Summary MacroEconomics 3 - All class material

Chapter 2&3: Money, Interest Rates and the Global
Economy.
What to analyse?
-Partial-equilibrium model: microeconomics.
-Gerneral-equilibrium model: macroeconomics.
This course:
-Short-run models (long-run: macro 4)
-Dynamic model: Short-run – medium run – long run equilibrium
 Dynamic Aggregate Supply and Demand model




Keynesian Cross
Assume:
1) fixed prices (short-run)  so output changes, not prices.
2) output is income determined by the demand side  demand side
policies!
Aggregate Expenditures (= planned) = AE = C+I+G+EX+IM = Y
 Y = c*Y +I+G+EX-IM
 Y – cY = I+G+EX-IM

 Y = ( 1−c1 ) I+G+EX-IM

So: the steepness/slope of AE depends
in this case on the MPC (c). The higher
the MPC, the steeper the slope of AE.



If Y<AE (above Y=AE line):
boom/employment
If Y>AE (below): bust.



 IS/LM
 Mundell Fleming




IS/LM model: closed economy (=world as a whole).
Assume:
1) fixed prices (short-run)
2) closed economy (no exchange effects)
IS: combinations of Y and interest rate i that lead to equilibrium in: goods

,market.
Y= C(Y,..) + I(i) + G
LM: combinations of Y and interest rate i that lead to equilibrium in: money
market.
Ms = M d
Note:
Money market is necessary for solution due to extra variable added: interest rate.
Investments are actually a function of the real interest rate, but since prices are
assumed to be constant, we can use the nominal interest rate.
Money market in equilibrium with real money supply instead of nominal money
supply, but also here: short run.


Money market:
-Money demand: L(i,Y)
-Money supply: MS (fixed).









So: higher income  higher money demand  higher interest rate = LM curve.

With expansionary monetary policy: MS goes up, IR down (in reality other way
around): shift of LM curve (in reality: money supply curve horizontal due to
interest rate targeting: money supply endogenous: “lm curve”  horizontal).
Reality: if income increases, then IR does not change (horizontal M S).




Monetary Policy rule: mix of interest rate targeting and money supply
targeting. lm curve in between “lm curve” and LM curve.
Monetary policy rule determines money supply. So for lm curve, you need

,to add the money
demand.
The steeper the lm curve, the less fluctuations in Y due fiscal
stimulation/subtraction.
Interest rate targeting: shocks in money demand do not affect your
economy.

Goods market
Y=C+I+G+EX-IM
 C = cY I = I0 + bi Ex = x1Yw + x2R Im = m1Y – m2R R:
exogenous.
Y = cY + I0 – bi + G +x1Yw +x2R – m1Y+ m2R
IS curve: Higher i ( lower investments)  lower Y.
Shift of IS curve: higher G, R or YW: IS goes up.

Model

In addition to Keynes: also interest rates (not
only marginal propensity to consume). Multiple
multipliers!




Multipliers
Suppose:
Consumption C = Ca + c(Y-T) Investment I = Ia – bi Money demand L = kY-
hi

Tax multiplier in IS/LM model:
1) write both functions to i:
kY −M k 1
LM: kY-hi = M  hi = kY-M  i = i= Y− M
h h h
IS: Y = C+I+G  Y = Ca+ c(Y-T) + Ia – bi + G i=
−1−c Ca−cT + Ia +G
Y+
b b

2) IS=LM to determine Y as a function of all variables
k 1 −1−c Ca−CT + Ia+G
Y− M = Y+
h h b b

, h(Ca−cT + Ia+G) b
Y= + M
kb+ h(1−c ) kb+h ( 1−c )

−C
∆Y h(−c)
3) kb
∆T = kb+h(1−c ) = +1−c
h




So: IS/LM model: closed economy, short run, determines Y and i.

Chapters 4/5: The Open Economy
Two ways of classifying the BOP:
Old classification: BoP = CA + CP + OR = 0 New classification: BoP = CA + CP +
FA = 0



 New capital
account = net
factor income
received from
abroad.
That was
previously
included in
Current Account
Negative OR: your
foreign reverves grow.




Mundell-Flemming model
With flexible exchange rates: if (old) CA+CP > 0; there is excess demand for
your currency  appreciation.
 CA and CP both decline until CA+CP=0. DETERMINES EQUILIBRIUM E!!
-CA: EX-IM (if we ignore net factor income from abroad)
CA= x1YW + x2R – m1Y + m2R
-CP: demand for financial assets
In case of risk neutrality, we have uncovered interest
parity
E e −E
=i=i + W
E  so if Ee = E, i=iw.