№1 Markets for goods
GDP: #1 – Expenditure Approach –
GDP = C + I + G +NX=
C + I + G + (X-IM)

C = All private CONSUMPTION/ consumer spending in the economy. It
includes durable goods, nondurable goods, and services.

I = All of a country’s INVESTMENT in capital goods (equipment, housing,
etc). NOT financial investments!

G = All of the country’s GOVERNMENT SPENDING. It includes the
salaries of government employees, construction, maintenance, etc.

NX (net exports or trade balance)= Net country EXPORT (X)– Net country
IMPORT (IM). X>IM – trade surplus, X<IM – trade deficit. Inventory
investment (investment in stocks {not financial}) – difference between
production and sales – accumulated not sold goods. Production = sales +
inventory investment.
#2 – Income Approach –
GDP = Rent + Wages + Interest + Profits
#3 – Production or Value-Added Approach –

Gross Value Added = Gross Value of Output – Value of Intermediate
Consumption
GDP = Sum of all value-added to products during the production of a
process.
Disposable income (𝒀𝒅 ) – part of income available to persons. National income
minus indirect taxes, minus retained earnings. Income plus government transfers
minus taxes 𝒀𝒅 = Y- T
GDP deflator has an advantage to reflect changes in goods and services produced
within the economy – not based on fixed basket of goods. Frequency: monthly
(advantage for inflation frequency analysis). Average price of output produced in
the economy (only domestic goods)
Consumer Price Index (CPI) based on a fixed basket of goods defined by national
statistical office as a representative of consumption bundle of typical household –
largely impacted by technological change. It changes every year depending in
people’s investment patterns. Frequency: quarterly (more rarely). Average price of
goods in basket consumed in the economy (both domestic and foreign imported
goods)
(π CPI) > (π GDP defl) if prices of imports increase relatively to domestic goods
Unemployment rate is countercyclical – means that it moves in the opposite
direction with business cycles. If GDP goes down, UR goes up. It reacts with a leg
to recession (goes down pretty slowly, like after 2008-9 crisis and 2000 dot com
bubble). Usually it goes up together with bankruptcy towards the end of the
recession.
Core inflation – inflation without considering food and energy – less volatile part.
Labor force (L) = employment (N) + Unemployment (U)
Okun’s Law – the bigger is change in unemployment rate (Δµ t) – the smaller is
output growth rate (g GDP) – growth up & unemployment down (negative
relationship)
Phillips Law – the higher is the core inflation, the lower is the unemployment rate
and vice versa (negative empirical relationship)
 Change in demand (Z) – change in production
 Change in production (Y) – change in income
 Change in income – change in demand
Consumption vs Investment: time horizon over which benefits of two activities are
paid out. Consumption gives immediate benefit, investment – over longer time. But
the distinction is not always clear.
Nonresidential investment (firms) – tools, machinery, plants. Residential (landlords)
– residential equipment. Private investment – investment by firms, public
investment – new houses.
Government spending – public procurement (purchase of goods and services),
wages to government employees, EXCLUDING government transfers.
Government transfers include social welfare programs (subsidies to firms,
pensions, interest payments on debt).
Aggregate Demand (Z) = C + I + G + (X-IM)
IF: -same good, -constant price (short run), -closed economy(X=IM=0),
demand=sales, slack in productive capacity (not full capacity)
Z = C + I + G (no inventory investment)
ENDOGENOUS QUANTITY (dependent):
 Private consumption C = C (𝒀𝒅 ) – behavioral function
Consumption linear function C = 𝒄𝟎 + 𝒄𝟏 𝒀𝒅 , where 𝑐0 is CONSUMER
CONFIDENCE (amount of consumption that households will perform even if their
disposable income is 0) and 𝑐1 is propensity to consume (between 0 and 1).
(1 - 𝒄𝟏 ) = propensity to save (between 0 and 1). 𝒄𝟏 + (𝟏 − 𝒄𝟏 ) = 𝟏
Disposable income 𝑌𝑑 = Y – T, where T is TAXES minus TRANSFERS
EXOGENOUS QUANTITY (independent):
 Investment (𝑰̅)
 Public sector (government fiscal policy): characterized
̅ ) and TAXES (𝑻
̅)
GOVERNMENT (public) SPENDING (𝑮
by
̅ (with disposable
̅ ) + ̅𝑰 + 𝑮
If taxes are an exogenous variable then Z = 𝒄𝟎 + 𝒄𝟏 (Y – 𝑻
income)
If taxes depend on your income (behavioral function) they’re an endogenous
̅.
̅+ ̅𝑰+ 𝑮
variable then Z = 𝒄𝟎 + 𝒄𝟏 (1-t) Y – 𝒄𝟏 𝑻
̅ + tY (automatic stabilizer, reduces fiscal multiplier and
Endogenous Taxes T = 𝑻
consumption response to positive shocks in income)
Equilibrium condition in the goods market Y=Z – no inventory investment, market
clearing
Fiscal multiplier:
1
1−𝑐1
̅ − c1 T
̅ – is positive because T=G (balanced
Autonomous spending: c0 + I̅ + G
budget), c1 between 0 and 1. Negative if government surplus is very large.
Y=
𝟏
𝟏−𝒄𝟏
̅ − 𝒄𝟏 𝑻
̅]
[𝒄𝟎 + ̅𝑰 + 𝑮
And if T = t0 + t1Y (endogenous taxes), then Y =
𝟏
̅ − 𝒄𝟏 𝐭𝟎 ]
[ 𝒄𝟎 + ̅𝑰 + 𝑮
𝟏−𝒄𝟏 (𝟏−𝒕𝟏)
 Private saving (S) = 𝒀𝒅 – C (disposable income minus private consumption)
Similarly, S = Y – T – C
= Y – T - 𝒄𝟎 - 𝒄𝟏 (Y – T)
= - 𝒄𝟎 + (1 - 𝒄𝟏 ) (Y – T)
 Public saving = T – G (taxes net of transfers minus government spending)
Public saving > 0 – budget surplus
Public saving < 0 – budget deficit
IS relation (IS-LM model) INVESTMENT EQUALS SAVING I = S + (T – G)
Equilibrium in closed economy is Y = C + I + G. If we subtract T from both sides:
Y – T – C = I + G – T (private saving = I + public saving).
So, S = I + G – T and I = S + (T – G) investment equals private saving + public
saving
I = - 𝒄𝟎 + (1 - 𝒄𝟏 ) (Y – T) + (T – G)
PRODUCTION = DEMAND
INVESTMENT = SAVING
The paradox of thrifting (saving) IN SHORT-RUN is that the more households
are trying to save, the less is the output (income, economic growth) and the saving
will remain the same. Saving causes 2 effects:
- On aggregate level higher saving provokes lower 𝒄𝟎 – lower output [S = - 𝒄𝟎
+ (1 - 𝒄𝟏 ) (Y – T)]
- saving cannot change because at equilibrium I = S + (T – G) - I, T, G fixed
- even if we had endogenous investment, it would lower S
- ofc on individual level it’s possible to raise one’s savings cutting on
consumption, and it would not impact the production
Typical example of fallacy of composition (what is true of a member of a
group is NOT true for the group as a whole)
- for long-run it’s different and could even have positive effect on economic
growth (capital accumulation)
The Ricardian Equivalence theory assumes that consumers can foresee
increased taxation well into the future. It assumes that consumers save excess
income to cover future liabilities (increased tax).
№2 Financial (money) market
“Fiat money” (from Latin “let it be done”) system means money that’s not tied
to any other commodity like gold, silver, etc. It has no intrinsic value. It was
introduced after 1971 when president Nixon cancelled gold exchange for dollar
(end of Bretton Woods system).
Why does a dollar have a value and a piece of paper doesn’t? It’s all because there’s
DEMAND for it and people BELIEVE that they will be able to exchange it for goods
and services in the future. You can TRUST using it. The notes have no value for
themselves but for what they will buy.
Which is the correct quantity of money and does it affect its value? Usually it’s
regulated by the government and Central bank. There are a couple of theories
regarding it.
o It should be proportionate to the goods produced and exchanged and
depends on how fast it passes from one holder to another (velocity of
money, Cantillon, Locke).
o Quantity Theory of Money (QTM) tells that price of goods is proportional
to the amount of money in circulation (Copernicus, Cantillon, Locke,
Hume, Mill).
o “Neutrality of money” – idea that change in stock affects nominal
quantities in the economy (prices and wages), not the real ones (no real
effect).
But! Many economists criticized QTM:
John Keynes said that the price level was not strictly determined by money
supply. Changes of money supply in short-run could have effect on output.
Knut Wicksell claimed the importance of credit money, rather than fiat
money. Paul Krugman gave evidence that QTM doesn’t operate when an
economy is in a liquidity trap.
Now money supply is typically regulated by Central banks. How independent are
Central banks from the government? In many countries they are at least formally
independent from political power having a mandate to ensure price stability (to keep
inflation under control). In other countries they have a mandate also to keep the
economy at full employment (f.ex USA). In the case of Italy, the independence from
the government was introduced 1981 and from then on Bankitaly was no longer
guaranteeing the full placement of public securities offered by the Treasury –
monetization of government debt. Central banks are not completely isolated given
that the Board of directors is typically APPOINTED by the president or parliament.
That’s why the behaviors of CB can be evaluated by the government and
approved/disapproved.
Financial markets play an essential role in the economy. But what’s better: to hold
bonds or money? It depends on 1) how many transactions you need and 2) the
interest rate on bonds. If you decide to hold money, you face an OPPORTUNITY
COST which expresses in missed interest payments. If instead you have only
bonds, you face an ILIQUIDITY ISSUE of bonds – you can’t extract immediately
your money selling a bond if you need to proceed with many transactions. That’s
why it’s so common to buy bonds only having some money apart for transaction
payment. You can also hold bonds with short maturity through money market funds
(mutual funds).
Semantic explainer: MONEY pays for transactions, INCOME is what you earn
(flow), SAVING is part of after-tax income that you don’t spend (flow), SAVINGS
is value accumulated over time, FINANCIAL WEALTH is value of all financial
assets minus liabilities (stock variable), INVESTMENT is purchase of capital goods,
FINANCIAL INVESTMENT is purchase of share or other financial assets.
Financial assets’ dimensions:
1. Liquidity – liquid assets used for transactions (highest liquidity asset is
CASH)
2. Profitability – level of interest rate (i) payments made on the bond
So, bonds are PROFITABLE assets but not liquid. Cash is a LIQUID asset but not
profitable.
ⅈ=
𝐹𝑣 −𝑃
𝑃=
𝑃
𝐹𝑣
1+ⅈ
, where 𝐹𝑣 is Face value, P – price, i – yields.
- zero-coupon bond. Tight relation between yield and price of a bond:
Higher i – lower the price.
Demand for money: 𝑴𝒅 = 𝒀 ∗ 𝑳(ⅈ), where Y+ is aggregate nominal output ($y)
reflecting TRANSACTION LEVEL (our liquidity needs), L(i)- is INTEREST
RATE (opportunity cost of keeping too much liquidity). The higher is Y, the higher
is the demand (proportional). The higher is L(i), the lower is the demand
(inversely proportional).
US currency – cash (coins and notes): the bigger part (~66%) of US currency is
outside USA (f.e countries suffering from high inflation in the past that adopted
dollar - DOLLARIZATION), US households own ~22%, US firms ~10%.
“Soft landing” – ability of Fed to obtain reduction on inflation without inducing a
recession (increase interest rates without having a banking crisis).
A larger money supply lowers interest rates, making it less expensive for
consumers to borrow. Conversely, smaller money supplies tend to raise interest
rates, making it pricier for consumers to take out a loan.
Equilibrium interest rate at money market is when: 𝑴𝒅 = 𝑴𝑺 – demand for
money equals supply of money. Monetary policy adopted by the government allows
them to expand or decrease supply of money (assuming the demand fixed) and thus
modify the equilibrium and interest rates. It can be done in many ways:
1. For example, intervening on market for bank reserves (modifying reserve
ratio). Bank reserves - deposit that commercial banks own at Central bank.
The federal funds market (USA) – actual market for bank reserves. The federal
funds rate – interest rate determined in federal funds market; it is the main
monetary policy instrument of the Federal Reserve (Fed) - Fed can choose
federal funds rate it wants by changing H, where H is High-powered money
supply (includes not only cash but also reserves of commercial banks at
central bank).
2. Giving loans to banks. When conducting monetary policies CB operates on
money supply or on interest rate? Equivalently, but interest rate target is used
more often and it’s more understandable for public, then alter supply to
achieve it.
In case of ECB (European Central Bank), the main rate is refinancing rate –
rate at which commercial banks can borrow money from ECB and ECB can
create more money supply. Banks can also deposit their money at ECB at the
deposit rate.
Interest rate corridor is limited on top marginal refinancing rate and on
bottom by marginal deposit rate. By controlling upper and lower bound of the
corridor the Central bank is able to influence the prevailing rate at which
commercial Euro-area banks lend money to each other at a very short-term.
This rate that ECB can control is called EONIA rate (average benchmark
reference interest rate for euro) EURIBOR, LIBOR (higher maturity of loans)
Why it’s important to control inter-bank rate and how can it affect the rest of the
economy? Because in this way it influences how its monetary policy is transmitted
to the rest of the economy. Central banks control short-term rates and thus they
control also longer-term interest rates (loans and mortgages).
What happens when the interest rate is close to 0? Monetary policy “LIQUIDITY
TRAP” (by Keynes) – when there’s an excess supply of money, CB is lowering
interest rates until interest rate is almost zero - then CB has no more room to further
decrease it below zero, so interest rates have zero lower bound. Increasing the
money supply does not affect interest rates anymore; consumers having their
liquidity satisfies will be indifferent either to buy bonds at 0% or currency, so
demand for money becomes horizontal. Historically it was just an academic case but
after the economic crisis of 2008-2009 it because practically relevant.
Solution: after 2007 CB applied unconventional monetary policy (when other tools
are not effective enough) – quantitative easing (QE) policy that implies expansion
of the Balance sheets of CB through purchases of financial securities from
commercial banks (way of providing liquidity to commercial banks potentially to
make loans to industrial and non-financial firms and thus stimulate economy). [In
other words, QE is then Central Banks create money to buy government securities
from the market in order to lower interest rates and increase the money supply.]
3. Through open market operations – by buying and selling bonds in the bond
market
Expansionary open market operations: CB expands money supply by buying bonds.
Central bank has Bonds (portfolio), Loans to banks in Assets and Money (currency),
Reserves θ in Liabilities. Effects: Bonds +1 million, Money +1 million; bond’s price
goes up, so Interest rate goes down.
Contractionary open market operation: CB contracts money supply by selling
bonds. Bond’s price goes down, so Interest rate goes up.
The role of commercial banks is to be a financial intermediary. They have Reserves
(θ), Loans and Financial securities in Assets and checkable deposits (short-term),
Received loans and Equity capital in Liabilities. They perform
 Maturity transformation function - they transform short-term deposits into
long-term maturity loans (from short-term LIABILITY to long-term ASSET).
It’s possible because deposits’ base is rather stable.
 Liquidity transformation – very liquid deposits are transformed into illiquid
assets. That’s why there’s an inert risk of bank activity, many financial
regulations (about the amount of equity capital and reserves - certain fraction
of deposits θ in order to face demand in cash/central bank money)
CB money supply H (central bank money, monetary base) = Currency +
Reserves θ
𝑴𝑺 (larger than H) = Currency + Bank deposits
Commercial banks play an important role in provision of money to the system
because they basically expand CB’s money through a multiplier effect.
-How much money individuals want to keep? 𝑴𝒅 = 𝒀 ∗ 𝑳(ⅈ)
-How much of that money do they want to hold in cash and how much in deposits?
Demand for currency: 𝑪𝑼𝒅 = 𝒄𝑴𝒅 , demand for deposits: 𝑫𝒅 = (𝟏 − 𝒄)𝑴𝒅 , where
c is how much currency people hold
Demand by commercial banks to reserves: 𝑹𝒅 = 𝜽𝑫𝒅 = 𝜽(𝟏 − 𝒄)𝑴𝒅
Demand for Central bank money: Hd = CUd + Rd = cMd + 𝜽(𝟏 − 𝒄)𝑴𝒅 = 𝑴𝒅 [c +
𝜽(𝟏 − 𝒄)]
If H = Hd, Md = Ms, Md = H (1/ c + 𝜽(𝟏 − 𝒄)), where 1/c + 𝜃(1 − 𝑐)>1 is a MONEY
MULTIPLIER mm
Md = H * mm = Ms
Equilibrium condition: $Y L(i) = H * mm
Excessive reserve (credit crunch) – increase in precautionary reserves
Endogenous money theory – money is not created only by Central banks but
endogenously by commercial banks. Loans create deposits (not vice versa)
IS – LM model for goods and financial markets by John Hicks and Alvin Hansen
(formalization of general theory by Keynes 1936)
IS part (investment-saving). Investment depends on production Y and interest rate
i:
I = I (Y, i) (+, -) When output increases, Sales increase, therefore firms expand
production and increase Investment. The higher is Interest Rate, the lower is
Investment.
Equilibrium in goods market: DEMAND Z= PRODUCTION Y (INCOME),
demand function ZZ with slope <1 is increasing. In linear case Z = C0 + C1(YΔ) + I
+ G. Where C1 – slope of demand function ZZ 0<C1<1, it’s flatter than 45 degrees.
IS relation: Y (real income) = C (Y - T) + I (Y, i) + G. Private consumption C and
also Investment I become endogenous. Taxes T and Government spending G are
exogenously set by government.
IS curve – Output on x-is, Interest rate on y-is, DOWNWARD-SLOPING (the
higher is Interest rate, the lower is Output).
LM part (liquidity preference-money supply).
LM relation:
Y=
$𝒀
𝑷
𝑴
𝑷
= 𝒀𝑳(ⅈ) (from M = $Y L(i)), where P is prevailing level of prices
= Real Income. P can be taken either from CPI or GDP deflator
o The target of the CB is to choose Interest Rate (it will modify money SUPPLY
to Interest Rate constant). In this case LM relation is FLAT (horizontal line
based on chosen monetary policy rate i)
o Alternatively, the target can be set as constant money supply M s and modify
interest rates. In this case LM relation is UPWARD-SLOPING (if money
supply is constant, increase in income raises Interest Rate). Why?
This happens because the higher income raises demand for money; since the
supply of money does not change, the interest rate must rise in order to restore
equilibrium in the money market.
Summary: IS relation Y = C (Y - T) + I (Y, i) + G downward sloping curve reflects
equilibrium in goods market. LM relation i = ⅈ ̅ flat horizontal curve reflects
equilibrium at financial (money) market. At the point of their intersection both
relations are satisfied.
Fiscal policies can be:
1) Decrease in G – T (decrease demand), then fiscal contraction (fiscal consolidation
[fiscal austerity]). Implemented either by REDUCING SPENDING, or by
INCREASING TAXES, or combination of the two. Government budget deficit goes
down. Shifts IS curve to the left, LOWER OUTPUT, consumption, deficit.
2) Increase in G – T (increase demand), then fiscal expansion. Implemented by
INCREASING SPENDING, or by CUTTING TAXES, LOWER INTEREST RATES.
Shifts IS curve to the right, HIGHER OUTPUT, consumption, deficit.
Effects on increasing taxes:
 Fiscal consolidation (decreases G – T, decreases the demand), IS curve shifts to
the left (lower Output). The shifts IS curve to the left (negative shock to
Government spending and negative shock to consumer confidence – drop in
private consumption, in disposable income, in output, in government budget
deficit). Leads to decrease in equilibrium level of output. But financial market’s
equilibrium (LM RELATION) stays unchanged, if LM: i = ⅈ .̅
Monetary policies can be:
1) Decrease in i (increase in Ms), then monetary expansion. Shifts LM curve down,
HIGHER OUTPUT, investment.
2) Increase in i (decrease in Ms), then monetary contraction (monetary tightening).
Shifts LM curve up, LOWER OUTPUT, investment.
Effects on decreasing interest rate:
 Monetary expansion (increases Ms), LM curve shifts down and IS curve stay the
same. We move along IS curve to higher output level because (Y = C (Yd) + I (Y,
i) + G) decreased interest rate leads to higher investment, [higher NPV].
Policy mix:
 implementation of both fiscal and monetary EXPANSION in order to strengthen
economy (go out of the recession). It LEADS TO HIGHER OUTPUT (IS curve moves
to right and LM curve moved down). Why should we use 2 policies together? Because
doing so we become more confident in the result achieved afterwards.
Also! If a country is in the situation of Zero-lower bound (liquidity trap), it’s practically
obliged to use fiscal policy as well because they can’t lower interest rates anymore.
 Implementation of fiscal CONTRACTION and monetary EXPANSION in order to
reduce government deficit without going into recession (T – G rise). (IS curve
moves to left and LM curve moves down). Fiscal contraction can be either done by
increasing taxes (it will lower disposable income and therefore private consumption)
or lowering spending (it has no direct effect on consumption but through the
multiplier).
But! Is deficit reduction good or bad for investment? I = S + (T – G). Only if S stays
constant, we can assume investment will rise with rise of (T – G). But fiscal contraction
lowers output so S goes down more than (T – G) rises so Investment lowers.
Nominal interest rates versus Real interest rates
 Nominal interest rates – rates in terms of dollar. [you need to ADJUST it to take into
account expected inflation]
 Real interest rates – rates in terms of goods that you can purchase with money that
certain loan or bond gives you. Based on 12-months ahead forecast of inflation
Real interest rate: (1 + 𝑟𝑡 ) =
Expected inflation rate:
πet+1
𝑃𝑡 (1+ ⅈ𝑡 )
𝑒
𝑃𝑡+1
=
𝑒
𝑃𝑡+1
−𝑃𝑡
𝑃𝑡
Fisher relationship (describes the relationship between inflation and both real and
nominal interest rates.): (1 + 𝑟𝑡 ) =
1 + ⅈ𝑡
1+ π𝑒𝑡+1
-If nominal interest rate and expected inflation are not too large, we can use
approximate equation: rt ≈ it – πet+1 (real rate is nominal minus expected inflation)
-When expected inflation = zero, nominal and real interest rate are equal
-As the expected inflation is typically positive, real interest rate is lower that
nominal. If expected inflation is negative (deflation), then real rate can be higher
than nominal rate (happens usually during recessions when CB exhausts its ability
to lower nominal rate lower 0)
-If nominal rate = expected inflation rate then real rate will be zero (loans are not
remunerated)
-For a given nominal rate: the higher is expected inflation – the lower is real rate
-Difference between current inflation rate and its expectation π – πe is called
forecast error
Risk and risk premia
Some bonds are risky so the holders ask for a risk premium.
To get the same expected return on a risky bond as on a riskless bond:
(1 + i) = (1 - p) (1 + i + x) + (p)(0), where i – risk-free nominal interest rate, p –
probability of default, x – risk premium, 0 – zero payoff in case of default.
Then, risk premium x =
(𝟏+𝐢)𝐩
𝟏−𝒑
- increase in higher probability of default
Another type of premium on the bond is TERM PREMIUM (related to maturity of
bonds – time preference) – interest rates on long-term bonds tend to be higher than
rates on shorter bonds because you need to wait for longer time before getting back
your money. As practice shows, term premium becomes negative (long-term interest
rates are lower than shorter ones) right before recessions.
Risk premia are determined by:
1) Probability of default
2) The degree of risk aversion (avoid risk) of bond-holders
Ratios to analyze the riskiness of bank’s structure:
 Leverage ratio (assets/capital), the higher it is, the higher is expected profit
rate but also implies higher risk of insolvency (debtor cannot pay the debts
they owe, often leads to bankruptcy) and bankruptcy. That’s why we have
regulatory capital requirements (BASEL regulations – minimum capital
requirements designed to respond to the level of riskiness of assets promoting
stability)
 Capital ratio (capital/assets)
Role of financial intermediaries:
Bank assets tend to be less liquid than bank liabilities, - if depositors decide to
withdraw their deposits it might be difficult for bank to liquidate their assets so they
might have to do FIRE SALE PRICES (prices far below true value) causing losses
that are to be absorbed by equity capital – insolvency risk.
The higher is the liquidity of liabilities (checkable or demand deposits - let you
withdraw your money without advance notice), the higher is the risk of bank runs
(when the customers of a bank or other financial institution withdraw their deposits
at the same time over fears and panic about the bank's solvency). That’s why after
1934 banks introduced deposit insurance (USA up to 250K) - to protect bank
depositors from losses caused by a bank's inability to pay its debts when due.
Another solution is narrow banking (restricts banks from making loans, to hold
liquid and safe government bonds). The Fed also implemented liquidity provision
to banks (so CB acts as a lender of last resort to the banks providing them with
liquidity overnight) – it should the last measure available, lend at penalty rate.
Central bank digital currency (a digital form of central bank money that is widely
available to the general public) allows households to borrow/deposit money directly
from/to CB.
Extended IS-LM model:
IS relation Y = C(Y – T) + I (Y, i – πe + x) + G, where πe is expected inflation, x is
risk premium
LM relation i = ⅈ ̅ CB can perfectly control real interest rate r through nominal rate i
CB chooses real policy rate r, IS relation Y = C(Y – T) + I (Y, r + x) + G,
real borrowing rate (r+x) = i – πe + x
LM relation r = 𝑟̅
If risk premium increases, then IS relationship moves to left (investment I goes
down, income Y goes down, borrowing rate r + x goes up). WHAT TO DO? Apply
economic policy (fiscal or monetary) – monetary expansion (through nominal
interest rate CB controls and lowers real rate, not risk premium x), limit can be zero
lower bound – then or a qualitative easing program (buying bonds) or engage in
forward guidance (management of expectations about future interest rates).
Some notions about financial crisis of 2007-2009
House price up – home equity up (money that you’ve paid for the house from pocket)
House price down – home equity down – underwater mortgages (value of the house
is smaller than value of the mortgage)
Foreclosure prices (amount of money you plan to receive from sale of mortgaged
property net of any expenses)
Subprime mortgages - are for borrowers with lower credit scores
Mortgage-backed securities – hard to evaluate
Banks underestimated the risk (low correlation in defaults), expected incentives
“bonus structure” for high expected returns without acknowledging risk of
bankruptcy, avoided financial regulations with structured investment vehicles (nonbanking institutions working for loans’ spread – shadow banking sector) –
Regulatory arbitrage (regulatory arbitrage occurs when businesses and consumers
frequently take advantage of differences in laws and policies between jurisdictions
to avoid strict local laws, regulations, or restrictions, it helps reducing costs).
Toxic assets are investments that are difficult or impossible to sell at any price
because the demand for them has collapsed.
Wholesale funding – when banks rely on financing purchasing their assets
(financing new loans) on borrowing from other banks or investors, not only deposits
– high rollover risk (of not be able to repay existing debt obligation with a new
debt) – led to collapse in funding market.
SUMMARY:
Senior securities first claim on return, junior – afterwards, as Collateralized loan
obligations (CLO) are securities backed by a pool of debt, usually loans to
corporations with low credit ratings or private equity firms (subprime mortgages).
Financial firms and banks transformed fresh-made subprime loans to CLO and sold
them to large commercial investors as mortgage-backed securities. The problem
occurred when interest rate started to rise and borrowers started defaulting not being
capable to pay interests, price for houses started to drop. By the fall of 2008,
borrowers were defaulting on subprime mortgages in high numbers; the collapse of
the financial markets and the global Great Recession ensued. Soon it had spread to
the whole economy, it considerably dropped consumer confidence c 0 and business
confidence (demand for investment and consumption went down) – therefore,
consumption and total production Y declined. Overall, IS curve shifts to the left.
CBs (Fed) responded by expanding federal deposit insurance from 100K to 250K,
providing liquidity provisions to banks to counter lack of access to wholesale
market, introducing (TARP) Troubled Asset Relief Program by buying banks’ toxic
assets at higher price expanding its balance sheet assets and stimulating economy.
Monetary policies: monetary expansion however interest rate was already down at
zero and buying assets (unconventional monetary policy) – led to shift LM curve
down. Fiscal policy: fiscal expansion (cutting taxes and increasing spending) for
$780 billion through American Recovery and Reinvestment Act – led to some shift
IS curve back to right. However, it was not enough to avoid major recession.
Net debt = government debt – government liquidity (gov. deposits at CB)
Labor market. Passing from short to medium run (prices and wages may vary)
 An active labor market: many separations (dismissals) and hires. Constant
exiting/entering unemployment/employment.
 A “sclerotic” labor market: few separations and hires, employed and
unemployed are more or less the same, stagnant unemployment pool – many
people that stay long enough in unemployment tend to drop out of labor force
and become discouraged workers.
Current Population Survey (CPS) shows monthly flows.
Unemployment rate = unemployed / labor force
Employment rate = employed / working age population
Unemployment tend to go up during recessions and stay up for some time after the
end of the recession
When unemployment is high workers worse off: if they’re employed there’s higher
probability to be dismissed and if they’re searching it’s much more difficult to find
job.
People with lower income have higher propensity to consume c1!
I = total saving = S (private) + T – G (public). Public saving is exogenous
(constant)
“Exit strategy” – «Смягчение неудачи» - f.e when government implemented fiscal
expansion, entered large government deficit and in order to reduce it, tries counter
policy – fiscal contraction. If we rise taxes or cut government spending to the same
amount, the thing that would impact output Y more is government spending G. (the
simplest output function)
Reservation wage – wage that makes workers feel different about working or being
unemployed, usually it’s higher than that. It’s connected with outside option (other
alternatives).
Nominal wage W = Pe F(u, z), (–, +) where Pe is expected level of prices, u is
unemployment rate, z are all other structural factors (a catch-all variable) f.e
employment protection laws, etc.
Wage setting equation WS (real wage) W/P = F(u, z). Downward-sloping graph
Production function Y = AN, where A is labor productivity (output per worker), N
is employment (number of workers). Assume A=1 and is constant so Y = N.
Marginal cost of production is W. Assume firms set their prices according to a
markup m (degree of competitive pressure of market – market power) over the
cost. Price determination equation: P = (1 + m)W, therefore real wage from price
setting equation PS: W/P = 1/ (1 + m), flat horizontal graph.
[Total factor productivity function Y = (A*, L, K), where A is productivity, L is
labor and K is capital. What’s productivity? It’s a measure of added value for unit
of input.]
Natural rate of unemployment (structural unemployment rate) = µN – equilibrium
F (uN, z) = 1 / (1 + m) between Real Wage W/P on y-axis and Unemployment rate
u on z-axis, it’s an unemployment rate that solves the equation.
Increase in unemployment benefits z leads to an INCREASE of natural rate of
unemployment, WS curve shifts up. Increase in markup m leads to DECREASE
in real wages W/P, INCREASE in prices P and INCREASE unemployment rate u,
PS flat curve shifts down.
Wage-price setting equations versus supply & demand
Y = AN. We reflect our graphs upside-down and associate WS with supply curve
(UPWARD-SLOPING – higher employment means higher real wage) and PS with
demand curve (labor demand) and it’s still HORIZONTAL FLAT (constant returns
to labor). Instead of unemployment u on y-axis we will have employment N.
Equilibrium – is natural employment NN.
U = L – N unemployment equals labor force minus employment
Phillips curve (by Phillips, Economica 1958)
Relation between unemployment rate and wage inflation is strictly negative. The
higher is unemployment the lower is wage inflation. Unemployment on x-axis and
inflation on y-axis, downward-sloping curve.
In 1970-2010 there was de-anchoring of inflation expectations – no expectations
(plot was completely scattered) – phase of high and persistent positive inflation and
low economic growth because of a negative supply shock of oil. Fed’s commitment
to price stability.
Then 1970-95 we move to accelerationist Phillips curve (it relates unemployment
rate u with changes in inflation Δπ- in other words, it’s a measure of how inflation
is accelerating: when unemployment is high inflation with accelerate and vice versa)
Then 1996-2018 CBs’ focus on price stability from 1980s led to re-anchoring of
expectations.
AS relation (Aggregate supply function): P = Pe (1 + m) F(u, z) relates current
prices with expected prices and unemployment rate, when P ≠ Pe. UPWARDSLOPING CURVE (higher Y higher P)
1) When Y increases, demand Z for goods increases, so unemployment u falls.
When Y is falling, u rises.
2) When unemployment u falls, workers get more bargaining power, so WS
shifts up – wages W rise.
3) As wages W rise, PS relation implies prices that higher wages W mean higher
prices P as well.
4) As current prices P are rising, expected prices Pe are rising as well. WS
relation implies that higher expected prices Pe mean higher wages W.
Here we need to pass to price growth rates (inflation) and how to determine them.
 We assume linear form for F(u, z) = 1 – α u + z, where α is sensitivity of
wages to unemployment.
 Pt = Pte (1 + m)(1 – αut + z) current prices = expectations …
 πt – πte = forecast error
 !!! Finally, πt = πte + (m + z) - αut, where m and z are constant.
Knowing that WS: W = Pe F(u, z) and PS: P = (1 + m)W
1) Increase in expected inflation leads to INCREASE in actual inflation π: πe
up – W up, P up, W up, P up… – π up.
2) Increase in markup m, or increase in wage factors z leads to INCREASE
in inflation π: m or/and up – P up, W up, P up, W up… – π up.
3) Given πe, increase in unemployment rate u leads to DECREASE in
inflation π: u up – W down, P down, W down, P down… – π down
(Phillips curve)
̅ + θ* πt-1
Expectation formation mechanism: πt = (1 - θ) 𝝅
Non-persistent (frequent changes) θ = 0 Classic Phillips curve time series
stationary (always come back to the same long-run mean). ANCHORED
̅ . Where θ is “degree of looking to the past”, when it’s
EXPECTATIONS πe = 𝝅
increasing it means persistence increases and there’s change in expectations.
Persistent (don’t change direction very frequently, in order to make predictions we
can look in past experience) time series non-stationary (it’s not connected to one
certain mean to come back to) θ=1
Stationary time series with persistence θ>0 – connected to long-run mean and come
back to it but changes are rare
So, if we consider expectations of persistent inflation (π te = θπt-1 – expectation is
equal to past events) – ADAPTIVE EXPECTATIONS, θ = 1
Modified Phillips curve (expectations-augmented or accelerationist Phillips
curve) Δπt = πt – πt-1 = 0 = (m + z) - αut
In this case unemployment rate u doesn’t affect inflation rate, but rather the
change in inflation rate Δπt, high u leads to decreasing inflation, etc.
Phillips curve + natural rate of unemployment = Non-Accelerating Inflation Rate
of Unemployment (NAIRU)
πt = πte + (m + z)–αu = uN =
𝒎+𝒛
𝜶
; m + z = uN * α depends positively on m and z,
negatively on sensitivity of wage to unemployment α (when α is high wages
decrease rapidly when unemployment raises). *For linear function F(u, z) = 1 - α u
+z
 When persistency is strong - adaptive expectations, θ = 1, πte = θπt-1 we have:
πt - πt-1 = – α (ut – uN) – new formalization of Phillips curve, based on NAIRU
(uN). INTUITION: rate of inflation goes up if unemployment rate is below
natural unemployment rate
ut < uN - π up,
ut > uN - π down,
uN keeps inflation constant.
 Connecting it with productivity function, knowing formula for inflation Labor
𝜶
force L - Employed N/Labor force L, we got: πt - πt-1 = Δ πt = (Y – YN)
𝑳
If Y>YN inflation is growing,
If Y<YN inflation is falling,
If Y = YN inflation is stable
Wage indexation λ is automatic stabilizer that increases wages with increase of
inflation.
If λ = 0 no immediate feedback nor on wages or on inflation, πte = 0,
(m + z) - αut
𝑥
ut < un ⇒ π > πt-1
𝑥
ut > un ⇒ π < πt-1
If λ > 0 there’s increase in wages
If λ = 1 then small change in u will cause large change on π.
But when there’s low inflation or even deflation it doesn’t mean that there will be
decrease in wages – downward nominal rigidity in wages
IS-LM-PC model
o IS curve: Y = C(Y – T) + I (Y, r + x) + G downward-sloping
o LM curve: target interest rate r=𝒓̅ = i - πe flat horizontal
o PC (Phillips curve): π – πe = – α (ut – uN) upward-sloping
-When u = uN natural unemployment is NN = L (1 – uN)
-When u = uN potential output is YN = L (1 - uN)
-Output gap: Y – YN = L ((1 - u) – (1 - uN) = –L (u – uN) negative relation
between Y and u
If Y>YN inflation is growing,
If Y<YN inflation is falling,
If Y = YN inflation is stable
𝜶
π – πe = (Y – YN)
𝑳
̅ , then π – 𝝅
̅=
Assume anchored expectations πe = 𝝅
𝜶
𝑳
(Y – YN), where 𝜋̅ is
target inflation rate by CB (Taylor rule – interest rate setting rule) – it is policy
interest rate will be increasing in the level of expectations about inflation and
it will be related to output gap: the higher output gap, the higher interest rate
in order to cool down the economy.
[Okun’s law: +1% in unemployment leads to nearly –1% in growth of output.
Downward-sloping graph with slope = -0.4 which is Okun’s coefficient.]
So, in order to fix higher production than a structural level, CB can INCREASE
̅ (so
policy rate target 𝒓̅ shifting LM curve up, to reduce inflation to π – 𝝅
investment, demand and production decrease, bonds will be sold from Balance Sheet
of CB decreasing money supply– holding money will become less attractive for
households).
The policy rate corresponding to natural (structural) production is called “natural”
or “neutral” or “equilibrium” or “Wicksell’s natural” rate of interest.
In medium run monetary policy does not affect real variables – neutrality of money.
It affects only policy target rate affecting real rate through nominal + inflation.
̅ ),
We pass from real money supply: M/P = Y L(i) in short run to M/P = YN L(rN + 𝝅
̅ are constant, M/P is constant in medium run because M
where YN, rN and 𝝅
̅ = rN + gM (growth of money)
changes at the same rate as P. Y = YN and i = rN + 𝝅
Possible problems: it’s no so easy to implement the correct monetary policy because
CB doesn’t know exactly where is the potential output and how far is output from
potential, what is the multiplier– measurement issues. And also, it takes time for the
economy to respond – “long and variable lags”. A “DEFLATION SPIRAL” or
“deflation trap” happens when real interest rate is pushed up by an expectation of
inflation, lowers output, leads to larger and longer deflation and lower output (Great
Depression). Why it happened? Because nominal rate can go down to zero lower
bound so when i=0 r = - πe, when we have deflation πe <0, real rate becomes
positive – de-anchoring of expectations, hard for households and businesses to
invest.
Like we’ve already seen in short-run, in order to decrease budget deficit CB can
implement fiscal consolidation, increasing taxes T, so output, disposable income and
investment go down. Inflation decreases to below target, output gap is <0. In
medium run CB then will lower rN, triggering higher investment (monetary
expansion) so that a new equilibrium will take us back to original YN, inflation rises
back to normal and becomes stable. BUT! Composition of production has changed
(less by consumption more by investment). Even though Y went back to productive
output, Taxes are up so disposable income went down and therefore consumption
went down. At the same time real rate went down and therefore investment rose.
In short run increase in markup – prices up, real wages down, unemployment up –
will lead natural level of output down and inflation rise above target – shift of PC
curve up. We assume IS curve doesn’t move. If price becomes permanent in medium
run it leads to lower output. STAGFLATION – lower output + higher inflation in
the adjustment phase. Solution: increase interest rate to bring output to its natural
level.
OPEN ECONOMY
How we define “openness” of economy?
1) Goods market - we can buy/sell goods whether inside domestic economy or from
foreign with some restrictions – quotas (limit on quantity of goods), tariffs (taxes).
Percent of output (GDP) is made of tradable goods/services.
2) Financial market – ability to choose between domestic or foreign assets – stocks
and bonds, with restrictions – capital controls (regulations that limit ability to buy
foreign stocks)
3) Factor market (market for production factors – labor, capital) – ability of firms to
relocate, or to move to other countries like a worker. – NOT STUDIED
Gravitational models – degree of trade with another economy decreases with
distance.
Tradable goods/services – exposed to international competition – goods for export
like corn, oil. Non-tradable goods – f.e cut at hairdresser.
Exchange rates
Real exchange rate 𝜺 = price of domestic goods / to foreign goods: 𝜺 = EP/P*, where
E is nominal exchange rate, P is prices of domestic goods in foreign currency,
P* is price of foreign goods in foreign currency. P & P* - GDP deflators
Nominal exchange rate E = price of domestic currency in terms of foreign currency
– the one we all know. If goes up/down – appreciation (increase in exchange
rate)/depreciation (decrease of exchange rate) of domestic currency – for flexible
(floating) exchange rates. BUT! When two or more countries maintain a constant
exchange rate between their currencies this system is called Fixed exchange rate.
“Appreciation” then is called – revaluations, and “depreciation” – devaluations.
Real appreciation – when Real exchange rate 𝜺 goes up – increase of domestic goods
price relating to foreign.
Real depreciation – when Real exchange rate 𝜺 goes down - decrease of domestic
goods price relating to foreign.
Balance of payments: Set of accounts that summarize country’s transactions with the
rest of the world
Current account balance: transactions above the line record payments to and from
world. Surplus – positive net payments from abroad (we increase holding of foreign
assets. We sell more than we buy), Deficit – negative net payments (we buy more
than we sell, debt to world)
 Exports and imports (trade balance EXPORT (X)– Net country IMPORT
(IM). X>IM – trade surplus, X<IM – trade deficit)
 Net income balance NI – difference in income received from the world
(people’s income from financial investments abroad) and income paid to
foreigners
 Net transfer received NT – difference in foreign aid given and received
Financial account reflects increases or decreases in a country's ownership of
international assets (net foreign holdings of domestic assets):
 Net capital flows or financial account balance (holding of domestic assets
minus increase in domestic holdings of foreign assets)
 Financial account surplus or deficit
 Statistical discrepancy – difference between current and financial account
transactions
Net borrowing to/from the world = current account – capital account
GDP vs. GNP
GDP – value added domestically (by factors located in the country)
GNP – value added globally (by factors located in country and abroad) = GDP + NI
(income received from the world minus income paid to foreigners)
Openness in FINANCIAL markets
(Choice between investment in domestic and foreign financial assets)
Return on buying a domestic asset: (1 + it)
Return on buying a foreign asset: (1 + it*) (
𝐸𝑡
𝑒
𝐸𝑡+1
), where
𝐸𝑡
𝑒
𝐸𝑡+1
Arbitrage (profit on price discrepancies): (1 + it) = (1 + it*) (
is expected depreciation
𝐸𝑡
𝑒
𝐸𝑡+1
) is called uncovered
interest parity relation. Risks: currency risk, transaction cost (foreign investment is
more expensive). Domestic interest rate must be equal to foreign interest rate
minus the expected appreciation rate of domestic currency – it ≈ it* –
𝑬𝒆𝒕+𝟏 −𝑬𝒕
𝑬𝒕
i can be equal to i* if countries have credible fixes exchange rate agreement, so
expected appreciation
𝑬𝒆𝒕+𝟏 −𝑬𝒕
𝑬𝒕
=0
Demand for domestic goods (ZZ): Z = C + I + G – IM/𝜺 + X in open economy,
where 𝜀 is real exchange rate, IM – imports and X – exports
Domestic demand for domestic goods (AA) – DD minus IM
Domestic demand for goods (DD): C + I + G = C(Y -T) + I(Y, r) + G (closed
economy)
In closed economy demand for domestic goods = domestic demand for goods. An
increase in domestic output leads to a trade deficit. Effect of government spending
on output is smaller – the multiplier is smaller than in open economy.
o Imports IM = IM (Y, 𝜺) (+, +) positively related to domestic income Y
(higher demand for imported goods) and as 𝜀 increases foreign goods become
cheaper than domestic goods (when there’s real appreciation of domestic
goods, purchasing power increases)
o Exports X = X (Y*, 𝜺) (+, –) – positively related to foreign income and
negatively to 𝜺 – as 𝜀 increases domestic goods become cheaper than foreign
(increase of foreign demand for their domestic goods)
How to transform closed economy function into open:
FIRST STEP. Subtract IM. Domestic demand for goods DD (including all
households want – domestic and foreign) subtracting Imports = domestic
demand for domestic goods (AA)
DD – IM/𝜀 = AA. IM/𝜀 (Y+, 𝜀)
AA slope is smaller than one of DD because part of domestic demand, as
output Y growth, goes to imports
SECOND STEP. Add X. Domestic demand for domestic goods (AA) add
Exports X = total demand for domestic goods (ZZ)
AA + X = ZZ. X (Y*+, 𝜀–)
ZZ shifts parallelly up, because X doesn’t depend on domestic output Y but
on foreign output.
-Total exports X = Imports IM/ 𝜀 when ZZ curve intercepts DD curve (demand for
domestic goods crosses domestic demand for goods so TB trade balance = 0 = YTB)
-If domestic output grows then imports go up and exports X stays the same, so TB
goes down, X < IM/ 𝜺 – trade deficit.
-If domestic output drops then import go down and exports X stays the same, so TB
goes up, X>IM/ 𝜺 – trade surplus.
Equilibrium output Y = Z and trade balance X = IM/ 𝜀.
(𝒀,𝜺 )
IS curve relation: Y = C(Y – T) + I(Y, r) + G – IM
𝜺
+ X(Y*, 𝜺)
Equilibrium – intersection of ZZ and 45-degree line (Y = Z production = income).
Domestic production = demand for domestic goods. If we move right/left from the
point of equilibrium – there will be investment on stock surplus/deficit.
Differences with closed economy:
1) Whenever domestic output is increasing, there will be TB deficit or at least
more negative TB.
2) Smaller effect of government spending on output, because ZZ is flatter than
DD, part of increased output goes to exports, the multiplier is SMALLER than
in closed economy.
Effects:
1. Government spending goes up – increased demand, output goes up
ΔY>ΔG because of the multiplier effect but it’s smaller than in closed
economy. NX curve stays constant – no direct impact of G. If increase
output in open economy, part of your benefits will go also to other
economies – country that in the recession decides to increase G and thus
helps foreign economies
2. Increase in foreign demand caused by an increase of foreign output –
causes increase in demand for domestic goods (causes more exports, it
creates a shift in NX curve up in domestic economy). Therefore, an
increase in X leads to shift up of ZZ curve (demand for domestic goods,
domestic demand for goods is unchanged). Higher level of output – leads
to a better trade balance TB – trade surplus. Country that in the recession
decides to wait another country to share the benefit from increased output.
3. That’s why in 1999 G20 was created and in 2008 leaders met to coordinate
their actions towards the crisis aiming to increase private or public
spending simultaneously.
Role of depreciation
Country can influence 𝜀 = EP/P* through changing nominal exchange rate –
appreciate or depreciate it.
What happens to NX when we change 𝜀? When domestic goods become cheaper than
foreign goods – real depreciation – TB is affected in 3 ways:
1) Exports X, increase – because domestic goods became cheaper for foreigners
2) Imports IM, decrease – it’ll be costly to buy foreign goods
3) Price of foreign goods increases relating to domestic goods 1/ 𝜀, increases
2 and 3 are opposing forces
Marshall-Lerner condition: A real depreciation leads to an increase in NX = X
– IM/ 𝜺 – depreciation leads to shift in demand both foreign and domestic towards
domestic goods – it leads to increase in domestic output and an improvement in their
trade balance.
POLICY MIX. How to reduce trade deficit without overheating economy?
 Government can implement real depreciation decreasing real exchange rate
𝜀 so NX goes up and demand for domestic goods ZZ shifted up.
 As demand increases, output rises higher than its natural level and that’s why
it overheats. We should keep it at its initial level by implementing fiscal
contraction (negative shock on government spending). Then domestic
demand will shift down and bring NX to trade balance.
Initial conditions
Low output
High output
Trade surplus
G up, ε?
ε up, G?
Closed economy I = S + (T – G)
Trade deficit
ε down, G?
G down, ε?
Open economy Y = C + I + G + NX
(Y + NX + NT - T) – C = I + (G – T) + (NX + NI + NT)
DISPOSABLE INCOME – Consumption = Investment + PUBLIC DEFICIT +
CURRENT ACCOUNT (CA)
S = I + (G – T) + CA [Savings = Investment + Public deficit + CA]
CA = S + (T – G) – I | I = S + (T – G) – CA
o Increase in Investment leads either increase in private or public saving, or
deterioration in CA balance.
o Deterioration in government budget account (T – G) causes either an increase
in private saving, or decrease in investment, or deterioration of CA balance.
o High saving rate countries S + (T – G) = I + CA must have high investment
rate or large CA balance.
Central bank money = currency (CU) + bank reserves (R)
Money demand Md = c Md (CUd) + (1 - c) Md = currency demand + demand for
deposits
Ratio of reserves to deposits: θ