expenditures create a demand for imports , solve for  y. In this
case we have to include X-M=10-0.1Y. The final increase in Y will be reduced by 0.1 of the change in
income that resulted from  G. That is Y is reduced by 3.7 relative to part (d) above.
The Keynesian Revolution
In the 1930s a major depression affected most of
the industrial world. Unemployment in the United
Kingdom reached levels around 20 per cent overall.
In the USA it reached around 25%. World trade
collapsed and factories lay idle. The economic
orthodoxy at the time suggested that the best
course for governments was first to let market
forces solve the problem and secondly to get their
own houses in order by increasing taxes and
cutting spending to reduce the budget deficits that
usually accompany recessions. Prices would adjust
to clear markets and eventually excess supplies
would be eliminated and confidence would be
restored by seeing the government being financial
prudent. Even if it was understood that this would
take time, there was thought to be nothing much
that government could do to help the process of
recovery other than by setting a good example of
financial prudence. John Maynard Keynes
challenged this conventional view in his pathbreaking
The General Theory of
Employment, Interest and Money (Macmillan,
interpretations and extensions, marks the
beginning of macroeconomics.
One insight that Keynes expressed that is still
considered valid today is that labor markets are not
like conventional commodity markets, in that prices
do not rapidly adjust to clear the market.. This
‘wage stickiness’ implies that unemployment can
persist for a long time without the market
mechanism doing much to eliminate it.
In the context where there is a general excess
supply of productive resources, the question then
arises: why is demand is not high enough to utilize
these resources? The answer was ‘effective
demand failure’. What this means in terms of the
analysis of this chapter is that the AE function is
too low. It is leading to an equilibrium level of GDP
that is well below its full employment or potential
level. Thus the cause of the ‘great depression’ was
that one or all of C+ I + G + NX were too low,
perhaps as a result of a collapse of consumer
confidence (and the reinforcing effect of
unemployment on GDP), a collapse of investor
confidence (in the context of low demand for
output), and decline of world demand (as other
countries were suffering too).
The analysis suggested not just the cause of the
problem but also a potential solution. By increasing
G, governments would create a positive multiplier
effect, shift aggregate spending upwards, and
cause GDP to move towards its full employment or
potential level. Thus, the Keynesian Revolution
suggested an active role for fiscal policy in helping
to stabilize the economy and a promise that mass
unemployment could be a thing of the past. The
idea did have a huge policy impact. It underpinned
the new deal policies of US President Roosevelt in
the 1930s and was influential in many other
countries, especially the United Kingdom, which in
the post-world war II period used fiscal policy
actively to manage aggregate demand in an
attempt to stabilize activity.
In December 1965, Time Magazine famously ran a
cover story with the headline: ‘We are all Kenesians
now’. Paradoxically, when President Nixon even
more famously quoted the same statement in
1971, it was almost certainly no longer true. In the
1970s and 1980s the problem most pressingly
facing the world was moving on from that of
unemployment to inflation and high energy prices.
In the inflation story, governments came closer to
being villain rather than savior, and active countercyclical fiscal policies went out of fashion. However,
in the recession of 2008-09 there was a collapse of
private demand on a global scale and governments
initially saw fit to let their deficits expand in order
to prop up aggregate demand in their home
endogenous, as tax revenues fell and welfare
spending rose, and partly policy included as
governments undertook new spending in order to
inject new demand into the economy and so
reduce unemployment. In Many places Keynes was
back in fashion, and fiscal deficits were once again
regarded by many as an important policy tool for
demand management. Although this change of
view was dramatic, it was not held by everyone,
and major controversies did occur, particularly in
the United States, over the wisdom of using fiscal
tools to fight the recession. Also those who thought
that the large budget deficits in many EU countries,
particularly those in the Mediterranean area, were
a more serious problem that unemployment urged
governments to rein in their spending and raise
taxes in order to reduce their deficits, despite this
being a contractionary fiscal policy.
Why We need Equilibrium Analysis; Cartoon by Paul Krugman, The new York Times, October
Chap.25: Output and Prices in the Short Run
Virtually all AS & AD shocks affect both national income and the price level; that is they have both
nominal and real effects. To understand these effects we have to drop the assumption of a constant
price level that we maintained in the previous chapters.
The Demand Side of the Economy:
Shifts in the AE function:
One Key Result: A rise in the P- level shifts the AE function down, and a fall in P- level shifts AE
function up. WHY?
I) P-level & Changes in Consumption: Two links:
a) P → Wealth → C. Much of persons' private wealth is the form of assets with fixed nominal value:
money and bonds. A rise in P-level reduces the purchasing power of money (M/P)  → money wealth ↓
→ real AE↓.
Also, govt. and corporate bonds are fixed in nominal terms. A rise in P – level reduces real repayment to
the bondholders (B/P) → wealth of bondholders ↓. However, for the bond issuer, since real repayment is
lower → his real wealth ↑ → No net change in aggregate wealth of, assuming that both sides have the
same mpc.
b) P → Wealth → S → C. When wealth is decreased due to a rise in P – level, people need to
increase their savings to restore their wealth to their desired level → Consumption ↓ → AE ↓.
The above is the direct effect of wealth on consumption. There is an indirect effect that operates
through the interest rate. It will be discussed in Chap.28.
II) P –Level & Changes in Net Exports: A rise in domestic P-level → prices of domestic
goods become more expensive relative to foreign goods. → (X-M) function ↓→ AE function ↓.
CHANGES IN EQUILIB. INCOME: When P- Level ↑ → (C & NX) ↓ as explained above →
AE function ↓ → equilb. GDP↓. A fall in the P- Level does the opposite. See Fig.25-1 below.
Figure 25-1
Aggregate Expenditure and the Price Level
Slide 25.2
©1999 Addison Wesley Longman
Note: In chap.23 & 24 the horizontal axis was labeled "Actual National Income". In this chapter it
is labeled "real GDP". It is still actual as opposed to desired, but it is real.
RECALL: The AE curve relates actual GDP to desired AGG.EXPEND. for a given P-Level, plotting
GDP on the horizontal axis.
The Aggregate Demand Curve (AD) relates equilibrium GDP to the price level, again
plotting GDP on the horizontal axis. SEE FIG25-2 below. Changes in the P- Level that cause shifts of
the AE curve, cause movements along the AD curve. A movement along the AD curve thus traces out
the response of quilib. GDP to changes in the price level.
Figure 25-2
Derivation of the AD Curve
Slide 25.3
©1999 Addison Wesley Longman
The Slop of the AD Curve:
Remember from microeconomics that the D- curve for an individual good relates the price of the good
to the quantity demanded of that good, holding all other prices and the consumer's money income
constant. It slops downward because of the availability of substitutes, and because a rise in the price
of the good reduces his purchasing power in terms of that good.
However, for the AD curve: the first reason does not apply, for the AD curve relates the total
demand (for all goods) to the general P- level (not just one good and not just price). All prices and
total output are changing as we move along the AD curve. Because the value of output determines income,
consumers' money income changes along this curve.
The second reason applies only to a limited sense; As the domestic P- Level changes there could a
substitution between domestic and foreign goods.
The above discussion explains why AD curve is different from the individual D- curve. However, it
does not explain why the AD- curve slops downward.
Explanation: Actually, as the P- level ↑ →real money supply (M/P) ↓. If nominal money supply, M
is constant, Ms= Mso → i ↑ → (C & I) ↓ → AD ↓ → movement along the AD curve. This is called the
interest rate effect. In short, the AD curve slops downward because of the wealth
effect (which is due to changes in the price level discussed above) and the interest rate
Points off the AD Curve: (V.V. Imp.) The GDP given by any point on the AD curve is such that if
that level of output is produced, its value will be exactly equal to aggregate desired expenditures at
that P- level. This is the meaning of equilib. Points along the AD curve mentioned above.
Points off the AD curve show either pressures on output to rise (to the left) or pressures o decrease (
to the right). SEE FIG. 25-3 below.
Figure 25-3
The Relationship Between the AE and AD Curves
Slide 25.4
©1999 Addison Wesley Longman
Shifts in the AD Curve: WE have already seen that any change in the price level causes a shift in the
AE function, and a movement long the AD curve. Any other change that causes a shift in the AE
function (such as a change in one or more of the components of AE) will cause a shift in the AD
curve. Such a shift is called an aggregate demand shock.
EX 1: in the early 1980's, changes in the US tax laws led to an increase in consumption at every level of
national income → an expansionary demand shock → the US. AE shifted up & the AD curve shifted
to the right.
EX 2: The Asian crisis of 1997 -1998 led to recession in these countries that reduced their demand for US
exports, and shifted US AE function down and thus the US AD curve Shifted to the left. → A
contractionary demand shock. The Asian crisis has actually led to a sharp decrease in oil prices that
also generated a prolonged recession in oil exporting countries.
The Simple Multiplier & The AD Curve: The simple multiplier is the one that measures the change in
equilibrium GDP in response to a change in autonomous expenditures when the p- level was assumed
constant. Under this assumption, the multiplier gives the horizontal sift in the AD curve in response to a
change in autonomous expend. SEE FIG 25-4 below.
Figure 25-4
The Simple Multiplier and Shifts in the AD Curve
Slide 25.5
©1999 Addison Wesley Longman
THE AGGREGATE SPPLY: Aggregate Supply refers to the total output of goods & service that
firms wish to produce, assuming they can sell all they wish to sell. Aggregate Supply (AS) thus
depends on the firms decisions to employ workers & other inputs to produce goods & services.
The aggregate supply curve relates AS to the P- level. Two types of AS curves:
The short run AS curve ( SRAS) relates the P-level & GDP on the assumption on that technology &
all factor prices are constant.
The long run AS curve (LRAS) relates the P-Level to desired sales after the economy has adjusted
to that P- level. We discuss this issue in detail in the next chapter.
The Slop of the SRAS Curve:
Costs & Output: Even though the SRAS assumes constant factor prices, this does not mean that
unit costs (cost per unit of output) will be constant. As output rises less efficient standby plants & less
efficient workers may have to be hired (i.e marginal productivity will eventually decline.) Thus, the law
of diminishing marginal returns is one reason why costs rise in the SR as firms try to squeeze more
output out of fixed capital.
Prices & Output: Firms are either price-takers (competitive industries), or price-setters
(monopolistic or oligopolistic industries).
As their unit costs rise with output, price -taking firms will produce more only if output price
increases, and will produce less if output price falls.
Price –setting firms will increase their prices when they expand output in the range in which unit
costs are rising.
Thus, the actions of both price-taking & price-setting firms cause the p-level & AS of output to be
positively related. Thus, the SRAS is upward sloping. SEE FIG.25-5 below.
Figure 25-5
The Short-Run Aggregate Supply Curve
Slide 25.6
©1999 Addison Wesley Longman
Shifts in the SRAS are called aggregate supply shocks.
1) Changes in Input Prices: if factor prices increase → firms' profitability of current
production↓ → So either higher prices will be required at each output level, or output will be
reduced at every price level. SEE Fig. above.
An upward shift in the SRAS reflects a reduction in AS due to change in input prices.
2) Changes in Productivity: if labor productivity ↑ → the unit costs of
production (for given wages) ↓ → prices of output ↓. Competing firms cut prices in an attempt to
raise their market shares.
The equilib. values of real GDP and the P- level are determined simultaneously at the intersection of the
AD & SRAS curves. SEE FIG 25-6 below. Any point above or below that point will generate either
excess supply or excess demand.
For macroeconomic equilibrium two conditions must be satisfied:
1) At the prevailing P- Level, desired AE must be equal to actual GDP- that is households are
welling to buy all that is produced. This condition holds everywhere on the AD curve.
At the prevailing P- level, firms must wish to produce the prevailing level of GDP, no more &
no less. This condition is fulfilled everywhere on the SRAS curve.
Figure 25-6
Macroeconomic Equilibrium
Slide 25.7
©1999 Addison Wesley Longman
1) A shift of (AD) changes Y & P in the same direction. See Fig.25-7
2) if AD shifts rightward  an expansionary demand shock, i.e. more output is demanded at all plevels.
3) if AD shifts leftward  a contractionary demand shock, i.e. less output is demanded at all plevels.
Figure 25-7
Aggregate Demand Shocks
Slide 25.8
©1999 Addison Wesley Longman
* The multiplier when P-level is changing: Look at Fig.25-8. Because the short run Aggregate supply
(SRAS) curve is upward slopping, an upward shift of AD causes the P-level ↑  real AE is somewhat
reduced  the magnitude of the multiplier is reduced. When the SRAS is positively sloped, the
change in real GDP is no longer equal to size of the horizontal shift of AD.
Figure 25-8
Multiplier When the Price Level Varies
Slide 25.9
©1999 Addison Wesley Longman
* The importance of the shape of SRAS curve: Fig.25-9
Figure 25-9
The Effects of Increases in Aggregate Demand
Slide 25.11
©1999 Addison Wesley Longman
  , but doesn’t
1) At the early flat range of SRAS (called the Keynesian stage) shifts in AD
rise. The flat stage of the SRAS implies that the economy is in a state of deep recession (or
depression.) A significant portion of resources are unemployed. AD and GDP can be increased
without any pressure on prices.
2) The rising stage of SRAS : as AD shifts , both Y& P 
3) The vertical stage, the economy is near full capacity utilization, very little more of output can be
added. The shift of AD causes more of P-level rise than output increase. When the SRAS is
completely vertical, the economy is at full employment  further shifts of AD only causes higher
and higher price level, but no more output. See Fig 25-10 below.
Figure 25-10
Demand Shocks When the SRAS Curve is Vertical
Slide 25.12
©1999 Addison Wesley Longman
However, note that SRAS is used to analyze only short- term effects, for the SRAS assumes constant
input prices and technology.
Aggregate supply shocks: Fig. 25-11
Figure 25-11
Aggregate Supply Shocks
Slide 25.13
©1999 Addison Wesley Longman
if inputs prices  , profits to firms  , for firms to maintain profits, they must charge higher prices
at every level of output  the short run AS curve shifts up ( to the left)  P  &  this is called a
case of stagflation “(stagnation +inflation).
Can you remember domestic and international examples of inputs prices increases and how they affected
SRAS curves in the respective countries?
Chap.26: Output & Prices in The Long Run
* The assumptions from Chapter 25:
1) Inputs prices are constant 2) Productivity is constant.
In this chapter we relax the first assumption. We want to see what happens when input prices are
Induced Changes in Factor Prices:
Figure 26-1
The Output Gap
Slide 26.2
©1999 Addison Wesley Longman
Since input prices can vary, changes in GDP can induce changes in input prices
i) in booms firms are optimistic  output(GDP)  demand for factors of
production    . Booms  inflationary gaps where Y>Y* & P-level 
ii) When firms are pessimistic  Profits   investment   GDP  … (opposite to booms)
Recession  recessionary gap where Y<Y* & P-level 
Closing the GDP gap: In recessions when demand for factor of production  , input prices,
especially wages   unit cost   SRAS shifts rightward until the economy at Y*.
In booms: when demand for factors of production  input prices, especially wages,  unit
cost  the Short Run Aggregate supply shifts left ward until econ. is at Y*, & P-level  .
* Asymmetry in adjustment (V.V. Imp.)
As a real -world observation nominal wages are much slower to adjust downward in recession than
adjusting upward in booms. Wages are said to be sticky in a downward direction. However, it is not
just wages; the international financial and economic crisis that has been going on since 2007
has shown that if business expectations are pessimistic, they may prolong recession that much
longer. In addition, the availability of credit (financing) has proven to be very crucial and operates
on both the supply side & the demand side of the economy. Thus, recession gaps are more difficult
to close than inflationary gaps. The economy may take much longer time to get out of recession.
The Philips Curve ( a very Important relation) When real GDP exceeds its potential, an excess
demand for labor pushes wages up  the unemployment rate is less than U*( the NAIRU) . When real
GDP is less than potential, an excess supply is of labor exerts a downward pressure on wages  the
unemployment rate exceeds U*.
This relationship between the unemployment rate, and the rate of change in wages is one of the most
famous relationships in macroeconomics & is called the Philips curve.
Extension 26-1:The Philips Curve & the Shifting of the SRAS Curve.
In the early 1950's professor A.W. Philips, of the London School of Economics pioneered a study on
the relationship between the inflation rate and the difference between actual and potential GDP,Y*.
Later he studied the relationship between the rate of increase of wages and the level of
unemployment. In 1958, he reported that a stable relationship had existed between these two
variables for 100 years in the United Kingdom. This relationship came to be known as the Philips
Curve. It provided an explanation, rooted in empirical observation, of the speed with which wage
changes shifted the SRAS curve by changing unit labor costs. Since unemployment & output gaps
are negatively related, we can therefore create another Philips Curve that plots wage changes
against output. See the Figure below.
Only when Y=Y* is the SRAS not shifting. In this case, AD for labor equals AS; the only
unemployment then is frictional and structural. There is then neither upward, downward pressure
on wages. Hence the Philips Curve cuts the axis at potential output, Y* and the corresponding level
of unemployment is U*.
The Philips Curve provided a link between national income models and labor markets. It allowed
economists to drop the uncomfortable assumption of sticky money wages.
In the figure below, if Y=Y1, the wage cost will be rising to W1. The SRAS will be
shifting upward by that amount. Thus, a movement along the Philips Curve, caused
by a change in output (and unemployment), implies a change in money wages and
thus a shift in the SRAS Curve.
What happens if the Philips curve shifts? And what would cause such a shift? An important
cause of shifts in the Philips curve is changes in firms' and households' expectations of
future inflation. As wages go up, so does the cost of production. Consequently the SRAS shifts
up further, until it closes the GDP gap. The Philips curve also shits up until it becomes vertical at Y*
(or U*.) At that point there is no trade off any more between inflation and unemployment.
Extension 26-1
The Phillips Curve and the Shifting SRAS Curve
©1999 Addison Wesley Longman
Slide 26.4
*Expansionary Demand Shocks: See Fig 26-2 below
Figure 26-2
The Long-Run Effect of a Positive Aggregate Demand Shock
©1999 Addison Wesley Longman
Slide 26.3
Suppose equilib. is disturbed by an increase of some autonomous expenditures such as investment.
The AD curve shifts upward & GDP rises to y1 > y*, creating an inflationary gap.
Closing the Inflationary Gap
If Y>Y*  excess demand for labor  unit labor cost   -level  & profit  SRAS  output  .
Note that prices  not to make more profit but to cope with rising costs. However, there is a limit as
to how much firms can raise prices because as P-level  real  i.e. demand.  ( a movement
along the demand curve, AD1.)
Contractionary AD Shocks:
Figure 26-3
The Long-Run Effect of a Negative Aggregate Demand Shock
©1999 Addison Wesley Longman
Slide 26.5
If AD shifts  for one reason or another (Eg. I or X  )  Y  & becomes < Y* 
recessionary gap.
Closing the gap
Case 1: If wages are flexible.  unemployment drives wages  SRAS shifts to the right until
Y= Y*. This is called the automatic (market) adjustment mechanism. i.e the economy reverts back to
full employment on its own without any intervention form govt.
Case 2: If wages are not flexible: quite often wages are not flexible and sticky in a downward
direction. Unemployment and the recessionary gap may persist for a long period of time if nothing
is done about it. So the economy must be activated by some components of AD, usually through
govt. stabilization policy. This is an important and very controversial issue of macroeconomics. Fig.
26-3 ii above.
Two important lessons: The asymmetry in wages adjustment helps to explain two facts:
1) Unemployment may persist for a long period of time, without causing wages and unit costs to go
2) Booms, along with labor shortages and production beyond normal capacity cannot persist for a
long period of time, without causing an increase in unit costs and the price level.
Extension 26-2 Anticipated demand shocks:
Demand shocks, say by change in Gov't. fiscal policy, if perfectly anticipated by both
workers and producers may lead to an equal rise in wages and output prices, such
that there will be a simultaneous shift in AD and SRAS curves that leaves real GDP
unchanged. In terms of Fig.26-2, the economy may move directly from E0 to E2. Thus,
wages and the price level may rise without the presence of an inflationary gap.
The possibility that anticipated demand shocks may have no effect on real GDP, plays
a key role in some important controversies concerning the effectiveness of Gov't.
policy. See Chapters 30 & 31.
The scenario explained above requires that everyone have full knowledge of both the
exact size of the AD shock & the new equilirium values of both wages and prices.
Generally, however, people do not have perfect knowledge & foresight, so there are
some temporary real GDP effects until the final equilibrium of wages and prices is
Demand Shocks & Business Cycles:
Each component of AD is subject to continual random shifts which are sometimes large enough to
disturb the economy significantly. Adjustment lags convert such shifts into cyclical fluctuations in Y.
The time needed for the economy to adjust depends on the source and magnitude of the shock. It
should be noted that using AD to activate the economy may also take time to bring results.
Activating existing plants, hiring and training workers takes time. The multiplier process that
translates an initial increase in autonomous expenditures to income takes time. However, AD
policies are usually faster to work than the automatic adjustment mechanism.
The Long Run Aggregate Supply Curve ( LRAS): is AS curve when the economy has fully
adjusted to all shocks. There is no excess demand, nor excess supply in any market. It is vertical at
potential GDP. This is sometimes called “The classical AS curve”, because classical economists were
more inserted in the long run.
SEE Fig 26-4 below
Figure 26-4
Long-Run Equilibrium and Aggregate Supply
Slide 26.6
©1999 Addison Wesley Longman
If the economy is already at long run position i.e. Y=Y*, further shifts in AD only causes price level
 . The LRAS is consistent with any price level. In other words, in the long run the price level can
take any value. However, output may be pushed beyond its LR position only if the economy’s
capital stock, its technology rise, or the supply of inputs increases. This means that potential GDP
(Y*) rises. This implies that LRAS shifts to the right.
LR Equilibrium: The Composition of output in The LR:
If the economy is already at LR Equilib., a shift in AD because of G and/or I   (P & W)
 SRAS curve  P - level  (C & NX)  (AE= AE 0 & Y=Y*)  a rise in autonomous G &
I crowds out C & NX => The composition of national output changes. There will be more of public
& investment goods but less of consumption and exportable goods. The position of LRAS is
determined by past economic growth.
Three ways for GDP to change:
Figure 26-5
Three Ways that Real GDP Can Increase
Slide 26.7
©1999 Addison Wesley Longman
1) Increases in AD: if AD shifts, a recessionary gap can be closed. A further shift turns the
recessionary gap into on inflationary one.  unit cost  SRAS  closing the gap at a higher
price level.
2) Temporary increase in AS: If there is a temporary increase in AS  decrease in input
prices  SRAS shifts downward  unit cost     . This will have no effect on LRAS and Y*.
However if input prices swing up again, the cycle is reversed.
3) Permanent Increase in AS: If the productive capacity of the economy increases, potential GDP
increases  LRAS shifts to the right.
* Sources of LR Econ. Growth (Very Imp.)
Governance of the law and equal opportunities
Improvement in labor productivity through education and training.
Changes in labor laws that reduce rigidities in the labor market.
Capital accumulation.
Population growth and natural discoveries.
Technological breakthroughs.
* Sources of cyclical changes in GDP (Very Imp.)
Changes in interest rates, exchange rates, government policies ( fiscal, monetary, commercial…etc),
input prices, changes in consumer and producers confidence.
SEE FIGURE 26-6 below for three different economic series.
Figure 26-6
Fluctuations in Economic Activity, 1960-1997
Slide 26.8
©1999 Addison Wesley Longman
* The Basic Theory of Fiscal Stabilization: FIG.26-7 & 8
The basic power of fiscal policy is our knowledge about which direction it should take. However,
there are problems with knowing the right timing, magnitude and mixture.
*Using fiscal policy to eliminate a recessionary gap: Fig.26-7
Figure 26-7
The Closing of a Recessionary Gap
Slide 26.9
©1999 Addison Wesley Longman
a) If we rely on market automatic adjustment mechanism,  SRAS shifts to the right but it could
take time.
b) Using fiscal policy (G  , or T  , or both)  AD shifts  . This method shortens the period
required to close the gap, but it could take place at the same time when private decision makers are
increasing their expenditures. The AD curve may shift too much to the right creating an
inflationary gap.
* Using Fiscal Policy to eliminate an Inflationary gap: Fig 26-8: An opposite reasoning to the one
Figure 26-8
The Closing of an Inflationary Gap
Slide 26.10
©1999 Addison Wesley Longman
* A Key Proposition: when the automatic adjustment mechanism fails to operate
quickly enough, there is room for stabilizing fiscal policy. This has been the way
countries dealing with the recession resulting from the international financial crisis
(2007- ); mainly through injecting government expenditures and money supply into the
financial and real sectors of the economies, in addition to lowering the interest rates
(Using monetary policy.)
* The Paradox of Thrift: states that an increase in savings at the individual level can be good,
but it may be bad if it is widespread in the whole economy, reducing real GDP in the short run. A
rise in S  AE    . The policy implication of the paradox of thrift is that in case of a major
and persistent recession the govt. should indulge in a budget deficit i.e. should have G>T. The
government should borrow and spend, not the other way around.
Limitation: It works as long as Y<Y* only. When Y=Y*, a rise in AE & AD only rises the P-level.
In the LR, economic growth is determined by the position of LRAS.
* Automatic stabilizers:
Even in the absence of active fiscal policy, the existence of taxes and transfer payments act as
automatic stabilizers to the economy. T –G = tY-G. In case of recession, as Y     .This reduces
leakages from the economy, puts a partial break to the downward shift of AD. Also, during
recession, transfer payments (like unemployment insurance & social security)  , slowing AD  shift.
In the case of a booming economy, the opposite is true. Tax revenues are said procyclical (They go
up in booms & go down in recessions.)
Limitations of Discretionary Fiscal Policy
a) Decision lags: changes in fiscal policy may require the approval of different govt.
organizations. Also, whose taxes and how much should they be changed? What expend. Should be
increased or decreased?
b) Execution lags: time between a decision taken and implementation. The economic
consequences may take some time to be felt. It is possible that by the time a given policy decision has
any impact on the economy, the behavior of the private sector may shift the AD curve too far,
converting a recessionary gap into an inflationary one. SEE FIG. 26-9 below.
Figure 26-9
Effects of Fiscal Policies That Are Not Reversed
Slide 26.11
©1999 Addison Wesley Longman
2) Temporary vs. Permanent Policy Changes: Temporary tax measures are generally less effective
than measures that are expected to be permanent. If households feel that tax cuts are to last for
short periods, they will adjust their consumption very little. This issue is discussed in ore detail in
Chap. 32.
The Role of Discretionary Fiscal Policy:
Fine Tuning: Trying to use economic policy to remove or to offset all fluctuations in private -sector
spending to hold GDP near its potential at all times. However, the above – mentioned difficulties
must be remembered.
Gross Tuning: Many economists still argue that when the recessionary gap is large and persistent,
occasional (gross) tuning must be used.
The desirability of using fiscal policy to stabilize the economy depends upon:
a) The speed of the economy's own adjustment mechanism.
b) in an economy that is at or near its potential level, expansive FP may lower national saving and
national asset formation and consequently lowers future economic growth. HOWEVER, THIS IS A
VERY CONTROVERSIAL ISSUE. It depends on how and where government is spending. SEE
Paul Krugman: Business vs. Economics -
The article explains the differences between managing a business and managing a whole economy
Chapter 27: The Nature of Money & Monetary Institutions
What is Money?
* Money is a generally accepted medium of exchange.
* Functions of money:1) A medium for exchange
2) A store of value
3) A standard of measurement of value
4) A means for deferred payments (debts)
What are the attributes necessary for an asset to serve as money?
The attributes of money: homogeneous, recognizable, divisible, portable,
and storable and stable in value. Humanity has known many different
forms of money such as precious stones, leather, salt, copper, gold and
silver. Under a bi- metallic monetary system ( where two metals, such as
gold and silver, serve as money at some exchange rate ratio between the
tow), a phenomenon called the Gresham’s Law could take place.
Gresham’s Law says: Bad money drives out good money out of circulation.
This could happen if something happens that generates an abnormal rise in
demand for one of the two metals such that the official exchange rate is no
longer acceptable in the market. The “good” money, whose exchange value
has increased, will disappear from circulation. People will hold on to it, and
the other, “bad” money, will be used in transactions.
In today’s world, most of money is accounting, electronic money.
Question: Can Gresham’s Law phenomenon take place in today’s world?
* How do commercial banks affect money supply in the economy.?
* Assumptions:
1) Money supply is currency plus demand deposits at banks.
2) There is only one type of assets: (loans), only one type of liabilities: (demand deposits).
Liabilities generate costs, assets generate revenues.
3) Banks hold a fixed ratio of cash and reserves to deposits, required by the central bank. E.g. 20%.
4) No cash drain form banks  households keep a fixed amount of cash with them.
See Tables 27-3 -10 below.
* Accounting identity:
Cash and other reserves
Assets = Equity + Liabilities.
TABLE 27-3
The Initial Balance Sheet of Incidental
Bank and Trust (IB&T)
Equities +Liabilities
Deposits 1,000
IB&T has a reserve of 20 percent of its deposit liabilities. The commercial bank earns money by
finding profitable investments for much of the money deposited with it. In this balance sheet, loans
are its earning assets.
In table 27-3 above
* Amount of loans= (Equities + liabilities) - cash and reserves
* Final change in deposits (for the whole banking system) = Change in Reserves
Required Reserve Ratio (ν)
Where 1/ν is the money multiplier.
EX: If the change in reserves is 100, and the required reserve ratio (RRR) is 20%, the final change
in deposits is:
= 100 = 100 = (100)(5)= 500. In this case the money multiplier =5
* The assumption of no cash drain implies:  in money supply =  in deposits
The change of money supply by commercial banks is not an automatic process. It depends on
1) Risk perceived by banks and
2) Expected change in future interest rates, and
3) The preferences of banks and households. All of these factors have an impact on money supply
in the economy.
TABLE 27-4
IB&T's Balance Sheet Immediately
After a New Deposit of $100
Cash and other reserves
Deposits 1,100
The deposit raises deposit liabilities and cash assets by the same amount. Because both cash and
deposits rise by $100, the bank's actual reserve ratio, formerly 0.20, increases to 0.27. The bank has
more cash than it needs to provide a 20 percent reserve against its deposit liabilities.
TABLE 27-5
IB&T's Balance Sheet after a New Loan
and Cash Drain of S80
Cash and other reserves
*  in loans =  in deposits -  in required reserves
IB&T lends its surplus cash and suffers a cash drain. The bank keeps $20 as a reserve against the
initial new deposit of $100. It lends $80 to a customer, who writes a check to someone who deals with
another bank. When the check is cleared, IB&T suffers an $80 cash drain. Comparing Tables 27-3
and 27-5 shows that the bank has increased its deposit liabilities by the $100 initially deposited and
has increased its assets by $20 of cash reserves and $80 of new loans. It has also restored its required
reserve ratio of 0.20.
TABLE 27-6
Changes in the Balance Sheets of
Second-Generation Banks
Cash and other reserves 16
Deposits +80
+ 64
Second-generation banks receive cash deposits and expand loans. The second-generation banks gain
new deposits of $80 as a result of the loan granted by IB&T, which is used to make payments to
customers of the second-generation banks. These banks keep 20 percent of the cash that they
acquire as their required reserve against the new deposit, and they can make new loans using the
other 80 percent. When the customers who borrowed the money make payments to the customers of
third-generation banks, a cash drain occurs.
TABLE 27-7
The Sequence of Loans and Deposit
After a Single New Deposit of $100
Addition to
2nd-generation bank
3rd-generation bank
4th-generation bank
Sth-generation bank
6th-generation bank
7th-generation bank
Sth-generation bank
9th-generation bank
lOth-generation bank
Total for first 10 generations 446.33
All remaining generations
Total for banking system
The banking system as a whole can create deposit money whenever it receives new deposits. The
table shows the process of the creation of deposit money on the assumptions that all the loans made
by one set of banks end up as deposits in another set of banks {the next-generation banks, that the
required reserve ratio {v) is 0.20, and that banks always lend out any excess reserves. Although each
bank suffers a cash drain whenever it grants a new loan, the system as a whole does not, and in a
series of steps it increases deposit money by l/v, which, in this example, is five times the amount of
any increase in reserves that it obtains.
TABLE 27-8
Change in the Combined Balance Sheets
of All the Banks in the System Following
The Multiple Expansion of Deposits
Cash and other reserves +100
Deposits +500
The reserve ratio is returned to 0.20. The entire initial deposit of $100 ends up as reserves of the
banking system. Therefore, deposits rise by (1/0.2) times the initial deposit-that is, by $500.
TABLE 27-9
Change in the Combined Balance Sheets of All the Banks
in the System Following the Multiple Expansion
of Deposits with a Cash Drain of $20
Cash and other reserves +80
Deposits +400
The reserve ratio is 0.20, and cash drain is 0.05. Only $80 of the initial deposit of $100 ends up as
reserves of the banking system. Deposits therefore rise by (1/0.2) times the $80-that is, by $400. The
cash drain ($20) is 5 percent of the increase in deposits ($400).
Note: Change in Deposits= (1/(1/5) ) ( Change in Res.) = (5) (80)= 400
Change in Loans = Change in Dep. – Change in Res.= 400- 80= 320
THE MONEY SUPPLY : The total stock of money in the economy at any moment is called the
money supply or the supply of money. Economists use alternative definitions of MS.
Definitions of Money Supply: See table 27-10 below. M1 concentrates on the medium- ofexchange function of money. M2 & M3 contain assets that serve the temporary store- of – value
function and are in practice quickly convertible into a medium of exchange.
TABLE 27-10
Money Supply in the United States, November 1997 " I
(billions of dollars)
Demand deposits
Traveler's checks
Other checkable deposits
Money market mutual fund balances
Money market deposit accounts and
savings deposits
Small-denomination time deposits
Large-denomination time deposits
Term repurchase agreements
Term Eurodollars
Institutional money market
mutual funds
2 33.5
The three widely used measures of the money supply are M1, M2, and M3. The narrow definition of
the money supply concentrates on what can be used directly as a medium of exchange. The broader
definitions add in deposits that serve the store-of-value function and can be readily converted to a
medium of exchange.
Note that M1 includes traveler's checks held by the public, which are clearly a medium of exchange.
Within M3, repurchase agreements are funds lent out on the overnight money market, and
Eurodollars are U.S. dollar-denominated deposits in U.S. banks located outside the United States.
M2 and M3 include similar items, with the difference in most cases being that the term deposits are
in MJ and the demand deposits in M2.
(Source: Economic Report of the President, 1998.)
Students should look at SAMA Annual Report for definition and measures of monetary aggregates
in Saudi Arabia.
NEAR MONEY & MONEY SUBSTITUTES: An important debate of monetary policy centers on
what is the appropriate definition of money. The problem arises because some assets perform poorly
as a store- of –value, while others perform poorly as a medium- of – exchange. For example during
times of inflation, currency (or M1 assets in general) may well serve as a medium- of exchange , but
poorly as a store of value. In contrast, heavy gold bars (& M2 and M3 assets) may do the opposite.
Assets that fulfill adequately the store- of – value function and are readily convertible into a
medium of exchange, but are not themselves mediums of exchange (such as M2 & M3) are
sometimes called near money. Usually M1 assets do not earn any income, while M2 & M3 do.
Why would anyone hold M1 assets? It is because of the transaction costs (the cost of inconvenience
in this case) involved in converting assets back and forth from one account into another.
Things that serve as temporary media of exchange but are not a store of value are sometimes called
money substitutes. Credit cards are a prime example.
CHOOSING A MEASURE: The definition of money supply for the purpose of conducting
monetary policy, has been debated among economists at least as early as the eighteenth century. The
specifics of the definition will continue to change over time as new monetary assets are developed to
serve some if not all the functions of money. For the purpose of this course, we will focus on the
medium- of – exchange function of money and hence money will be currency plus deposits that can
be withdrawn and converted on a very short notice.
Question1: What is the difference between total stock of money and GDP?
Question2: How do we classify ATM cards? Are they near monies or money substitutes?
THE CLASSICAL VIEW: Economists of the eighteenth & nineteenth centuries claimed that potential
GDP(Y*) is independent from monetary factors. They distinguished sharply between the "real sector"
and the "monetary sector" of the economy. This is now referred o as the Classical dichotomy.
According to this view:
The allocation of resources, and hence the determination of real GDP, is determined
only by the real sector of the economy.
It is relative prices, including the level of wages relative to the price of commodities, that
matter for this process.
The price level is determined in the monetary sector of the economy. i.e the p- Level is
determined by the rate of growth of money supply (MS.)
If the quantity of money were doubled, other things being equal, the prices of all
commodities and money (nominal) income would double. Relative prices would remain unchanged,
& the real sector of the economy would be unaffected.
The doctrine that the quantity of money influences the level of money prices but has no
effect on the real part of the economy is called the neutrality of money. Money is spoken of as a
"veil" behind which occur the real events that affect material well-being.
1) most modern economists accept the insights of the Classical economists that relative prices are
the major determinant of the allocation of resources, and that the quantity of money has a lot to do
with determining the absolute level of prices.
2) They accept the neutrality of money in the LR when all forces causing change have fully
worked themselves out.
3) However, they do not accept the neutrality of money when the economy is adjusting to the
forces that caused it to change- that is when the economy is not in a state of LR equilibrium.
4) Consequently, they reject the Classical dichotomy of the economy in the SR.
5) The LR neutrality of money makes modern economists stress the strong link between money &
the P- Level, especially over long periods of time.
Figure27-1 below gives long run perspective on prices in the USA. Two things stand out from the
figure. First, there have been periods of dramatic price reductions. Second, there has been more or
less uninterrupted increase in the P- level – positive inflation rates- since the end of World War II.
Figure 27-1
An Index of Producer Prices in the United States
1785-1997 (1967 = 100)
©1999 Addison Wesley Longman
Slide 27.2
The relationship between the interest rate & the price of a bond: If i↑→ Pb ↓ & vise versa why?
Suppose i = 5% per year & the price of a bond, Pb= SR100. At the end of the year, the investor has
SR 105.
if i↓ to 3% how much does the investor need to invest in order to get SR105?
Answer: he needs to invest more than 100, Hence, as i ↓, Pb ↑ and visa versa.
For simplicity, we assume that (wealth) is only Money balances + Bonds.
In a capitalist economy, the interest rate represents the opportunity cost of holding money.
What is the opportunity cost of holding money in an Islamic economy?
Q: If there is an opportunity cost to holding money, why do people hold money?
The motives for the demand for money (Why Do People Hold Money?):1) The Transaction Motive: payments & receipts are rarely synchronized. Thus, people & firms
need to hold money to conduct their transactions. The size of the transaction demand for money is
affected by the size and no. of transactions, which is affected by level of income (GDP). MTr = f (Y+).
2) The Precautionary Motive: To cover the holders of money against emergency situations when
payments are suddenly > receipts. The amount held for those purposes is a function of the cost of
borrowing & the level of income.
MPr = f (i-, y+ ).
3) The Speculative Motive: This was first discussed by John Maynard Keynes & later explained
further by James Tobin, the1981 Noble Laureate in Economics. This demand for money is driven
by speculative expectations about future interest rates & the prices of stocks and bonds. MSP= f(i-).
Because their prices fluctuate, stocks and bonds are risky assets. Many H.H & firms are risk averse.
Investors must balance the expected interest or profit from bonds and stocks against the risk of
price fluctuations. Thus, they try to diversify their holdings between money and financial assets.
Real values are measured in purchasing power units; nominal values are measured in money units.
The real demand for money is the nominal quantity divided by the price level: md = Md/ P. If
increases in nominal money balances are matched by a rise in the P- Level, the increase in real
balances is that much reduced. Demand for real money balances is determined by real GDP (Y) & i.
However, the nominal demand for money, Md = f ( p+, y+, i-). So if y & i are held constant, a rise in P
increases Md proportionately.
Note: the three motives are not "visible" in reality, but each is partially responsible for the total
demand for money. See FIG 28-1 below.
The relationship between i & Md is called the liquidity preference function (LP).
Figure 28-1
The Demand for Money as a Function of Interest Rates, Income, and the Price Level
©1999 Addison Wesley Longman
Slide 28.2
Monetary Equilib. & Aggregate Demand
The liquidity Preference (Portfolio Balance) Theory of the Interest Rate (A
Keynesian Theory of what determines the interest rate): Monetary equilib. occurs when
the supply and demand for money are equal. In the money market, the interest rate is the "price"
that adjusts to bring about equilib. The LP theory implies that the interest rate is determined in the
monetarysector, rather than the real sector of the economy, (contrary to the neo-classical belief.)
Figure 28-2
The Liquidity Preference Theory of Interest
Slide 28.3
©1999 Addison Wesley Longman
If, for some reason, the economy is at i1 → ED for money. How does the Mkt adjust? ED for
money→ people sell some bonds ( or any other assets they have) → Pb↓ → i↑→ the opp. cost of
holding money ↑→ demand for money ↓ (moving upward along LP-Function) until the economy
rests at i0. Alternatively: if i=i2 , → ES: The scenario is reversed.
The Quality of theory of money
The quantity theory of money is a famous theory that relates
the quantity of nominal money in an economy to its price level.
The theory can be set out in the following equations. Equation
(1) states that the demand for nominal money balances, Dm,
depends on the value of transactions as measured by nominal
GDP, which is real GDP, Y, multiplied by the price level. P:
Dm = kPY
Equation (2) states that the supply of nominal money, M, is
exogenously determined by the central bank (or under the gold
standard by past gold flows from abroad) at some given level
M = Ms,
Equation (3) states the equilibrium condition that the demand
for money must equal the supply:
Dm = Ms,
Substitution from eqns (2) and (3) into eqn (1) yields.
Ms = kPY
Rearranging (4) gives
P = Ms/kY
The original classical quantity theory assumes that K is a
constant given by the transactions demand for money and that
Y is constant because potential GDP is maintained.
Letting (1/kY) = a we can write:
P = aMs.
In words, the price level is determined by the quantity of
money. By taking first differences (ΔP – aΔM), we derive the
prediction that changes in the price level will be proportional to
changes in the quantity of money, or equivalently that the rate
of inflation will be equal to the rate of growth of the money
supply if Y remains constant at its potential level. Alternatively,
if Y is growing at a constant rate, a constant price level requires
that the money supply grows at the same rate. Although we
know that GDP does not stay constant at its potential level, but
instead cycles around it,
the theory can be interpreted as showing what will happen
when GDP is at potential.
The quantity theory is often presented using the equation of
MsV = PY,
Where V is the velocity of circulation of money. From equation
(5), V is just the reciprocal of K. Thus it makes no difference
whether we choose to work with K or V. So if K is assumed to
be constant, V must also be constant.
Velocity can be interpreted as showing the average amount of
‘work’ done by a unit of money. If annual money GDP is £600
billion and the stock of money is £200 billion, on average each
pund’s worth of money is used three times to create the values
added that compose GDP. An example may help to illustrate the
interpretation of each. Suppose that the stock of money that
people wish to hold equals one-fifth of the value of total
transactions. Thus K is 0.2, and V, the reciprocal of K, is 5. If
the money supply is to be one-fifth of the value of annual
transactions, each pound must be ‘used’ on average five times.
The modern version of the quantity theory does not assume
that k and V are exogenously fixed. However, it does argue that
they will not change in response to a change in the quantity of
money. Considering only potential GDP and dividing (7) by Y we
P = MV/Y.
If we assume that V is constant and use a for the constant value
of V/Y, we obtain, once again, that
Which only shows that it does not matter whether we state the
theory in terms of k, the fraction of GDP that people wish to
hold as money balances or V, the amount of times that the
typical unite of money must change hands to create the existing
level of GDP.
The Transmission Mechanism: The mechanism by which disturbances in the monetary
(financial) sector are transmitted to the real sector.
It goes in 3 stages.
1) Disturbance of Md & Ms affects the interest rate.
2) From the interest rate to Investment, consumption & AE
3) From AE into AD & GDP
See Fig28-3 ,-4 -5 & -6
Monetary equilib. can be disturbed either because of a change in money supply or money demand.
Figure 28-3
Monetary Disturbances and Interest Rate Changes
©1999 Addison Wesley Longman
Slide 28.4
Figure 28-4
The Effects of Changes in the Money Supply on Investment Expendi ture
©1999 Addison Wesley Longman
Slide 28.5
Figure 28-5
The Effects of Changes in the Money Supply on Aggregate Demand
©1999 Addison Wesley Longman
Slide 28.6
Figure 28-6
Transmission Mechanism for an Expansionary Monetary Shock
©1999 Addison Wesley Longman
Slide 28.7
The transmission mechanism shows the very important role of the interest rate in
“regulating” the capitalist economy. It affects both the monetary & real sectors of the
AGG . DEMAND & AGG .Supply: A rise in money supply causes AD to shift upward, but because
the price level may rise (SRAS is upward sloping), the increase in real GDP is less than the horizontal
shift of AD. SEE Fig 28-7 below.
Figure 28-7
The Effects of Changes in the Money Supply
©1999 Addison Wesley Longman
Slide 28.8
A Further look at the slope of the AD:In previous chapters, we explained the downward slope of AD on the basis of:
The wealth effect:
As P-level ↑→real wealth ↓→ AE↓→ AD↓
The substitution effect: as P-level ↑→ people substitute foreign goods for
domestic goods → AE ↓ →AD ↓
Now the interest rate effect: if P-level ↑→Md ↑, if Ms=Ms0 (i.e. central bank
does not increase MS) → i ↑ → (I &C )↓ →AD↓
This link is very important because it is known empirically that the interest rate is the
most important link between the monetary sector & real expenditure flows.
More on The Automatic Adjustment Mechanism:
a) The rise in the demand for factors of production →their prices↑→ profits ↓
→firms reduce output & employment of factors of production →SRAS shifts upward.
b) As AD ↑→ P ↑→ i↑ (provided MS is constant) →I↓→ AE↓, AD↓(a movement
along the AD).
Thus, the interest rate effect reinforces the automatic adjustment mechanism to close a
GDP gap in the economy.
. Note that (a) above, operates on the supply side of the market and (b) operates on the demand side
of the market.
 An Important Proposition: A sufficiently large increase in the P-level will
eventually eliminate any inflationary gap, provided there is no further increase in
money supply.
Frustration of The Adjustment Mechanism:
Q: what happens if the central bank continues to increase MS? See fig. 28-8 below.
Figure 28-8
Frustration of the Adjustment Mechanism
©1999 Addison Wesley Longman
Slide 28.9
An Expansionary Monetary Policy → AD0 → AD1→ inflationary gap (y↑ &P↑). If this is a once and –for- all increase in Ms → the automatic adjustment mechanism will close the gap → SRAS
shifts upward. However, if the central bank continues its expansionary monetary policy, the
automatic adjustment mech. is frustrated, AD shifts to AD2, GDP stays at Y0. However, P↑↑.
Inflation is said to be validated.
The Strength (effectiveness) of the Monetary Policy(V.V.Imp.): Fig.28-9 below shows that
the adjustment mechanism operates to insure that in the LR, regardless of the rate of growth of the
money supply, real GDP converges to its potential level. This is often referred to as the long run
neutrality of money. In other words, in the long run changes in the rate of growth of money supply
cannot influence potential real GDP. This is a much- debated issue.
Figure 28-9
The Long-Run Neutrality of Money
©1999 Addison Wesley Longman
Slide 28.10
Short Run Effects Of Money Supply: Two views on The Strength of Monetary policy.
10 ( V.V. Imp.)
See Fig 28-
Figure 28-10
Two Views on the Strength of Monetary Changes
Slide 28.11
©1999 Addison Wesley Longman
Effective Monetary Policy Requires Two Conditions:
1) a relatively inelastic function of the demand for money (LP has relatively sharp slope)
a relatively elastic demand for investment. (MEI slope is relatively small).
What does each condition mean?
The monetarists' view is that monetary policy is effective (the upper panel of the figure.)The lower
panel represents the Keynesian view that monetary policy is ineffective. The Keynesian alternative
to activate the economy would be fiscal policy.
END of Chapter 28
Chapter 29: Monetary Policy
Policy Instruments:
Intermediate Targets
Ms, i, ER
Policy Variables (Ultimate Targets)
GDP(y), P - level (P) & Unemp. (u)
I) Policy Instruments: - are tools in the hands of the Central Bank to conduct Monetary Policy.
These are:
1) Open Market Operations (OMO):The central bank buying & selling govt. securities (bonds).
If the C.B. would like to increase money supply, the C. B. buys govt. securities from individuals,
firms, or the gov't. and gives them money in return. It issues a check against itself. The check
holder deposits it in his bank account → Deposits at banks ↑→ The Bank deposits the check in its
acct. at the CB.→ Bank reserves (or the monetary base= C +R)↑→ the bank's ability to extend loans
& accept deposits ↑. To reduce Money Supply, the C.B. sells govt. securities. See table 29.1
2) Required Reserves Ratio (RRR): assuming banks are loaned up (no excess reserves). If the CB
increases the RRR, banks must reduce deposits. This is done by:
not extending new loans
calling back some old loans →deposits at Banks ↓ →MS ↓
The impact on MS of increasing RRR is definite i.e it reduces money supply.
However, if the Central Bank decreases RRR→ Banks will have more reserves →Banks can, but do
not have to extend more loans and accept more deposits. The impact on MS of reducing RRR is not
definite. It depends upon Banks' decisions to lend, and decisions of H.H. and Firms to borrow.
The Discount Rate:- is the interest rate at which the Central Bank lends to commercial banks
to meet short terms shortages of reserves. The CB is said to be a lender of last resort. The operation
is conducted through the discount window. The discount rate as a cost of borrowing, affects directly
interest rates charged by commercial banks. It is called the discount rate because for banks to
borrow from the CB, they sell some of their holdings of government bonds to the CB at a discount of
the face value.
In Saudi Arabia, the discount rate (when banks borrow from SAMA) is called the "Repo". When
banks have excess liquidity and deposit additional reserves with SAMA, they get an interest rate
called "Reverse Repo."
4) Credit Controls: like maximum interest rates on consumer loans, mortgage rates, margin
requirements…. Etc. Check SAMA and CBB (Central Bank of Bahrain) web cites for consumer
credit controls.
A Review of The Transmission Mechanism:
Figure 29-1
Monetary Policy and Macroeconomic Equilibrium
Sli de 29.2
©1999 Addison Wes ley Longman
II) Policy Variables & Policy Instruments:
The CB policy variables (The variables that it would like to influence) are real GDP, the P-Level, &
unemployment. Monetary policy shifts the AD curve and changes P & Y simultaneously. Therefore,
the CB cannot control both independently. If it targets one, it must accept the consequences for the
other. For this reason, the CB often, but not always, concentrates on nominal GDP, (PY) as a target
in the SR. Sometimes the CB may want to target inflation. However, in the wake of the current
financial crisis, CB’s of industrial countries, like the USA, have been targeting unemployment, and
later they shifted to targeting the inflation rate. See the article at the end of the chapter.
Monetary policy and LRSA: It is argued by some economists (called monetarists) that in LR,
monetary policy have no impact on LRAS, and thus in LR monetary policy can only influence the Plevel. This is called the principle of the neutrality of money. This is a highly controversial issue. The
alleged LR neutrality of money (that money cannot affect LR GDP) led many CB's to concentrate
on the inflation rate as the LR target of monetary policy. The European Central Bank (ECB) is an
example. The first Chairman of the ECB, Wilhelm Duisenberg said in the inaugural speech of the
ECB (January 1999) "Monetary policy is neither the cause, nor the cure of unemployment." This
means that the prime policy target variable for the ECB has been price level stability (i.e. fighting
inflation). Consequently, the charter of the ECB does not allow it to purchase government bonds,
and thus is not supposed to participate in financing budget deficits of the member governments.
Governments are supposed to float bonds in the market. This has changed a bit, however, with the
current financial crisis, since 2008, as the ECB has been participating in stabilizing European
economies, and purchased large amounts governments' bonds. The process has been called “
Quantitative Easing”. Send end of the chapter for an article on this issue.
III) Intermediate Targets: i, MS, & ER
Daily information about policy variables(Y, P, &U) is rarely available. Hence, policy makers
typically use intermediate targets indicated above. To serve as a target, a variable must satisfy
two criteria. First, information about it must be available on frequent basis- daily if
possible. Second, its movements must be closely correlated with those of the policy
Since the C.B. can not effect directly the policy variables (Y, P, U) it tries to influence what
is called intermediate targets (the Ms or i). These are not independent from each other, targeting
one automatically determines the other. See Fig,29-2 below.
It may sound immaterial which variable to target. In reality, they are not the same.
Figure 29-2
Alternative Intermediate Targets
©1999 Addison Wesley Longman
Slide 29.3
Debate about Intermediate Targets
Targeting the Interest Rate:Monetarists argue that the interest rate is pro-cyclical (i.e. it rises in booms, & decreases in
recessions). Thus, it is hard to tell whether the interest rate is changing due to the phase of the
business cycle or due to C.B Policy. Monetarist Prefer the C.B. concentration on monetary
aggregates (the growth rate of money supply), in particular on M1.
The Keynesian Counter Argument:1) Targeting money supply is a reasonable policy only if the function of the demand for money is
stable. In many cases, it is not. In the figure 29-3 below, the C.B. fights inflationary pressures by
reducing MS (so that i ↑). However, if L.P. function isn’t stable and for some reason LP↓, i ↓ instead
of rising,
2) Also, which monetary aggregate to target? Suppose CB targets M1. If there is change in
households preferences from demand deposits into saving deposits → M1↓ & M2↑. The CB may
have to change its target accordingly.
Most central banks today (Before the current financial crisis 2008- ) concentrate on the interest rate
as their prime intermediate target.
Figure 29-3
Intermediate Targets When the Demand for Money Shifts
©1999 Addison Wesley Longman
Slide 29.4
The Role of Exchange Rate:Changes in the ER can affect X &M →affect AE & AD→(Y&P)
Two sources of change in ER:a) If X↑→ demand for the country's currency ↑→ ER↓(currency appreciates)→ (AE=AD) ↑→P↑
in other words, the sources of change in ER is in this case is a rise in demand for exports. The CB
may try to curb inflation by trying to restrain the economy close to its potential.( Does this sound a
wise policy ?)
b) The other case:- suppose there is a rise in the demand for the country’s financial assets (stocks
& bonds )→demand for currency of the country ↑→ ER↓ (currency appreciates) → (X ↓ & M ↑ )→
AD ↓ →P↓. The C.B may try to stimulate the economy by trying to keep GDP close to its potential
Movements in the ER can provide valuable information for the conduct of monetary policy.
The two cases above show that although in both cases the ER appreciates, yet the source of change
could have very different impact on the conduct of monetary policy and the economy.
A Historical Debate (See Application 29-1): Monetarists believe that monetary policy is
very powerful in affecting the economy in the SR. Keynesians believe otherwise. The source of
debate goes at least as early as the great depression, which was accompanied,( may have been
started), by bank failures in the US →MS↓→AD↓
The counter argument was that the great depression in Canada & UK wasn’t
accompanied by bank failures, so there wasn’t a reduction in MS.
The debate involved more than just the size of the effect of change in MS. It focused on
factors that are thought to render monetary policy ineffective. The debate centered on lags &
Sources of execution lags in monetary policy: monetary policy may not be effective
because of execution lags due to
(1) lags in creation and destruction of demand deposits: it depends upon decisions by both
commercial banks, households and businesses.
(2) Investment plans take time to be decided upon & implemented
(3) The full multiplier effect takes time to show its impact on the economy.
The long & variable execution lags makes monetary fine tuning difficult & may be
destabilizing to the economy.
A MONETARY RULE: Monetarists believe that:
Monetary policy is a potent (effective) force of expansionary & contractionary pressures;
Monetary policy works with long & variable lags;
The CB may indulge in sudden & sharp reversals in its policies.
Monetarists believe that the CB should stop stabilizing the economy. Instead, it should expand MS,
year in and year out at a constant rate that is equal to the rate of growth of real GDP. When the rate
of growth shows signs of long-term change, the CB adjusts the rate of money expansion.
Many other economists disagree with the monetarists and believe that fine tuning of
MS can in principle reduce cyclical GDP fluctuations.
The possibility of an unstable function of the demand for money, explained earlier, is mentioned as
a major counter argument. In this case, a constant –money rule may be destabilizing.
Inflation & Monetary Growth: Does an increase in the rate of money growth rate necessarily
cause a rise in the inflation rate? The relationship is not so tight to be viewed as automatic or
mechanical, nor does it appear to resolve the issue of causality. In other words,
is it as MS ↑ → P-level ↑ ?
Or is it that
as the P-level ↑ , MS has to rise ?
Historical experience shows that unless the economy is under great recession or depression, there is
an unmistakable connection between MS & the P- level. Monetarists believe in the first line of
causality. Others believe money expansion was mainly a passive reaction to price increases caused
by aggregate supply shocks.
An important lesson : a sharp reduction in monetary growth led to high interest rates, a sever
recession, and a dramatic reduction in inflation in the USA in the early 1980s.
The experience of the 1990's ,shows that in the presence of AD shocks, GDP growth and inflation
are positively related. In the presence of AS shocks, GDP growth and inflation are negatively
related. The growth of the American (and other western) economies in the late 1990's can be
explained by the following examples of AS shock events:
The collapse of the Southeast Asian economies that began in 1997-1998 led to a
reduction in those countries' demand for raw materials. The reduction in world input prices implied
a positive AS shock to western economies. But it also meant a negative AD shock (reduction of
exports) to oil exporting countries.
Also, as the currencies of Asian countries depreciated, the cost of imports from these
counties declined, thus reinforcing the Positive AS shock to western economies.
The collapse of the USSR (the former Soviet Union) in the early 1990s enabled the
USA to reduce military spending & relieved resources for civilian use.
The Stock Market: How would a negative shock to the stock mkt. (such as the crash of October 19,
1978 in the USA) affect the economy & monetary policy? How was a crisis avoided? A fall in stock
of money and decrease in prices coupled with rising interest rates was expected to slow economic
expansion. The crash had a smaller effect on the American economy than expected. This was largely
due to strong infusion of liquidity by the Fed into the American economy. A similar infusion of
liquidity took place in the aftermath of the collapse of Lehman Brothers Bank and the beginning of
the current financial crisis in September 2008.While it did not prevent a crisis, it reduced the
severity of its impact on the Industrial economies.
How would a positive shock to the stock mkt. (Such as that of 1994-1998) affect the economy &
monetary policy? A rise in prices of bonds implies wealth of H.H rise, which in turn implies
consumption rises. The American economy was already heating up. Because of the height of the
stock market (Dow Jones reached 9000 points) a crash was expected. This would have decreased
H.H wealth significantly & reduce AD.
What was the impact of the crash of he Saudi Stock Market in May 2004
and the Big Stock market Crash of February, 2006? How different was it
from the US case?
CONCLUSIONS: 1) The economy is too complex for simple monetary rule to provide the best
monetary policy.
2) Monetary policy can vary between being restrictive & expansive for reasons that are
related to shifts in the private sector's demand for money, and not necessarily related to
change in CB policy.
3) To judge the stance (position) of current monetary policy, the CB needs to monitor a
number of variables.
4) Contrary to what was once believed, monetary policy is a very potent tool for
influencing AD. It may be difficult, however to predict how fast & how strongly a given
policy will operate, but if the CB is prepared enough, it can reduce inflation.
5) There is room for debate about whether the result is worth the cost (in terms of GDP).
More on the neutrality of money
Are there real effects when the economy is hit by a
temporary monetary shock? Given a fully
anticipated, fully accommodated two percent
inflation, this means temporary increases in the
rates of monetary expansion and inflation above 2
per cent. However, when considering neutrality
theories it is simpler to study an economy with a
stable price level, in which case a monetary shock
means a once-and-for-all injection of new money
and a temporary inflation that causes a once-andfor-all increase in the price level.
Short-run neutrality
An extreme version of neutrality states that
anticipated monetary shocks have no real short-run
effects. Assume a monetary shock that would raise
the price level by 10 per cent. If it is perfectly
foreseen, everyone will alter their prices when the
shock occurs. Hence, there will be no changes in
relative prices and no real effects. In practice,
because monetary impulses cannot be generated
instantaneously, it takes real time for money to be
injected into the economy, and for the effects to
work out. Although these transition effects are not
included in the equilibrium theories of micro
economics, they are important in practice. An
increment to the money supply is typically fed into
the system by the central bank buying short-term
securities to drive down the short-term interest
rate and increase lending to their customers. This
increases demand in the first instance on the part
of those who sell to the recipients of the new
loans. Profit maximization requires that those who
first gain an increase in the demand for their
products should raise output (and possibility prices)
even if they know that eventually the prices of
everything else will rise and they will be induced to
go back to their original level of output at the
higher price. So all that is needed for short-run
non-neutrality is that the monetary impulse is
injected over a period of time, that not all agents
receive the injection initially, and that it takes time
to work through the economy—no one has ever
identified a real economy where this is not so.
Indeed, if money was neutral in the short run, the
sort of monetary policy that is practiced by the
central banks of many countries, including the bank
of England, would be ineffective.
Long-run neutrality: A more controversial
version of the doctrine of neutrality states that the
monetary shocks have no real effects over the long
run. Note that the effects of changes in the price
level are typically only studied in macro models.
Virtually all Micro theory texts deal with real
quantities and relative prices, while saying nothing
absolute prices or other monetary effects. Because
they do not include the monetary side of the
economy, they are not set up to consider the
question of the possible interactions between the
real and monetary sides over any run. In many
major macro models money is neutral.. Thus the
amount of money determines only the level of
money prices and has no effect on real equilibrium
GDP. Although there is a monetary sector in these
models, it is only specified in terms of macro
variables. The real micro relations that, when
disturbed in the short run might have long run
effects are not included in the model. Both of these
equilibrium types of model, micro and macro, omit
some key behaviors in the real economy that blurs
the division between the real and the monetary
sectors. The structure of the economy is continually
being altered by endogenously generated changes
in product, new production processes, and new
firms are to a great extend financed by credit. Thus
credit conditions can alter the flow of production
based on new technologies. So a once-and-for-all
bout of credit contraction designed to reduce the
quantity of money (or reduce its rate of growth),
not matched in other countries, can restrict the
flow of funds to the local firms innovating some
new technology. This can give a first entry
advantage to firms in other countries and thus
affect the future course of technological evolution,
and hence the nature of employment, GDP, and
economic growth over the foreseeable future.
There are other possible long-lasting effects of
a monetary disturbance. For example, since
contracts set in monetary units have various
lengths to run, from weeks to many years,
monetary disturbances have real effects on the
distribution of income and wealth. Such effects can
be long-lasting and profound. Also a phenomenon
called hysteresis shoes that the persistence of large
negative GDP gaps, such as occur in a recession
and can be induced by restrictive monetary policy,
can have long-lasting effects on the labor force
that can in turn affect the level of potential GDP.
For these reasons some economists, while
admitting that money is neutral in the long term in
many economic models, hold that it is not neutral
in the real economy. They argue that the short-run
behavior that occurs over the business cycle or
when the economy is hit by a monetary shock, can
have long-term effects on such real macro values
as potential GDP and the growth rate.
Jeffrey Frankel
Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, previously served as
a member of President Bill Clinton’s Council of Economic Advisers. He directs the Program in
International Finance and Macroeconomics at the US National Bureau of Economic Research, where he is
a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery.
The Death of Inflation Targeting
16 May 2012
CAMBRIDGE – It is with regret that we announce the death of inflation targeting. The monetary-policy
regime, known as IT to friends, evidently passed away in September 2008. The lack of an official
announcement until now attests to the esteem in which it was held, its usefulness as an ornament of
credibility for central banks, and fears that there might be no good candidates to succeed it as the preferred
anchor for monetary policy.
Inflation targeting was born in New Zealand in March 1990. Admired for its transparency, and thus for
facilitating accountability, it achieved success there, and soon in Canada, Australia, the United Kingdom,
Sweden, and Israel. It subsequently became popular in Latin America (Brazil, Chile, Mexico, Colombia,
and Peru) and among other developing countries (including South Africa, South Korea, Indonesia,
Thailand, and Turkey).
One reason that IT gained such wide acceptance as the monetary-policy anchor of choice was the demise
of its predecessor, exchange-rate targeting, in the currency crises of the 1990’s. Pegged exchange rates
had come under fatal speculative attack in many of these countries, whose authorities thus needed
something new to anchor the public’s expectations concerning monetary policy. Inflation targeting was in
the right place at the right time.
In the early 1980’s, prior to the reign of exchange-rate targeting, the fashion was money-supply targeting,
the brainchild of the monetarist Milton Friedman. But that rule succumbed rather quickly to violent
money-demand shocks, though Friedman’s general argument – that a credible commitment to low
inflation requires favoring rules over discretion – remains very influential.
Inflation targeting was best known as a rule that instructed central banks to set – and try their best to attain
– a target range for the annual rate of change of the consumer price index (CPI). Close cousins included
targeting the price level instead of the inflation rate, and targeting core inflation (the CPI minus volatile
food and energy prices).
There were also proponents of flexible inflation targeting, who held that it was fine to put some weight on
real GDP growth in the short run, so long as there was a clear longer-term target for CPI inflation. But
some felt that if the definition of IT were stretched too far, it would lose its meaning.
Regardless of the form it took, IT began to receive some heavy blows a few years ago
(analogous to the crises that hit exchange-rate targets in the 1990’s). Perhaps the biggest setback hit in
September 2008, when it became clear that central banks that had been relying
on IT had not paid enough attention to asset-price bubbles.
Central bankers had told themselves that they were giving asset markets all of the attention that they
deserved, by specifying that housing prices and equity prices could be taken into account to the extent that
they implied information regarding goods inflation. But this escape clause proved insufficient: when the
global financial crisis hit (suggesting, at least in retrospect, that monetary policy had been
too loose from 2003 to 2006),
it was neither preceded nor followed by an upsurge
in inflation.
That the boom-bust cycle could occur without inflation should not have come
as a surprise. After all, the same thing happened when asset-price bubbles
ended in crashes in the United States in 1929, Japan in 1990, and Thailand
and Korea in 1997. And the hope of long-time US Federal Reserve Chairman
Alan Greenspan that monetary easing could clean up the mess in the aftermath
of such a crash proved wrong.
While the lack of response to asset bubbles was probably IT’s biggest failing, another major setback
was inappropriate responses to supply shocks and terms-of-trade shocks. An economy is
healthier if monetary policy responds to an increase in the world prices of its exported commodities by
tightening enough to cause the currency to appreciate. But CPI targeting instead tells the central bank to
tighten policy in response to an increase in the world price of imported commodities – exactly the opposite
of accommodating the adverse shift in the terms of trade.
It is widely suspected, for example, that the reason for the European Central Bank’s otherwise puzzling
decision to raise interest rates in July 2008, as the world was sliding into the worst recession since the
1930’s, was that oil prices were just then reaching an all-time high. Oil prices are given substantial weight
in the CPI, so stabilizing the CPI when dollar-denominated oil prices go up requires euro appreciation visà-vis the dollar.
One candidate to succeed IT as the preferred nominal monetary-policy anchor has lately received some
enthusiastic support in the economic blogosphere: nominal GDP targeting. The idea is not new. It had
been a candidate to succeed money-supply targeting in the 1980’s, since it did not share the latter’s
vulnerability to so-called velocity shocks.
Nominal GDP targeting was not adopted then, but now it is back. Its fans point out that, unlike IT, it
would not cause excessive tightening in response to adverse supply shocks. Nominal GDP targeting
stabilizes demand – the most that can be asked of monetary policy. An adverse supply shock is
automatically divided equally between inflation and real GDP, which is pretty much what a central bank
with discretion would do anyway.
A dark-horse candidate is product-price targeting, which would focus on stabilizing an index of producer
prices rather than an index of consumer prices. Unlike IT, it would not dictate a perverse response to
terms-of-trade shocks. Supporters of both nominal GDP targeting and product-price targeting claim that
IT sometimes gave the public the misleading impression that it would stabilize the cost of living, even in
the face of supply shocks or terms-of trade-shocks, over which it had no control.
Inflation targeting is survived by the gold standard, an elderly distant relative. Although some eccentrics
favor a return to gold as the monetary anchor, most would prefer to leave this relic of another age to its
peaceful retirement.
This article is available online at:
Copyright Project Syndicate -
Explainer: How Does the fed Stimulate the Economy? Price easing vs.
Quantitative Easing (QE)
By Mark Thoma MONEYWATCH November 14, 2013, 5: 58 PM
(MoneyWatch) In her testimony Thursday morning in front of the Senate Banking Committee, Federal
Reserve Chair nominee Janet Yellen emphasized that one of the Federal Reserve's primary duties is
to pursue its dual mandate for maximum employment and stable prices.
The Fed attempts to pursue these two goals through changes in its target interest rate. For example, it
decreases this rate when the economy is struggling, and it increases the target interest rate when inflation is
too high. But how does the Fed do this? How does it change interest rates? And what happens at times like
now when unemployment is too high, inflation is not a problem and interest rates are already as low as they
can go? If the Fed cannot lower interest rates further, how does the it pursue its dual mandate?
Open market operations and the federal funds rate
The specific interest rate the Fed targets is the federal funds rate. This is the rate a bank pays to
borrow reserves from another bank overnight, so it's a very short-term rate. For example, if one
bank has reserves in excess of the amount it is required to hold by regulation, and another bank
falls short of its required reserves, the bank with excess reserves can lend to the bank with a
shortage. The interest rate on the loan is the federal funds rate, and it is determined by the supply
and demand for reserves.
In ordinary times, the main tool the Fed uses to control the supply of reserves and hence the
federal funds rate is purchases and sales of T-bills (T-Bills are the "IOUs" the Treasury issues
when the Federal Government borrows money from the public). For example, suppose the Fed
purchases a $10,000 T-Bill from a bank. To pay for the T-Bills, the Fed creates new money (it's
easiest to think of this as paper money, but it's mostly electronic), and credits the bank's reserve
account for $10,000 in return for the T-Bill.
This trade of newly created money for the T-Bill causes the bank's reserves increase by $10,000,
and the increased supply of bank reserves lowers the price of reserves which is the federal funds
rate. If the transaction is with an individual or financial firm rather than a bank, it works essentially
the same. In this case the Fed pays for the T-Bills with a check. When that check is deposited into
a bank the Fed honors the check by crediting the bank with newly created reserves.
When the Fed wants the target rate to go up, it does the opposite and sells T-Bills to banks or to
the public. When the bank or the individual pays for the T-Bill, the result is that bank reserves fall
by the amount of the sale, and the reduced supply of reserves puts upward pressure on the
federal funds rate.
How do changes in interest rates affect the economy?
Since all interest rates tend to move together -- the supply of bank reserves relative to demand is
a measure of the tightness of looseness of credit generally -- when the Fed increases or
decreases its target federal funds rate, that increases or decreases interest rates more generally.
The effects of these interest rate changes on the broader economy come mainly through changes
in consumption, business, investment, and the construction of new housing. When interest rates -the cost of borrowing money -- fall, the purchase of consumer durables tends to rise. Then both
business and housing investment tend to rise as well (though less so when the economy is in
recession). This increase in spending by households and businesses stimulates the economy and
increases output and employment.
And, of course, when interest rates rise, perhaps to fight inflation in an overheated economy, the
opposite happens. The consumption of durables, business investment, and housing construction
fall and this slows the economy down.
How does quantitative easing differ from traditional policy?
Traditional policy works through what we might call "price easing." As the quantity of reserves is
increased through open market operations, the price of reserves -- the federal funds rate -- falls
and that stimulates the economy as described above.
But once the target interest rate hits zero (interest rates cannot be negative) and it cannot be
lowered further, how can the Fed pursue its dual mandate?
The answer is that it can continue to purchase financial assets and increase the quantity of bank
reserves, i.e. it can pursue "quantitative easing" once "price easing" has hit the lower bound (and
the Fed has also broadened the types of financial assets it purchases beyond T-Bills as it has
pursued quantitative easing. For example, it has also purchased mortgage backed securities).
How does quantitative easing impact the economy? Traditional policy uses changes in interest
rates to stimulate or slow down the economy, but since a fall in the target interest rate is not
possible when it is at the lower bound, as now, how does increasing the quantity of reserves
stimulate the economy?
Quantitative easing works through several channels. First, as the Fed creates more and more
reserves, some of those will be used to purchase financial assets, and that tends to cause their
prices to rise. That's one reason why we generally see increases in stock values during
quantitative easing. The resulting increase in wealth tends to stimulate more spending.
Quantitative easing also puts downward pressure on exchange rates, and that should stimulate
exports and decrease imports, which provides another means to stimulate the economy.
Finally, large increases in bank reserves tend to increase inflation expectations, and when people
are worried that prices will rise in the future they tend to purchase more now and that provides
another means to stimulate the economy. The increase in inflationary expectations also lowers
real interest rates (interest rates adjusted for inflation), and that stimulates business investment,
housing, and the consumption of durables.
However, while quantitative easing can impact the economy, it is not as powerful as traditional
"price easing," or interest rate lowering policy. Thus, quantitative easing may be able to ease a
recession somewhat. But as we are seeing right now, it is not enough by itself to spur the
economy to a speedy return to full employment.
© 2013 CBS Interactive Inc.. All Rights Reserved.
Mark Thoma is a macroeconomist and time-series econometrician at the University of Oregon. His research focuses
on how monetary policy affects the economy, and he has also worked on political business cycle models. Mark is
currently a fellow at The Century Foundation.
A very important article below: QE ended in the USA by the end of October 2014. Below is an article that explains the
history and impact of QE on the American economy.
Quantitative Easing Is Ending. Here’s What It Did, in Charts. -
How Does the Bank of England Do QE?
Martin Feldstein
Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of
the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of
Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's
Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's
Economic Recovery Advisory Board. Currently, he is on the board of directors of the
Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit,
international body that seeks greater understanding of global economic issues.
JAN 29, 2016
The Shortcomings of Quantitative Easing in Europe
CAMBRIDGE – Why has the US Federal Reserve’s policy of quantitative easing been so
much more successful than the version of QE implemented by the European Central Bank?
That intellectual question leads directly to a practical one: Will the ECB ever be able to
translate quantitative easing into stronger economic growth and higher inflation?
The Fed introduced quantitative easing – buying large quantities of long-term bonds and
promising to keep short-term interest rates low for a prolonged period – after it concluded
that the US economy was not responding adequately to traditional monetary policy and to
the fiscal stimulus package enacted in 2009. The Fed’s chairman at the time, Ben Bernanke,
reasoned that unconventional monetary policy would drive down long-term rates, inducing
investors to shift from high-quality bonds to equities and other risky securities. This would
drive up the value of those assets, increasing household wealth and therefore consumer
The strategy worked well. Share prices rose 30% in 2013 alone, and house prices increased
13% in the same twelve months. As a result, the net worth of households increased by $10
trillion that year. The rise in wealth induced consumers to increase spending, which restarted
the usual expansionary multiplier process, with GDP up by 2.5% in 2013 and the
unemployment rate falling from 8% to 6.7%. The expansion continued in subsequent years,
bringing the current unemployment rate down to 5% – and the unemployment rate among
college graduates to just 2.5%.
The ECB has been following a similar strategy of large-scale asset purchases and extremely
low (indeed negative) short-term interest rates. But, although the policy is the same as the
Fed’s, its purpose is very different.
Because Europe lacks the widespread share ownership that exists in the United States,
quantitative easing cannot be used to stimulate consumer spending by raising household
wealth. Instead, a major if unspoken purpose of the ECB’s low-interest-rate policy has been
to stimulate net exports by depressing the value of the euro. The ECB succeeded in this, with
the euro’s value falling by some 25% – from $1.40 in the summer of 2014 to $1.06 by the
fall of 2015.
I have been an advocate of reducing the value of the euro for several years, so I think this
strategy was a good one. But, although the fall in the value of the euro has stimulated the
eurozone’s net exports, the impact on its members’ exports and GDP has been quite limited.
One reason for this is that much of the eurozone countries’ trade is with other eurozone
countries that use the same currency. Moreover, exports to the US don’t benefit much from
the decline of the euro-dollar exchange rate. European exporters generally invoice their
exports in dollars and adjust their dollar prices very slowly, a point made clear in an
important paper that Gita Gopinath of Harvard presented at the Federal Reserve’s Jackson
Hole conference in August 2015.
As a result, total net exports from the eurozone rose less than €3 billion ($3.2 billion)
between September 2014 and September 2015 – a negligible amount in an €11 trillion
A further motive of the ECB’s bond purchases has been to increase the cash that eurozone
banks have available to lend to businesses and households. But, as of now, there has been
very little increase in such lending.
Finally, the ECB is eager to raise the eurozone inflation rate to its target of just under 2%. In
the US, the QE strategy has increased the “core” inflation rate – which excludes the direct
effect of declining prices of energy and food – to 2.1% over the past 12 months. This has
been a by-product of the increase in real demand, achieved by reducing unemployment to a
level at which rising wages contribute to faster price growth.
This strategy is unlikely to work in the eurozone, because the unemployment rate is still
nearly 12%, about five percentage points higher than it was before the recession began. The
ECB’s quantitative easing policy can probably achieve higher inflation only through the
increase in import prices resulting from a decline in the value of the euro. This very limited
process still leaves core inflation in the eurozone below 1%.
ECB President Mario Draghi recently responded to the new evidence of eurozone weakness
and super-low inflation by indicating that the Bank is likely to ease monetary conditions
further at its next policy-setting meeting in March. This could mean further reducing
already-negative short-term interest rates and expanding and/or extending its bond-purchase
Eurozone financial markets reacted in the expected way. Long-term interest rates fell, equity
prices rose, and the euro declined relative to the dollar. But past experience and the reasons
spelled out here suggest that these policies will do very little to increase real activity and
price inflation in the eurozone. To make real progress toward reviving their economies, the
individual countries need to depend less on quantitative easing by the ECB and focus
squarely on structural reforms and fiscal stimulus.
© 1995-2016 Project Syndicate
Interest rates
Negative interest rates: what you need to know
Following the Bank of Japan’s launch of negative interest rates, we answer the key questions
A man walks past a board showing stocks in Tokyo. The markets went into reverse after the Bank of Japan
announced its plan. Photograph: Shizuo Kambayashi/AP
Jill Treanor and Larry Elliott
Thursday 18 February 2016 13.02 GMT Last modified on Thursday 18 February 2016 13.38 GMT
What are negative interest rates?
Normally savers earn interest when they deposit their money in banks. Similarly, commercial banks that
lodge money with central banks receive interest for doing so. Negative interest rates turn this arrangement
on its head. Savers have to pay banks for holding their money and central banks penalise banks for
depositing cash with them.
Why are we talking about them?
Because central banks are increasingly using them to boost growth and raise the level of inflation. At
present, it is really only commercial banks that are being charged negative interest rates but there is a
possibility, if things get worse, that they will affect members of the public as well.
Related: OECD calls for less austerity and more public investment
What’s the rationale for negative rates?
The idea is that negative interest rates provide banks with an incentive to lend money rather than to hoard it.
The same would apply to members of the public, who would be encouraged to spend rather than save.
Isn’t this unusual?
It is, but it reflects the low level of inflation across the global economy despite seven years of economic
recovery. In the past, interest rates would have been strongly positive by this point. Japan has had the
longest experience with low inflation and deflation, and on Tuesday the Bank of Japan introduced negative
interest rates. It is charging banks 0.1% for their excess deposits.
Is Japan the first country to go negative?
In recent history, the Swedes were first. Between July 2009 and September 2010 Sweden cut the deposit
rate to -0.25% in an attempt to fend off the deep recession that followed the 2008 banking crash and global
financial crisis. It reintroduced them in July 2014 and the deposit rate is currently -1.25%.
Sweden’s central bank became the first country to lend at a negative rate when in February 2015 it
announced a negative repo rate – its main lending rate to commercial banks. Economists point out that this
is largely a technicality because of the way its banking system operates.
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Photograph: Morgan Stanley
Switzerland introduced a negative rate in December 2014. However, it has experimented with them in the
past; in 1972 it put a 2% penalty charge on deposits by non-residents.
Denmark tried to reduce the pressure on its currency in July 2012 by having a negative deposit rate
between July 2012 and April 2014. After a period of being back in positive territory, it imposed a -0.75%
rate on certificates of deposit from September 2014.
Eurozone: the 19 countries in the single currency area have had negative rates since June 2014. The deposit
rate was set at -0.1% in June 2014 and then cut to -0.2% and to -0.3% in December 2015.
Is anyone else thinking about it?
The eurozone countries could yet get a deeper negative rate after the European Central Bank meets next
month. Analysts at Morgan Stanley note that even the US central bank, the Federal Reserve, is “starting to
sound more open to the idea”.
There is even some chatter that the Bank of England could end up with negative rates, or at least cut them
from the historic low of 0.5% – an idea raised by its chief economist Andy Haldane last year.
Are negative rates helping growth?
Analysts at Morgan Stanley think not, warning they are a “dangerous experiment”, particularly for the
banking sector. “We are concerned it erodes bank profitability, creating other systemic risks,” they said.
They acknowledge that when there was first a discussion of negative interest rates, it helped bolster
sentiment “because it ended the debate on whether central banks are running out ammunition”.
That has changed. Michael Pearce, a global economist at Capital Economics, said: “Policy loosening has
fuelled, rather than soothed, market fears.”
What do negative rates mean for banks?
If the share-price gyrations of Japanese banks are a gauge, there will be considerable turbulence. Analysts at
UBS note that following the announcement of negative rates by the Bank of Japan on 29 January, Japanese
bank share prices fell by around 30%.
Bank shares globally have already been pummelled this year – eurozone banks are down 28% – and analysts
at Morgan Stanley calculate that bank profits will be knocked by between 5% and 10%.
How does it affect bank customers?
Savings rates will remain low and banks will look to make profits in other ways. They could push fees for
loans, such as mortgages, or impose charges on current accounts, which might otherwise be seen as “free”.
How might customers react?
There is a concern that customers might make withdrawals of cash, although, according to the Swedish
central bank, there have been no signs of any substantial rise in the use of cash in Denmark, Sweden and
This is because the banks did not pass on the negative rates to their customers - but that could change if
negative rates were imposed for lengthier periods.
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Photograph: Morgan Stanley
Customers might also seek out higher returns elsewhere by looking at riskier investments.
What would happen if negative rates became common?
According to the Swedish central bank: “The most obvious problem associated with negative interest rates
is that cash will sooner or later become a viable alternative to keeping money in the bank.”
Phasing out cash and replacing it with electronic money or putting a tax on money – known as the “Gesell
tax” after the economist Silvio Gesell – could also be an option. But whether policymakers would want to
implement this and how it would work in practice is not clear.
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Remember from Chap. 21:
The unemployed are people who are without jobs and are actively searching for jobs.
In macroeconomics, economists distinguish between the NAIRU, and the rate of cyclical
unemployment, which is unemployment associated with fluctuations of real GDP around its
potential (Y*).
Issues of this chapter:
1) Cyclical unemployment, why it exists and why the adjustment mechanism often takes so long to
make it disappear.
2) Unemployment rate follows a cyclical path, rising during periods of recession and falling in
periods of business expansion. What are the sources of these cyclical fluctuations? What are the
sources of the upward trend?
3) Are government policies partly (and perhaps unintentionally) responsible for increases in the
NAIRU? Can government policy do anything to reduce the NAIRU?
Changes in the Total Unemployment:
On the supply side, the causes have included a rising population, increased labor force participation
by various groups, especially women; and net immigration of working-age persons.
On the demand side, economic growth causes some sectors of the economy to decline and others to
expand. Recessions are a major cause of unemployment.
Flows in the Labor Market
Usually the focus on the labor market tends to be on the overall level of employment and
unemployment rather than on the amount of job creation and job destruction. This focus can
often lead us to the conclusion that few changes are occurring in the labor market when in fact the
truth is exactly the opposite. The disaggregation of data may reflect a very active labor market with
very large amounts of both gross job creation and gross job destruction. The size of change in either
or both areas reflects the degree of dynamism in the economy. Economists & policy makers must
look at both gross & net flows in the labor market.
Consequences of Unemployment : Two costs of unemployment.
1) Lost Output. According to an empirical relation sometimes called Okun’s Law-named after the
economist Arthur Okun (1928-1980), for every percentage point of unemployment above the
NAIRU, output falls by about 2.5 percentage points below potential outpu t. This loss
represents a serious waste of resources.
2) Personal Costs. The loss of self-esteem and the dislocation of families that often result from
situations of prolonged unemployment are genuine tragedies, in addition to rising crime.
Classification of Unemployment
The unemployed can be classified by personal characteristics, such as age, gender, degree of skill or
education, and ethnic group. They can also be classified by geographical location, occupation,
duration of unemployment, or reasons for unemployment.
The recorded figures, for unemployment may significantly understate or overstate the numbers of
people who are actually willing to work at the existing wages. Overstatement arises because the
measured figure for unemployment includes people who are genuinely not interested in work but
say they are interested in order to collect unemployment benefits.( Some people registered in Hafiz
Program in Saudi Arabia may be an example.) Understatement arises because of people who would
like to work but have ceased to believe that suitable jobs are available for them, voluntarily
withdraw form the labor force. Although these people are not measured in the survey of
unemployment (which requires that people actively look for work), they are unemployed in the
sense that they would accept a job if one were available at going wage rates. People in this category
are referred to as discouraged workers.
Three types of unemployment: Cyclical, frictional, and structural. Both frictional and
structural unemployment exist even when real GDP is at its potential level, and hence there is
neither a recessionary gap nor an inflationary gap.
Cyclical Unemployment:
a) The term cyclical unemployment refers to unemployment that occurs whenever real GDP is
below potential GDP.
b) People who are cyclically unemployed are normally presumed to be suffering involuntary
unemployment in that they are willing to work at the going wage rate.
c) It can be measured by estimating the difference between the No. of people currently employed &
the No. of people who would be employed at potential output. This means that potential GDP has
been estimated.
d) The fluctuations in aggregate demand causes real output to fluctuate around its potential level.
all labor markets had fully flexible wage rates, wages would fluctuate to keep quantity
demanded in each individual market equal to the quantity supplied in that market. Employment
and the labor force would be pro-cyclical rising in booms and falling in slumps, but there would be
no significant amounts of involuntary unemployment. Some people would withdraw from the labor
force, being unwilling to work at the lower wage.
The case of flexible (competitive) labor markets is shown in FIG. 31-1 – part(i) blow.
Figure 31-1
Employment and Wages in a Competitive Labor Market
Slide 31.3
©1999 Addison Wesley Longman
The realities of the world are however different. Although wages do tend to vary over the cycle, the
fluctuations are not sufficient to remove all cyclical unemployment. Why is this so?
Two types of explanation have been advanced in recent years.
New Classical Theories
The classical theory assumes that labor markets are always in equilibrium in the sense that the
quantity demanded is continually equated with quantity supplied. If not, it gives two explanations
for unemployment:
a)Fluctuation in the willingness of people to supply their labor. The supply of labor increases in
booms, and falls in recessions. This explanation of cyclical behavior in the labor market has two
First, wages will tend to rise in slumps and fall in booms, which is not what we observe. SEE FIG
31-1, part (ii) above.
Second, there will still be no systematic cyclical unemployment because labor markets always clear,
leaving everyone who wished to work actually working. Supply-induced fluctuations in employment
form part of the basis of what is called real business cycle (RBC) theory, which is discussed in
Extension 31-1.
b) Second line of explanation lies in errors on the part of workers and employees in predicting the
course of the price level over the business cycle. In chapter 28, we saw that the increase in the money
supply leads to an increase in desired aggregate expenditure and a rise in prices of both inputs &
outputs. Firms will produce more and workers will work more since both groups think they are
getting an increased relative price for what they sell. Thus total output and employment rise. The
extra output and employment occur only while people are being fooled. When both groups realize that
their relative prices are in fact unchanged, output & employment will fall back to their initial levels.
The only difference is that now the price level is higher, leaving relative prices unchanged.
New Classical explanations assume that labor markets clear, and then they look for reasons why
employment fluctuates. They imply, therefore, that people who are not working have voluntarily
withdrawn from the labor market for one reason or another; there is no involuntary unemployment.
New Keynesian Theories
Keynesian economists believe that:
a) People correctly read mkt. signals, but react in ways that do not cause mkts. to clear at all
times .
b) Many people are involuntarily unemployed in the sense they would accept an offer for jobs they
are trained for, at the going mkt. wage rate, if such an offer were made.
These theories start with the everyday observation that wage rates do not change
every time demand or supply shifts. SEE FIG. 31-2 below.
Figure 31-2
Unemployment with Sticky Wages
Slide 31.4
©1999 Addison Wesley Longman
I) Long Term Employment Relationships
Both workers and employers look for relatively long-term and stable employment relationships.
Workers want job security in the face of fluctuating demand. Employers want workers who
understand the firm’s organization, production, and marketing plans. Wages are not the only
determinant of employment decisions, & they become insensitive to fluctuations in current economic
conditions. Given this situation, the tendency is that employers “smooth out” the income of
employees by paying a steady money wage and letting profits and employment fluctuate to absorb
the effects of temporary increases and decreases in demand for the firm’s product.
Many long-term contracts provide for a schedule of money wages over a period of several years.
Similarly, fringe benefits, such as pensions and health care, tend to bind workers to particular
employers. Another example is payment that rises with years of service. This helps to bind the
employee to the company, whereas seniority rules for layoffs bind the employer to the long-term
Thus, in labor markets in which long-term relationships are important (and this is the case in
many labor markets), the wage rate does not fluctuate to continuously clear the market. Wages
are written over what has been called the long term “economic climate” rather than the shortterm “economic weather”. Because wages are thus insulated from short-term fluctuations in
demand, any market clearing that occurs does so through fluctuations in the volume of
employment rather than in wages. Of course, wages must respond to permanent shifts in mkt.
conditions. ( Eamar company in Saudi Arabia kept and fired people on the basis of seniority. They
could have cut wages across the board, and keep most employees, but they did not)
II) Efficiency Wages
Employers may find that workers may become more efficient if they are paid somewhat more than
the minimum amount to induce workers to work for them. This increases the opportunity cost to
workers if they shrink on the job & get fired.
Several economists observed that, workers who feel that they are treated well work harder than
those who believe that they are treated badly. This gives a reason for paying an efficiency wage
provided that the increased output from treating workers well covers the increased cost of doing so.
(AL-Zamel Group in Saudi Arabia has an end-of- year bonus system related to both overall profits
and worker’s own performance)
A variant of efficiency wage theory seeks to explain why firms do not cut wages during
recessions. If workers feel unfairly treated when their wages are reduced, wage reductions (at least
in response to moderate recessions) may cost firms more (in lost output from unhappy employees)
than they save in reduced wages. If so, real wages may not fall rapidly enough to eliminate
involuntary unemployment. (Mobily house ownership program for its employees is an example.)
The basic message of New Keynesian theories of unemployment is that competitive labor
markets cannot be relied upon to eliminate unemployment by equating current demand for labor with
current supply. As a result, unemployment will rise and fall as the demand for labor falls and rises
over the cycle.
THE NAIRU is composed of frictional and structural unemployment. Our interest is in how the
NAIRU changes over time and in the extent that economic policy can affect the NAIRU.
Frictional unemployment results from the normal turnover of labor. An important source of
frictional unemployment is young people who enter the labor force and look for jobs. Another
source is people who leave their jobs because they are dissatisfied or fired. Persons who are
unemployed while searching for jobs are said to be frictionally unemployed or in search
How “voluntarily” is frictional unemployment? Some of it is clearly voluntary. An extreme New
Classical view regards all frictional unemployment as voluntary. Critics of that view argue that
many frictionally unemployed workers are involuntarily unemployed because they lost their jobs
through no fault of their own (e.g. their factories may have closed down) and have not yet located
specific jobs for which they believe they are qualified. The distinction between voluntary and
involuntary unemployment is not always clear, as it might at first seem.
Structural adjustments in the economy can cause unemployment. When the pattern of demand for
goods and services changes, the pattern of the demand for labor changes too. Such unemployment
may be defined as unemployment caused by a mismatch between the structure of the labor force in
terms of skills, occupations, industries, or geographical locations – and the structure of the demand
for labor.
1) Natural Causes
a) Changes that accompany economic growth shift the structure of the demand for labor,
especially if it generates a significant shift toward high-skilled jobs. The evolutionary shift toward
service-sector employment and the restructuring within all industries in response to technological
change has favored workers with more years of schooling. Some existing workers can retrain and
some new entrants can acquire fresh skills, but the transition is often difficult, especially for already
experienced workers whose skills become economically obsolete.
Increases in international competition can also cause structural unemployment. This could
happen either through the immigration of industries to other countries, or through increased
imports of cheaper products.
2) Policy Causes
a) Policies that discourage firms from replacing labor with machines may protect employment over
the short term. However if the industry cannot compete effectively, an industry decline may cause
more unemployment in the LR.
b) Minimum wage laws can cause structural unemployment by pricing low-skilled labor out of
the market. This is a very controversial issue.
c) Unemployment Insurance. In some countries, unemployed workers are generally eligible for
unemployment insurance only if they have worked for a given number of weeks in the previous
year-this is known as the entrance requirement. In some cases these ER are very low & encourage
seasonal workers to work for a few months & collect UI. See
for conditions of unemployment benefits in Saudi Arabia.
d) Immigration Policies: low- wage foreign workers could price out local workers & increase
Is Structural Unemployment Voluntary? According to the New Classical view all structural
unemployment is voluntarily. However, a skilled computer programmer, if unemployed can work as
dishwasher, but an unskilled dishwasher cannot work as a computer programmer.
The Frictional-Structural Distinction
Distinction becomes blurred at the margin. In a sense, structural unemployment is really long term
frictional unemployment. If the reallocation were to occur quickly, economists would call the
unemployment frictional; if the reallocation were to occur slowly, they would call the
unemployment structural.
The major characteristic of both frictional and structural unemployment is that there are as many
unfilled vacancies as there are unemployed persons.
In practice, structural and frictional unemployment cannot be separated. But the two of them,
taken together, can be separated from cyclical unemployment. Specifically, when real GDP is at its
potential level, the only unemployment (by definition) is the NAIRU, which comprises frictional and
structural unemployment.
Why Does The NAIRU Change?
1-a) An increase in the rate of growth, for example, usually speeds up the rate at which the structure
of demand for labor is changing.
1-b) the adaptation of labor to the changing structure of demand may be slowed by such diverse
factors as a decline in education and new regulations that make it harder for workers in a given
occupation to take new jobs in other areas or occupations.
2) Demographic Changes: Young or inexperienced workers have higher unemployment rates than
experienced ones. Also, the change in social values, such as the increase in the number of women
going out for work contributes to a rising NAIRU. .
Learning on-the-job experience is a critical part of developing marketable labor skills, and people
who suffered prolonged unemployment during their teens and twenties have been denied that
experience early in their working careers. Such people may have no choice but to accept temporary
jobs at low wages.
3) Hysteresis
Recent models of unemployment show that the size of the NAIRU can be influenced by the actual
current rate of unemployment. Such models get their name from the Greek word hysteresis,
meaning “lagged effect”. One mechanism that can lead to hysteresis in labor markets arises from
the importance of experience and on-the-job training. Suppose that a recession causes a
significant group of new entrants to the labor force to encounter unusual difficulty obtaining their
first jobs. When demand increases again, this group of workers will be at a disadvantage relative to
workers with normal histories of experience, and the unlucky group may have unemployment rates
that will be higher than average.
Another force that can cause such effect is heavily unionized labor force. This has been noticed
in Western Europe. In times of high unemployment, people who are currently employed (insiders)
may use their bargaining power to insure that new workers (outsiders) do not join in.
If outsiders are denied access to the labor market, their unemployment will fail to exert downward
pressure on wages, and the NAIRU will tend to rise.
4) Policy and Labor-Market Flexibility
One important cause of unemployment in very general terms is inflexibility in the labor market. If
workers are unable or unwilling to move between regions or between industries, then changes in the
structure of the economy can cause unemployment. If it is costly for firms to hire workers then
firms will find other ways of increasing output (such as switching to more capital -intensive methods
of production).
Any government policy that reduces labor-market flexibility is likely to increase the
We discuss two examples.
The first example is unemployment insurance. UI provides income support to eligible
unemployed workers and thus reduces the costs to the workers of being unemployed. This income
support will typically lead the worker to search longer for a new job and thus increases the
unemployment rate. Longer search may be desirable since by reducing the cost of unemployment
the worker is able to conduct a thorough search for a job that is an appropriate match for his
specific skills. On the other hand, if the UI system is so generous the workers have little incentive to
accept reasonable jobs.
The second example concerns policies designed to increase job security for workers. In most
Western European countries, firms that lay off workers are required either to give several months
notice before doing so, or required to make severance payments equal to several months worth of
pay. But this inflexibility on the part of the firms is passed on to workers. Firms are very hesitant
about hiring workers in the first place. Given this reduction in labor –market flexibility, such
policies are likely to increase the NAIRU.
Job security is very rare in the United States. Its rarity contributes to the general belief among
economists that U.S. labor markets are much more flexible than those in Europe. Many economists
see this as the most important explanation for why the unemployment rate in the United States is
significantly below the unemployment rates in Europe, and has been for the past two decades.
What is the situation in Saudi Arabia?
Cyclical Unemployment: Cyclical unemployment control is the subject of stabilization policy, which
we have studied in several earlier chapters. A major recession that occurs because of natural causes
can be encountered by monetary and fiscal policies to reduce cyclical unemployment. There is room
for debate however, about how much the government can and should do in this respect. Whatever
may be argued in principle, policy-makers have not yet agreed to abandon such stabilization
measures in practice.
Frictional Unemployment: Frictional unemployment is a natural part of the learning process for
young workers. Increasing the knowledge of workers about market opportunities may help.
Unemployment insurance is one method of helping people cope with unemployment. It has reduced
significantly the human costs of the bouts with unemployment that are inevitable in a changing
society. Nothing however is without cost. It also contributes to unemployment, as we have already
observed. Supporters of UI emphasize its benefits. Critics emphasize its costs. Workers must be
actively seeking employment in order to be eligible for UI. Finally, a system of experience ratings
has helped to distribute the costs more in proportion to the benefits. Under experience rating, firms
with histories of sizable layoffs, pay more than those with better layoff records.
Structural Unemployment
a) There are two basic approaches to reducing structural unemployment: try to prevent the changes
that the economy experiences or accept the change and try to speed up the adjustments. Workers
have often resisted the introduction of new techniques to replace the older techniques at which they
were skilled. Older workers may not even get a chance to start over with the new technique.
b)However, new techniques are a major source of economic growth.
Over the long term, policies that subsidize employment in declining industries run
into increasing difficulties. Agreements to hire unneeded workers raise costs and can hasten the
decline of an industry that is declining because of economic change becomes an increasingly large
burden on the public budget as economic forces become less and less favorable to its success.
Sooner or later, public support is withdrawn, followed by a precipitous decline. There is often a
genuine conflict of interest between the private interests of workers threatened by structural change
& the social interest served by generating change for the benefit whole society.
CONCLUSION: Harsh critics see unemployment as proof that the market system is badly flawed.
Reformers regard it as a necessary evil of the market system and a suitable object for government
policy to reduce its incidence and its harmful effects. Others see it as overblown in importance and
believe that it does not reflect any real inability of workers to obtain jobs if they really want to
work. Whatever the case may be, unemployment is always a problem of economic, social, political,
and psychological dimensions that must be dealt with.
The Rise of Invisible Unemployment
The Rise of Invisible Unemployment3 theories about today's biggest economic mystery: If unemployment is
shrinking, why aren't wages growing?
By Derek Thompson
In the last year, the most important question for US economists and economic journalists has changed from
Where are the jobs? to Where are the wages?
It's a problem best summed up by Matthew O'Brien in the Washington Post. As the labor market approaches
full employment, there should be more pressure on wages to rise. In the graph below, that would look like a
trend-line pointing up and to the left. Instead, as you can see in a half-a-second glance, the trend-line is a
blob and it's certainly not pointing up. The unemployment rate has fallen below 6 percent, and earnings
growth is flat.
O'Brien/Washington Post
Here are three theories for why.
1. Wage growth and job growth are happening in different places.
When economists and writers say "wages aren't growing," we're making a blanket statement that hides the
fact that some wages are growing somewhere. Mining and energy jobs have had a fantastic few years, while
retail and food service wage growth has been awful. The problem is that there are far more retail and food
service workers than mining and manufacturing employees.
We're adding lots of jobs in industries with stagnant wages, and a few jobs in industries with rising wages,
according to new research out of the Cleveland Fed. "It may seem counterintuitive that wages and salaries
are growing the slowest in industries where jobs are growing the fastest, but it actually is not," writes
LaVaughn M. Henry, vice president of the bank's Cincinnati branch. We're adding few jobs in goodsproducing industries like manufacturing, which have the highest overall post-recession wage growth, and
lots of jobs in service-producing industries (e.g. health care, leisure and hospitality, and education), which
have the lowest real wage growth.
Real Annual Wage Growth, by Industry
Cleveland Fed
2. The rise of invisible unemployment is too large to ignore.
What is "invisible unemployment"? It's discouraged workers and part-timers who want more hours. The
official unemployment rate doesn't consider them unemployed. So when we talk about the official
unemployment rate—now at a lowish 5.8 percent—we're ignoring these workers. They're statistically
Here's a picture of invisible unemployment (in blue) vs. official unemployment (in red). Since early 2010,
the number of unemployed Americans has declined by twice as fast as the number of discouraged/parttimers (42 percent vs. 21 percent).
In 2002, official unemployment swamped invisible unemployment. The official unemployment rate was an
accurate description of the labor force. But the spread between invisible and official unemployment is
shrinking. In the last 20 years, the six months with the smallest gaps between official and invisible
unemployment were all in 2014. That means the official unemployment rate is getting worse and worse at
describing the real conditions facing American workers.
Invisible unemployment is hurting the participation rate even more than economists predicted with an aging
work force. The entire developed world is getting older. But US participation fell faster in the years after the
recession that just about any other country.
3. The rise of invisible work is too large to ignore.
By "invisible work," I mean work done by American companies that isn't done by Americans workers.
Globalization and technology is allowing corporations to expand productivity, which shows up in earnings
reports and stock prices and other metrics that analysts typically associate with a healthy economy. But
globalization and technology don't always show up in US wage growth because they often represent
alternatives to US-based jobs. Corporations have used the recession and the recovery to increase profits by
expanding abroad, hiring abroad, and controlling labor costs at home. It's a brilliant strategy to please
investors. But it's an awful way to contribute to domestic wage growth.
This article available online at:
Copyright © 2014 by The Atlantic Monthly Group. All Rights Reserved.
The Govt. Budget Constraint is:
Govt. Expenditures = Tax Rev. + Borrowing
In other words, part of govt. expenditures is financed by taxes, & part is financed by borrowing.
Govt. Expenditures is composed of three broad components:
G+TR+(i x D) = Tax Rev. + Borrowing,
Where G is govt. purchases, TR: transfer payments( such as social security, unemployment
insurance, or industrial subsidies), i: interest on Govt. debt, D: total outstanding public( govt.) debt
, (i x D) is the debt-service payments,
The Budget Deficit= Borrowing =  D (change in Public Debt) = G+TR+ (i x D) - T
Every budget deficit (BD) is financed by borrowing, which in turn adds to (and is equal to the
change in) public debt.
Two points about BD:
a) a change in the size of the deficit requires a change in the level of expend. relative to the level of
tax revenue.
b) Govt. debt will rise whenever the BD is positive. Debt will fall only if the deficit becomes negative.
i.e only if there is a budget surplus.
The Primary Budget Deficit: The debt- service component of total expenditures is beyond the
control of govt. policy because it is determined by past govt. borrowing. In contrast, the other
components of the govt. budget are said discretionary because the govt. can choose the levels of G,
TR, or T. The discretionary part of the BD is called the
Primary Budget Deficit = Total Deficit – Debt Service Payment
= {G+TR+ (i x D)-T} – (i x D)
= (G+TR) – T
Where (G+TR) is discretionary expenditures. It is called the Government's Program Spending. It is
possible that the govt. has an overall BD but a primary budget surplus (BS). SEE FIG. 32-1 below.
Figure 32-1
The Government’s Budget Constraint
Slide 32.2
©1999 Addison Wesley Longman
In both cases above, there is an overall BD. However in case i there is also a Primary Budget Deficit
(T< (G+ TR). In case ii, there is a Primary Budget Surplus (T> (G+ TR).
Deficits & Debt in THE USA Compared to SAUDI ARABIA:
SEE FIGURES 32-2-3-4:
The size of govt. expenditures, revenues, BD, Primary BD, public debt, & debt- service payments
may not be meaningful unless we relate them to the level of GDP. This is what the figures below are
telling us about the US economy.
Figure 32-2
Federal Revenues, Expenditures, and Deficits, 1962-1997 (as a percentage of GDP)
Slide 32.3
©1999 Addison Wesley Longman
Figure 32-3
Federal Government Net Debt (as a percentage of GDP) 1940-1997
Slide 32.4
©1999 Addison Wesley Longman
Figure 32-4
Budget Deficit and Debt-Service Payments 1970-1997
Slide 32.5
©1999 Addison Wesley Longman
II-1)The Stance of Fiscal Policy: Expansionary or Contractionary?
a) The Budget Deficit Function:
Budget Deficit= (G + i x D) – (T – TR)
partially endogenous
(due to policy)
(a function of GDP).
Thus with no changes in expend. Or the tax rate, the BD tends to rise in recession and fall in booms.
In reality, however, the govt. does use its discretion to change many variables. Thus, the BD is
actually two parts:
Budget Deficit
Part of the budget deficit is due to the govt.'s own discretion (policy), but part of it is due the state of
the economy (which phase of the business cycle the economy is in). To judge the stance of fiscal
policy, we have to isolate one part from the other. To do this, economists speak of something called
b) CAD: The Cyclically Adjusted Deficit:
Deficit measured assuming the economy is at potential GDP (Y*). This removes the effect of the
business cycle. The change in CAD determines the stance of fiscal policy: If CAD increases, it
implies that fiscal policy is expansionary. Otherwise, it is contractionary. SEE FIG. 32-5 below.
Figure 32-5
The Budget Deficit Function and Cyclical Adjustment
Slide 32.6
©1999 Addison Wesley Longman
The govt.'s policy determines the position of the BD function. Moving from B0 to B1 in (iii ) above
represents a restrictive fiscal policy.
Figure 32-6
The Actual and Cyclically Adjusted Deficit, 1970-1997
Slide 32.7
©1999 Addison Wesley Longman
From Extension 32-1 we have:
 d= X+(r-g) x d
Where d: is the debt-to-GDP ratio
X= is the govt. primary deficit as a percentage of GDP
r= is the real interest rate
g= is the growth rate of real GDP.
There are two distinct forces that tend to increase the debt-to- GDP ratio:
If r > g, then the debt- to – GDP ratio rises (that is  d will be positive). It also means
that government debt is rising faster the economy’s growth rate.
If the govt. has a primary BD (if X is positive), then the debt- to – GDP ratio rises.
1-a) The Importance of Real interest rates: It is the real interest rate not nominal interest rate that
is important to determine d. Many commentators argue that high nominal interest rates are largely
responsible for increasing the govt.'s debt-service requirements & thus pushing up the deficit & the
debt .This is only partially correct. The real financial liability of the govt. is determined by real
stock of debt. High nominal interest rates are usually associated with high inflation which reduces
the real value of govt. debt.
2-a) The Role of The Primary Deficit: If the focus is to be on the debt-to- GDP ratio, rather than the
absolute size of the debt, then tracking the behavior of the overall BD is misleading. The reason is
that it is possible to reduce the debt- to- GDP ratio even though the overall BD may never be
eliminated, & thus even though the absolute size of the debt continues to increase.
Stabilizing The Debt-to-GDP ratio ( V. Imp): To do this the govt. must maintain certain
relationship between the primary deficit, the debt-to- GDP ratio, & the values of r and g. For
example, if r > g, then a govt. with a positive stock of outstanding debt must run a primary surplus
in order to stabilize the debt- to- GDP ratio. See the equation above.
We have seen in Chapter 24 that:
National saving= private saving + govt. saving (T- G)
An increase in govt. BD is a reduction in govt. saving and national saving. Alternatively, we can
National saving= private saving - govt. BD ( G- T)
The effect of the BD on the level of national saving thus depends on the link between BD & private
saving. For example, if BD rises by SR 10 billion and this reduction in govt. saving leads to an
increase in private saving by exactly SR10 billion, there will be no change in national saving. If not,
national saving will fall as a result of the BD.
But what is the link between BD & private saving? Remember that govt. expenditures must be paid
for either by current taxes or current borrowing (future taxes). This implies that Government Debt
represents deferred liabilities for taxpayers.
The Ricardian Equivalence: The link between Government Debt & private saving is associated
with idea of the Recardian Equivalence, named after the Classical economist David Ricardo
(1772-1823). The central proposition is that consumers recognize that current govt. borrowing as a
future tax liability & thus view govt. borrowing as equivalent to taxes in terms of its impact on their
own wealth. In other words, taxes reduce households’ wealth, but current govt. borrowing reduces
future wealth too. Therefore, a reduction in taxes and a rise in borrowing (or the reverse case) does
not make people feel wealthier by holding govt. bonds and thus don’t increase their consumption.
Thus “Ricardian” consumers faced with a change in taxes will change their private saving exactly to
offset the change in govt. saving. If this is the case fiscal policy may not be effective to manage the
Why this might not be so?
1) Short-sightedness: many people don’t care much about the future and spend accordingly.
2) Uncertainty about future govt. fiscal policy: would reductions in taxes today be matched with
more taxes tomorrow or reduced govt. expenditures?
The issue of the Recardian Equivalence is an empirical one. Most evidence suggests that it does not
hold completely and hence suggests a limited negative relationship between GD & national saving.
In this case expansionary fiscal policy would stimulate private consumption and GDP.
Does the govt. BD crowd out private economic activity? Does it harm future generations? Does it
hamper the conduct of economic policy?
Investment in Closed Economies: in a closed economy the amount of national saving exactly
equals the amount of domestic investment. Suppose govt. reduces taxes and increases borrowing.
What is the effect on domestic investment? This depends on the degree that taxpayers are
Ricardian—that is on the degree to which taxpayers recognize that today's deficit must be financed
by higher future taxes. If taxpayers are not fully Ricardian, then private saving will rise by less than
the fall in govt. saving. This implies a decrease in the supply of national saving. The resulting excess
demand for funds will put upward pressures on domestic real interest rates. The components of AD
that are sensitive to interest rates- investment in particular- will fall. This is called the crowding out
of domestic investment. SEE FIG. 32-7.
Figure 32-7
The Crowding Out of Investment
©1999 Addison Wesley Longman
Slide 32.8
b) Net Exports in Open Economies:
If the government reduces taxes, it thus increases its budget deficit. Furthermore, suppose that
taxpayers are not purely Ricardian, so that private saving rises by less than the fall in government
saving. What is the effect of such a fall in national saving in an open economy? As domestic real
interest rates rise in the country, foreigners are attracted to the higher-yield domestic assets and
thus foreign financial capital flows into the country, thereby dampening the initia1 increase in
domestic interest rates. However, since U.S. dollars are required in order to buy U.S. interestearning assets, this capital inflow increases the demand for U.S. dollars and thus increases the
external value of the dollar (the U.S. dollar appreciates).
This appreciation makes U.S. goods more expensive relative to foreign goods, inducing an increase
in imports and reduction in exports, thereby reducing U.S. net exports. In an open economy,
therefore, a rise the government deficit leads to an appreciation in the currency and to a crowding out
of net exports.
In an open economy instead of driving up interest rates sufficiently to crowd out private investment,
the government budget deficit tends to attract foreign financial capital, appreciate the currency, and
crowd out net exports.
A Closed Economy: The overall effect of the increase in the government deficit in a closed economy
is a rise in the real interest rate and a fall in the level of domestic investment. However, less current
investment means that there will be a lower stock of physical capital in the future, and-thus
'reduced ability to produce goods and services in the future. This reduction in future production
possibilities, which implies lower consumption levels for future generations, is the long-term burden
of the debt.
An Open Economy: The overall effect of the increase in the government deficit in an open economy
is an appreciation of the currency and a reduction in net exports. Recall from Chapter 24, however,
that such a reduction in net exports implies a reduction in the country's national asset formation.
This in turn increases the need for the domestic economy to make interest payments to foreigners in
the future. Thus, in an open economy, an increase in the government budget deficit does not lead to
a reduction in the domestic capital stock but less of it is owned by domestic residents. This reduced
ownerships lowers the domestic residents' future stream of income because payments must be paid
to the foreign owners of the domestic capital stock. This reduction in the future stream of income
for domestic residents is the long term burden of the public debt in an open economy.
In both cases, there is less output available for consumption by future generations of domestic
residents. This reveals an important aspect of the costs associated with government debt and
This last sentence suggests that current government deficits are always financing goods and services
that are provided to the current generation. But is this really true? Some government spending is on
good and services that will continue to be used well into the future. For example if the government
increases- its current borrowing to finance the building of bridges or the expansion of highways,
future generations will receive some of the benefits of this government spending.
Whether current government deficits impose a burden on future generations, depends upon the
nature of the government goods and services being financed by the deficit. At one extreme, the
govern borrowing may finance a project that generates a return only to future generations, and thus
the future generations may not be made worse off by today's budget deficit. An example might be
the government's financing medical research projects that generate a return only-in the distant
The concern that deficits may be inappropriately placing a financial burden on future generations
has led some economists to advocate the idea of budgeting by the government. Under this scheme,
the government would essentially- classify all of its expenditures either consumption or investment;
the former would be spending that mostly benefits the current generation while the latter would be
spending that mostly benefits future generations.
The costs imposed on future generations by government debt are very real. Unfortunately, the fact
that these cost sometimes occur in the very distant future often leads us to ignore their importance.
But other costs associated with the presence of government debt are more immediately apparent. In
particular government debt may make the conduct of monetary and fiscal policy more difficult.
Monetary Policy
Recall that the long-term goal of monetary policy is influence ~rate-o[inflation,- and that the
Federal Reserve's primary instrument is its control over the rate of growth of money supply. In
Chapter 30 we saw that sustained inflation possible only when the Fed permitted a sustained
growth in the money supply. These facts appear to suggest that government deficits cause inflation.
Note, however, that when the government operates a budget deficit and is thus borrowing funds, it
can borrow from households or firms in the private sector, it can borrow from the Federal Reserve.
But not all of these are these are same in. term of effect on the money supply.
As we saw in Chapter 29, changes in the Fed's balance sheet are central to changes in the money
supply. And, when the government borrows from either the private sector or from foreigners~ there
is no change in the Fed's balance sheet, and thus no change in the money supply. In contrast, if the
government borrows from the Fed (an open-market purchase by the Fed), this increases the Fed's
assets (government securities) and similarly increases the Fed's liabilities (currency). Thus it is no
necessary link between budget increase the money supply.
To summarize the foregoing argument, unless the central bank finances some of the budget deficit,
there is no necessary link between budget deficits (fiscal policy) and inflation (monetary policy).
Thus a budget deficit can cause a one time increase in the price level, but, unless the Fed increases
the rate of growth of the money supply, it will not cause a sustained inflation.
The last point suggests that the independence of the central bank from the government deficits and
inflation. For example, if the government were able to force the central bank to finance some
fraction of government deficits-referred to as monetizing the deficit-then government deficits would
clearly-1ead to the creation of money and eventual inflation. Though budget deficits need not be
inflationary, their accumulated value over many years-the stock of government debt: can still make
monetary policy more difficult. To see how a large stock of government debt can hamper the
conduct of monetary policy, consider a country that has a high debt to GDP ratio and that has a real
interest rate above the growth rate of GDB. As we saw earlier in this chapter, the debt-to- GDP
ratio will continue to grow in this situation unless the government starts running significant
primary budget surpluses. Such fears of future debt monetization will lead to expectations of future
inflations of thus will put upward pressure on nominal interest rates and on some prices wages.
How does the presence of government debt affect the government's ability to conduct such counter
cyclical fiscal policy?
∆d = x + (r -g) X d
Thus, there may well be room for the government to increase the primary deficit-either by
increasing the programs spending or by reducing tax rates without generating a large increase in
the debt-to-GDP ratio.
In this case, the high value of d means that even in the absence of a primary budget deficit, d will be
increasing quickly. Thus, any increase in the primary deficit brought about by the counter-cycled
fiscal policy runs the danger of generating increases in the debt-to-GDP ratio that may be viewed by
creditors as unsustainable.
A tradeoff therefore appears to exist between the desirable short-run stabilizing role of deficits and
the undesirable long-run costs of government debt. This tradeoff has been the source of constant
debate. Here we examine some possible solutions.
Before examining some proposals for dealing with deficits, however, note that not everyone agrees
that government deficits and debt represent a problem. Some economist that take the view that
Ricardian equivalence does hold and thus budget deficits do not lead to a crowding out of
investment or net exports and thus there is no long-term burden associated with the public debt.
Other economists accept the view that sufficiently high deficits and debt can indeed represent a
problem, but argue that the current debt-to-GDP ratio in the United States, about 48 percent, is not
high enough to cause concern.
Though these debates might be reasonable, there are some unreasonable arguments for why
government debt is a problem. For example, many people argue that the main problem with the
government debt is that much of it is held by foreigners and that such foreign ownership is bad,
because interest payments are remitted abroad, reducing the income available for Americans. Such
claims have even inspired a proposal that the U.S. government issue new "U.S.-only" bonds to
Americans and then use the newly raised funds to redeem foreign-held government debt.
Even with the success that the Clinton Administration has had in reducing the budget deficit-from
$290 billion in 1992 to $22 billion in 1997, and a likely balanced budget by 1999-there is still
considerable support among leading members of Congress for an amendment to the US
Constitution that would require the federal government to balance, its budget on an annual basis.
Balancing the budget on an annual basis would extremely difficult to achieve. The reason is that a
significant portion of the government budget is beyond the short-term control of the government,
and a further large amount is hard to change quickly. For example, the entire debt-service
component of government expenditures is determined by past borrowing and thus cannot be altered
by the current government. In addition, as we saw in our discussion of the cyclically adjusted deficit,
changes in national income (real GDP) that are-beyond the control government lead to significant
changes in tax revenues (transfer payments) and thus generate significant changes in the budget
deficit. Even if it were possible for the government to perfectly control its path of spending and
revenues on a year-to-year basis, it would probably be undesirable to balance the budget every year.
We saw above government-tax-revenues (net of transfers) tend to fall in recessions and raise inbooms. In contrast, the level of government purchases is more or less dependent of the level of
national income. With a balanced budget, government expenditures would be forced to adjust to the
changing level of tax revenues. In a recession, when tax revenues -naturally decline, a balanced
budget would require either a reduction in government expenditures or an increase in tax rates,
thus generating a major destabilizing force on national income. Similarly, as tax revenues naturally
rise in an economic boom, the balanced budget would require either an increase in government
expenditures or a reduction in taxes, thus risking an over-heating of the economy.
An annually balanced budget would accentuate the swings in real GDP.
One alternative to the extreme policy of requiring an annually balanced budget is to require that the
government budget be balanced over the course of a full economic deficits would6epermitted in
recessions as long as they were matched by surpluses in booms. In principle, this is a desirable
treatment of the trade off between the short-run benefits of deficits and the long-run costs, of debt.
Although more attractive in principle than the annually balanced budget, a cyclically balanced
budget would carry problems of its own. Congress might well spend in excess of revenue in one
year,. leaving the next Congress with the obligation of spending less than current revenue ,in
following years. Could
Figure 32-8
Balanced and Unbalanced Budgets
Slide 32.9
©1999 Addison Wesley Longman
such an obligation to balance the budget over a period of several years bema-de-binding? It could
be made a legal requirement through-ah-act of Congress. Indeed, both the Budget Enforcement Act
of 1990 and the Omnibus Budget Reconciliation Act of 1993 has taken this direction (see
Application 32-2). These laws do not require balance over the cycle, but they do limit overall
spending while still allowing automatic stabilizers to operate. However, what Congress does,
Congress can also undo.
Perhaps the most important problem with a cyclically balanced budget is an operational one. In
order have a law that requires the budget to be balanced over the cycle. it is necessary to be able to
define the unambiguously. But there will always be disagreement about what stage of the cycle the
economy is currently in, and thus there will be disagreement about the current government should
be increasing or reduction its deficit. Compounding this problem is the fact that politicians will
have a stake in the identification of the cycle.
A further problem with any policy that requires a balanced budget whether over one year or over
the business cycle is that the emphasis is naturally on the overall budget deficit. But, as we saw
earlier in this chapter, what determines the change in the debt-to-GDP ratio is the growth of the
debt relative to the growth of the economy. With a growing economy, it is possible to have positive
overall budget deficits and thus a growing debt and still have a falling debt to GDP ratio. Thus, to
the extent that the debt-to-GDP ratio is the relevant gauge of a country’s debt problem, focus should
be placed on the debt-to-GDP ratio rather than directly on the budget deficit.
Some economies view a stable (or falling) debt-to-GDP ratio as the appropriate indicator of fiscal
prudence. Their view permits a deficit such that the stock of debt grows no faster than GDP.
CH.37 : Exchange Rates and the Balance of Payments
The Exchange Rate: The price of one currency in terms of another. Usually, it is the price
of a unit of foreign currency in terms of a local currency. Example: ($1=SR.3.75).
Foreign Exchange: Holdings of a country o f foreign currencies and financial assets
denominated in foreign currencies.
Currency Appreciation: Arise in the external value of home currency >>>According to
the above definition of the ER, the Exchange rate will decrease. The opposite will happen if
the currency depreciates.
Note: When one currency appreciates, the other depreciates. See Fig.37.1
Figure 37-1
The Dollar-Yen Exchange Rate, 1972 -1998
Slide 37.2
©1999 Addison Wesley Longman
The Balance of Payments (BOP): It is an accounting record of all transactions between a
country and the rest of the world.
*Sales of any assets (real or financial) or services >>> Receipts >>> Credit to BOP.
*Purchases of any assets (real or financial) or services >>> payments >>> debit to
Table 37-1.U.S Balance of Payments,1997, (Billions of dollars)
Trade Account
Merchandise exports
Service exports
Merchandise imports
Service imports
Trade balance
Capital-Service Account
Net investment income (including Unilateral transfers)
Current Account balance
Net change in U.S. investments abroad [capital outflow (-)]
Net change in foreign investments In the U.S [capital inflow (+) 717.6
Capital Account balance
Change in official reserves [increases (-)
Change in liabilities to official foreign agencies[(increases (+)]
Statistical Discrepancy
Official Financing balance
The overall balance of payments always balance, but individual components do not have to
Structure of BOP: (Table 37.1 above):
1- Current Account: a) Trade Account. b) Capital Service Account (net income from
foreign investment.
2- Capital Account: _ Foreign investment in the country >>> Capital inflow >>>
Receipts >>> credit to BOP
Our investment abroad >>> Capital outflow >>> Payments >>> Debits to BOP.
a) Short Term Capital Movements: Buying & selling short term financial assets such as
bank accounts or treasury bills
b) Long Term Capital Movements: Purchasing or selling long term financial assets and/or
physical assets…
*if the long term capital is for a voting, or controlling share, it is called Foreign Direct
Investment (FDI)
*if the long term capital is NOT for voting share >>>It is a Portfolio Investment.
3- Official Reserve (Settlement) Account: transactions of the central bank, buying and
selling foreign currencies, foreign financial assets, gold and SDR.
*Note: BOP must balance >>> sum of the sub-accounts must be zero. However, this does
not mean that each account must be zero.
*Balance >>> Total Receipts = Total Payments
>>> (Cr+Kr+Fr) = (Cp+Kp+Fp)
>>> (Cr-Cp) + (Kr-Kp) + (Fr-Fp) = 0
*Surplus in one or two accounts >>> Deficit in at least one account…WHY? a deficit in
one or two accounts, must be financed by a surplus in the other account(s)
*Ex., a favorable balance in the current account (a Surplus) must be either invested abroad
(Capital Outflow) >>> Capital account is negative >>> and/or the official reserves balance
must decrease. What does it mean that the official reserves balance decrease?
It means that the central bank would be buying foreign exchange from the private sector.
* If the other two accounts of the BOP are in surplus, the central bank is adding to its
reserves, and it appears with a negative sign.
*In day-to-day language of news, a BOP is: Current Account + Capital Account
*Under flexible exchange regime, the official reserve account = 0, because central bank
does not need to intervene in the foreign exchange market:
BOP = (Cr-Cp) + (Kr-Kp) = 0
(Cr-Cp) = - (Kr-Kp)
* This implies that a deficit in one account must be balanced by a surplus in the other
*National Assets Formation = I + (X-M). Since the surplus of the current account is
invested abroad >>> an increase the size of national assets. Both domestic investment and
surplus in current account contribute to national assets & thus generate incomes to the
country. This is a very important concept of macroeconomics.
Students may visit for information on Saudi balance of payments, and
other info. on the Saudi economy in general.
* The Sources of Foreign Exchange Market:
1- Exports: These are payments by foreigners.
2- Capital Inflow: When foreigners buy some of the country’s financial assets and/or
physical assets. Example: Foreign companies invest in Saudi petrochemicals or
telecommunication sector,
3- Reserve Currency: Changing the country's portfolio of foreign exchange.
* Supply and Demand Curves of Foreign Exchange: Fig.37.2
Figure 37-2
The Market for Foreign Exchange
©1999 Addison Wesley Longman
Slide 37.3
- On the Supply Curve: Suppose the Yen appreciates >>> $/Yen will increase >>>
Japanese find it cheaper to buy $ and American products >>> Japanese supply more Yen
(the quantity supplied of Yen will increase).
- On the Demand Curve: American finds Yen more expensive >>> they demand less Yen
and Japanese products >>> the quantity demanded of Yen will decrease.
* Determination of Exchange Rate: Generally, there are three major ER regimes:
1) A Country could choose a fixed exchange rate against another currency (or gold).
2) Completely flexible (floating) exchange rate >>> exchange rate determined by the
3)Between these two extremes, there could be may intermediate arrangements such as
adjustable peg( where the ER is essentially fixed, but adjusted once- and- a while), a
managed float( where the ER is essentially floating but the central bank seeks to have some
stabilizing influence. However it does not try to fix it at some publicly announced value),
and pegging against a basket of currencies.
See Fig.37-3 below.
Figure 37-3
Fixed and Flexible Exchange Rates
Slide 37.4
©1999 Addison Wesley Longman
_ At e1: the value of the home currency is kept artificially low >>> X will increase and
M will decrease >>> C\A tend to a surplus.The low value of home currency may
encourage an inflow of foreign investment >>> the K/A tend to a surplus. >>> As a result
of both sub-accounts, foreign reserves increase >>> central bank purchases the surplus of
FR to maintain exchange rat at e1 >>> (Fp> Fr).
_ At e2: Home currency is kept artificially high >>> an opposite scenario takes place.
*Causes of Changes in Exchange Rates:
Figure 37-4
Changes in Exchange Rates
Slide 37.6
©1999 Addison Wesley Longman
1-A Rise in the Prices of Exports: Assume elasticity of exports (  X >1) >>> receipts
(supply) of foreign currency will decrease (  TRX=  PX.QX   ) >>> at the same time,
quantity demanded of home currency will decrease >>> supply curve for foreign currency
will shift upward (Panel ii)>>> ER will increase >>> home currency will depreciate.)
2-A Rise in the Prices of Imports: Assume elasticity (  M >1) >>> Payments for F.C
decrease (  TPM=  PM.QM   ) >>> demand curve for foreign currency will shift
downward (Panel i, Note: the shift of the D- curve in the fig. is wrong. It should be
downward))>>> at the same time demand for home currency increases and ER will
decrease >>> home currency will appreciate.
Note: the assumption about elasticity is very crucial about what should happen to the ER.
If reversed, it would change the conclusion about the ER.
3-Changes in the Overall Price Levels:
a) Equal inflation in both countries: if home & foreign prices change in the same direction
and at the same magnitude >>> terms of trade (PX/PM) is not affected >>> NO effect on the
exchange rate.
b) Inflation in Only One Country: >>> terms of trade are disturbed >>> exchange rate
will change.
C) Inflation at Unequal Rates: Here also the terms of trade are disturbed >>> exchange
rate will change.
However in all cases, remember the assumption about the elasticity (E X > 1 & EM > 1). The
direction of change depends on that assumption.
4-Capital movements:
a) Short term capital movement: Most important factor is changes in interest rates. If the
interest rate of a country increases >>> its financial assets are more attractive >>> demand
for the country’s currency will increase >>>its exchange rate will decrease >>> its
currency will appreciate.
b) Speculation about future value of a country's exchange rate: If a country's ER is
expected to appreciate in the future, investors rush to buy assets denominated in that
currency. The country's currency appreciates, & visa versa.
c) Long term capital movements: are largely affected by long term expectations of about
profit opportunities in a country and the long term value of its exchange rate.
5-Structural changes: Are large and Long- lasting changes that may affect the economy.
They are not necessarily permanent. They may affect long term terms of trade & thus long
term ER, such as:
a) Changes in cost structure of production, such as a permanent rise in real wages and real
interest rates,
b) R&D that leads to growth in some sectors at expense of others,
c) Discovery of natural resources. The development of natural gas in the Netherlands in
1960s, and the development of North Sea oil in the UK in 1970s brought about the socalled the Dutch Disease in both countries. It led to the appreciation of Dutch Guilder &
the sterling Pound respectively and had a negative effect on other Dutch & British exports.
d) Major changes in the terms of trade may generate structural changes and affect
exchange rates, as happened in 1997-1998 when commodity prices in many countries
declined and affected the currencies of major commodity exporters such as Australia, New
Zealand, Canada and South Africa. Also, in that period, oil prices severely declined and
had a profound effect on the oil exporting countries.
* Behavior of Exchange Rate:
- The Law of one price: In the absence of all trade barriers, the price of identical baskets
of goods should be the same in all countries. If not, arbitrage will take place until prices are
-The Purchasing Power Parity Exchange Rate (the PPP exchange rate): is the
exchange rate that guarantees the validity of the law of one price. This means If the
market ER is equal to the PPP rate, the purchasing power of a currency should the same
both at home & abroad. Or, the price of identical goods should be the same in the two
countries when expressed in the same currency. This means:
Ph= e X Pf
-Example: Suppose that the price of a Shawrma Sandwich in Dhahran is SR10 and the
price of the same Sandwich in Bahrain is 1 Dinar. If the exchange rate is: BD 1 = SR 10
>>> the exchange rate makes the cost of the Sandwich the same across the two
countries. This exchange rate is called the PPP rate. If the exchange rate is different
from PPP rate >>> currency is either overvalued or undervalued.
-Definition (V.V. Imp.): An overvalued currency is one that has a stronger purchasing
power abroad than it has at home. In this case, imports are encouraged and exports
are discouraged. The BOT and the BOP will tend to be in deficit. An undervalued
currency (abroad) implies the opposite.
-Note that: the PPP rate is an equilibrium exchange rate. So, PPP theory of exchange rate
is an equilibrium theory of the ER. It says that in the long run, exchange rates should
adjust to make the prices of identical goods the same across countries when expressed in
the same currency.
Why the absolute version of PPP theory may NOT hold???
1) Differentiated products that may entre into the calculation of different price indexes.
This makes basket of goods are not identical across countries. Consequently, it renders the
comparison of price indexes difficult.
2) Costly information about prices.
3) The theory assumes the absence of trade barriers. In reality, there are many trade
barriers. Thus, the law of one price cannot be validated.
4) Price indexes include prices of both tradable and non-tradable goods. Only tradable
goods affect exchange rate.
5) Changes in relative prices of some goods affect supply and demand of foreign
exchange rate & thus affect exchange rates. This may happen while the overall price
levels are NOT affected.
*The Relative (Weaker) Version of PPP Theory of Exchange Rate:
Because of the reasons explained above, economists came up with concept of relative PPP
E^ = Π^h -Π^f
This says that the percentage change in the ER is equal to the difference in inflation rates
between the two countries.
-PPP in the short run (Effect of speculation): Some economists argued that speculation in
currencies may not be bad, for it will eventually bring exchange rates to their PPP values.
However, this may be true only if speculators know that deviations from PPP are small and
-Experience shows that under flexible exchange rates, swings around PPP have been wide
and long lasting. Changes in interest rates have been a major cause of swings
in exchange rates. Whatever the causes of swings, speculation has been destabilizing to
exchange rate.
*Exchange Rates, Interest Rates and Monetary Policy:
*If monetary policy is tight >>> interest rate will increase >>> exchange rate will decrease
>>> the currency will appreciate >>> Expenditures on (I,C,X) will decrease and M will
increase >>> AD (AE) will decrease >>> a recessionary gap may take place.
*The appreciation of the currency will continue until it has appreciated enough so
that investors expect a future depreciation that just offsets the interest premium for
investing in the securities of that country.
*The implication of this theory is that a central bank that is seeking to use its monetary
policy to achieve its domestic policy targets may have to put up with large fluctuations in
the ER.
* Other countries may be affected by the monetary a policy of another country. The
interest rate differential among countries >>> capital outflows from other countries into the
country with a higher interest rate. Also, the appreciation of one country's currency implies
depreciation of currencies of other countries. This stimulates exports from other countries
to the country that started a tight monetary policy. As a result wages & prices in other
countries may rise. This leaves these countries with the uncomfortable choice of either
following the example of the other country (raising interest rates), or maintaining a lower
interest rate and suffer inflation.
This scenario assumes that the capital markets of the concerned countries are integrated.
*In 1980s when the US tightened it monetary policy, other central banks in major
industrial countries were forced to follow the US example, which led to sever world
Something Just Snapped In Saudi Money Markets
Submitted by Tyler Durden on 04/08/2016 15:40 -0400
Away from the headlines about The Panama Papers, global financial markets turmoiled quietly this
week with a surge in equity and FX volatility and banks suffering more death blows. However,
something happened in Saudi Arabia's banking system that was largely uncovered by anyone in the
mainstream... overnight deposit rates exploded to their highest since the financial crisis in
It is clear that that the stress in Saudi markets has spread from the forward derivatives
markets to actual funding problems.
This suggests one of the two main things: either Saudi banks are desperatly short of liquidity or Saudi
banks do not trust one another and are charging considerably more to account for the suspected credit
Either way, not good. So what is going on behind the scenes in Saudi Arabia?
Fiscal Austerity and the Euro Crisis:
Where Will Demand Come From?
Adair Turner
Adair Turner, a former chairman of the United Kingdom's Financial Services Authority and
former member of the UK's Financial Policy Committee, is Chairman of the Institute for
New Economic Thinking. His latest book is Between Debt and the Devil.
FEB 5, 2016
Japan’s Wrong Way Out
LONDON – Financial markets were surprised by the Bank of Japan’s recent introduction of
negative interest rates on some commercial bank reserves. They shouldn’t have been. The
BOJ clearly needed to take some new policy action to achieve its target of 2% inflation. But
neither negative interest rates nor further expansion of the BOJ’s already huge program of
quantitative easing (QE) will be sufficient to offset the strong deflationary forces that Japan
now faces.
In 2013 the BOJ predicted that its QE operations would deliver 2% inflation within two
years. But in 2015, core inflation (excluding volatile items such as food) was only 0.5%.
With consumer spending and average earnings falling in December, the 2% target
increasingly looks out of reach.
The unanticipated severity of China’s downturn is the latest factor upsetting the BOJ’s
forecasts. But that slowdown is the predictable (and predicted) consequence of debt
dynamics with roots going back to 2008.
Excessive private credit growth in the advanced economies before 2008 left many
companies and households overleveraged, and their attempted deleveraging after the global
financial crisis erupted that year threatened Chinese exports, employment, and growth. To
offset that danger, China’s rulers unleashed an enormous credit-fueled investment boom,
pushing the debt/GDP ratio from around 130% to more than 230%, and the investment rate
from 41% of GDP to 47%. This in turn drove a global commodity boom, and strong demand
for capital-goods imports from countries such as South Korea, Japan, and Germany.
But the inevitable consequence within China was wasteful construction investment and
enormous overcapacity in heavy industrial sectors such as steel, cement, and glass. So even
though service-sector expansion supports strong employment growth (with 13.1 million new
urban jobs created in 2015), the Chinese industrial sector is in the midst of a hard landing.
Indeed, official survey results suggest that manufacturing has contracted for six months in a
row. This, in turn, has reduced demand for commodities, driving countries such as Russia
and Brazil into recession, and posing a major threat to African growth. Lower industrial
imports are having a major impact on many Asian economies as well. South Korea’s exports
fell 18% year on year in January, and Japan’s fell 8% in December.
In the eurozone, annual inflation is running at 0.2% – still far below the European Central
Bank’s target, and German exports to China are down 4%. As a result, at its March meeting,
the ECB’s Governing Council may also consider moving interest rates further into negative
territory, or increasing the scale of its QE program.
But it is increasingly clear that ultra-low short and long-term interest rates are not boosting
nominal demand. Nor should that surprise us. Japan’s experience since 1990 teaches us that
once companies feel overleveraged, pushing low interest rates still lower has little impact on
their investment decisions. Cutting Japan’s ten-year yield from 0.2% to 0.1%, and
Germany’s from 0.5% to 0.35% – the movements over the last week – just doesn’t make a
significant difference to consumption and investment decisions in the real economy.
The BOJ’s announcement of a negative interest rate certainly did produce a currency
depreciation. But a lower yen would help Japanese exporters only if China, the eurozone,
and South Korea – all themselves struggling with deflationary pressures – do not match
Japan’s rate cuts.
At the global level, currency depreciation is a zero-sum game – we cannot escape a global
debt overhang by depreciating against other planets. And if multiple currencies all depreciate
against the US dollar, the resulting impact on the US manufacturing industry could slow the
American economy, undermining its import demand and thus hurting the word’s exporters.
Forecasts for US economic growth have been revised downward significantly since the
Federal Reserve’s interest-rate hike in December.
Depressed equity markets and falling bond yields worldwide in January 2016 thus illustrate
the global nature of the problem we face. Demand is still depressed by the overhang of debt
accumulated before 2008. Indeed, this pre-2008 debt has not gone away; it has simply been
shifted between sectors and countries.
Total global debt (public and private combined) has increased from around 180% to more
than 210% of world GDP. Faced with this reality, markets are increasingly concerned that
governments and central banks are running out of ammunition to offset global deflation,
with the only tools available those that simply redistribute demand among countries.
But the fact is that central banks and governments together never run out of policy
ammunition to offset deflation, because they can always finance tax cuts or increase public
expenditure with printed money. This is precisely what the Japanese authorities should do
now, permanently writing off some of the BOJ’s huge holdings of Japanese government
bonds and canceling the planned sales-tax increase which, if it goes ahead in April 2017,
will further depress Japanese growth and inflation.
Such a policy, as I set out in a paper at the IMF’s 16th Annual Research Conference in
November, is undoubtedly technically possible. And it does not, contrary to some objections,
involve commitment to perpetually low interest rates. Rather, it is the only way by which
Japan can now escape from a debt trap so deep that only zero interest rates make it
There are no credible scenarios in which Japanese government debt can ever be repaid in the
normal sense of the word “repay”: and none in which the bulk of the BOJ’s holdings of
Japanese government bonds will ever be sold back to the private sector. The sooner that
reality is admitted, the sooner Japan will have some chance of meeting its inflation targets
and stimulating total demand, rather than seeking to shift it away from other countries.
© 1995-2016 Project Syndicate
Economy is really bad...*
Can U help these guys?!