Résumé de ‘Macroeconomics’ de Burda & Wiplosz (4th edition) Chapter 2 : Macroeconomic Accounts GDP – 3 definitions : 1. Sum of all net final sales 2. Sum of value added 3. Sum of factor incomes earned from economic activities The division of the value added is arbitrary and potentially separate from the issue of whether value added is generated at all. GDP doesn’t measure happiness: Painful expenses (having a tooth removed) enter the stats in the same way as pleasurable ones. Used-goods sales are not counted at all (second hand market). Sales by retailers from inventory accumulated in earlier periods actually reduce GDP, as they represent a depletion of stocks (?). GDP: location-based GNP: Ownership-based GDP deflator: Ratio of nominal to real GDP (Ex: Nominal Growth: 10%, Real growth: 6%, GDP deflator growth: 4%). Prices rose therefore roughly by 4% (inflation). Alternative measure of inflation: price index (average of prices with fixed weights). An example is the consumer price index (CPI): based on a basket of goods consumed by a representative or average individual. GDP Deflator and CPI are normally congruent, only when there are external shocks on import prices (oil shock, etc.) they might differ. *PPI: Producers Price Index (closest to the GDP Deflator) 1
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GDP – 3 definitions · Web viewChapter 2 : Macroeconomic Accounts. GDP – 3 definitions : Sum of all net final sales. Sum of value added. Sum of factor incomes earned from economic
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Résumé de ‘Macroeconomics’ de Burda & Wiplosz (4th edition)
In countries with chronically high inflation nominal interest rates are often indexed.
*The real exchange rate (Sigma) is defined as the ratio of domestic to foreign prices. The real
exchange rate is constant when equal to the inflation differential (between foreign country
and domestic one).
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*Relative purchasing power parity (PPP)
Bringing together PPP and the explanation of long-run inflation, we see that the long-run rate of
exchange rate depreciation depends on the difference between the rate of money growth at home
and abroad.
A much stronger version of this idea is absolute PPP, which asserts that price levels are equalized
across countries when converted into the same currency. The evidence on this is rather spotty, but
in Europe it might just as well work in the future (works only in very integrated markets).
*The demand for money increases with transaction costs because agents have an incentive to limit
the number of transactions between money and other assets.
*Inflation reduces purchasing power of money. An expected increase in inflation leads agents to
reduce their real demand for money. This effect is captured by the nominal interest rate, the sum
of the real interest rate, and the expected rate of inflation (the Fisher principle).
*In the long run, in the absence of real disturbances and relative purchasing power, parity holds.
Then the rate of nominal exchange rate depreciation is equal to the inflation differential.
Chapter 9: The Supply of Money and Monetary PolicyCB are typically required to deliver low and stable inflation.
*ESCB: European System of Central Banks (or Eurosystem)
Inflation may be the objective, but central banks cannot control it directly. Inflation is determined
by the confrontation of the real demand for money with a nominal money supply. The ‘art of
central banking’ is to match the supply of money today with its ultimate, long-run impact on
inflation. Thus achievement of the inflation objective is indirect. To that effect, CB rely on targets
and instruments.
Instruments:
a.) Bank refinancing rates
b.) Open market purchases and sales
c.) Reserve ratios
Targets: (intermediate objectives)
a.) Long-term market interest rates
b.) Monetary aggregates
c.) Exchange rates
d.) Inflation rates
Objectives:
a.) Price stability
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b.) Short-term growth
c.) Exchange rate stability
Nowadays, interest rates set directly by the CB have become the instrument of choice. The money
supply is then determined by the market.
CB control only cash and bank reserves held by commercial banks at the CB. Secondly, it regulates
commercial banks’ money creation by limiting the volume of their reserves.
The sum of currency in circulation and commercial bank reserves is known as the monetary
base, sometimes called M0.
Were it not for banks, the only circulating medium of exchange would be currency. Contrary to
all other financial intermediaries, commercial banks issue money by lending money that they
do not directly possess.
It is the CB that shifts the money from one reserves account to another, when a customer cashes in
a cheque. For such transactions, a positive reserve balance is obviously necessary at the CB. In
other countries there are reserve requirements (a certain reserve ratio). EU: 2%, USA: 3%, none in
CH, UK who rely entirely on prudential behaviour.
The linkage between loans and reserves implies a relationship, known as the money
multiplier, between the monetary base and each monetary aggregate.
*Reserve multiplier = 1 / rr (reserve ratio)
Since the CB is interested in controlling the aggregate money stock (M1, M2, or broader
aggregates), rather than reserves per se, more attention is paid to the monetary base multiplier, or
money multiplier, which relates the monetary base to a monetary aggregate, for example M2:
Monetary multiplier = M2/M0.
The larger the share of currency is in M0, the fewer reserves which remain in the banking system,
and the smaller is the multiplier.
Leakages: Deposits in non-bank financial institutions which operate with a 100% reserve
requirement plus, money can leak abroad. But the reserve availability is less automatic than
implied by the money multiplier formulae. As conditions change, or are expected to change, the
actual multiplier can fluctuate.
At a time of globalization, reserve requirements subject the domestic banking sector to a
competitive disadvantage relative to other countries with lower or non-existent minimum ratios.
*MOd = M / m;
(Derived demand for the monetary base equals the nominal demand for money devised by the
money multiplier m)
Any change in the demand for the overall money stock M is transmitted to a change in the demand
for the monetary base.
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*The market for the monetary base is called money market or open market, the linchpin of all
financial markets.
Open market operations:
1.) short-term loans from CB to commercial banks, guaranteed by a collateral MO
rises M1 as well
2.) Purchase or sales of assets (foreign exchange, government securities)
3.) Changing the binding reserve ratio
Because these loans are short-term, commercial banks continuously need to pay back and borrow
again, a procedure called rolling over. This increases the precision of CB intervention.
* The money market rate reflects the cost of money to banks (the rate they use for trading reserves
among themselves); in EU: EONIA
The CB cannot define the supply of money and the level of money market interest rates at the
same time (see Fig. 9.6)
As long as the public’s demand for monetary aggregates is stable, money growth ultimately
determines inflation.
Lately, the link between money growth and inflation has become less predictable over the policy
planning horizon (two, three years), much as the link between money base and wider monetary
aggregates has become clouded. Monetary targeting has become unreliable, main reason is the
variable money multiplier: control of MO does not deliver a precise handle on the wider
aggregates.
A promising approach is inflation targeting.
Monetary policy in an open economy: CB use their foreign assets to intervene on the foreign
exchange market to influence the exchange rate.
There is a similarity between exchange and open market interventions. Both affect the liabilities of
the CB (monetary base) as well as its assets and in both cases the money multiplier then amplifies
the initial effect of the intervention. The difference lies in which asset holding changes (domestic
or foreign).
Monetary policy autonomy is lost when the CB is compelled to intervene on foreign exchange
markets to fix the exchange rate (in case of fixed exchange rate). Sterilization (‘quick fix’)
strategy: Do the opposite intervention on both holdings. This is a reshuffling of the asset side of
the CB’s balance sheet – an increase in domestic asset holdings matched by a reduction of foreign
exchange – leaving the liability side, in particular the monetary base, unchanged.
monetization of the public debt
Seigniorage is the main source of profit for the CB (counterpart for printing bills for the
government)
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Inflation tax: Erodes all nominal government liabilities that are not protected against
inflation, not just the monetary base (tax because the household – the ultimate borrowers –
pay for it: it’s an indirect tax like the TVA and consequently an unjust one).
Since most of the money stock is created by commercial banks, control of the money
supply by the central bank is only indirect.
The public’s demand for money translates into a derived demand for the monetary base.
This demand is expressed in the money market.
There exists an automatic link between foreign exchange market interventions and the
money supply. Sterilization is one way of breaking the automatic link.
As a public institution, a CB can assist the government in the financing of its expenditures
in three ways:
a.) it can lend directly to the government
b.) it usually remits most if not all of its seignorage profits
c.) by allowing inflation to rise, it creates an inflation tax which lowers the burden of
the public debt when the latter is not indexed.
In addition to establishing the standard of payment, the CB ultimately guarantees the value
of money. This is done by a variety of regulations and the lender-of-last-resort function. Bank
deposits are guaranteed – sometimes up to a certain level – through a combination of insurance
schemes and implicit understanding that the CB will create sufficient monetary base in case of
bank failure. In return, the CB may impose on banks constraints designed to reduce their
vulnerability.
Chapter 10: Aggregate Demand, Output, and the Interest Rate
*Keynesian assumption: the sticky price assumption (prices are constant over the short run):
implies that output is determined by demand, and that production adjusts passively to shifts in
aggregate demand.
*trade openness: % of international trade in GDP
*CH share of world GDP: 0.8% (USA: 32.1%), openness: 40.9% (USA, Japan, EU: 10.5-11.8%)
*General macroeconomic equilibrium: Interactions between several markets, focusing on the
conditions required for their simultaneous equilibrium. Through the interest rate, the money market
affects the goods market, and thus the level of output. The goods market, in turn, influences the
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demand for money and thereby the interest rate. The real exchange rate influences the demand for
domestic goods and the money market affects exchange rate.
*Y = C + I + G + PCA (primary account which represents the net demand from the rest of the
world: X – Z)
*Consumption function:
*Investment function:
‘Tobin’s q’: business expectations or entrepreneurial ‘animal spirits’ (exogenous)
*Import function:
*Export function (‘Z of the rest of the world’):
*Primary current account function:
Those factors which boost domestic absorption A (increases in wealth, disposable income, Tobin’s
q, real growth, or a decline in the interest rate) increase imports and worsen the PCA. Finally, a
real exchange rate appreciation leads to a deterioration of the primary account as imports rise and
exports fall.
*Rewritten PCA function in terms of GDP:
*Desired demand function:
GDP has thus two effects. The consumption effect dominates, because Z represent a fraction of
domestic spending.
*The 45° diagram: the schedule is flatter than the 45° line because, when income or GDP rises,
demand for domestic goods and services increases by less. One reason is that part of any spending
falls on imported goods, plus consumers usually save part of any additional income plus parts of
the additional income is taxed away (is this missing tax share not already mathematically indexed
in the original 45° parameters?).
*Consumption smoothing behaviour: Not sure whether an increase in Y will last, the consumer
saves parts of it.
This schedule (Fig. 10.3) only captures the effect of GDP on demand, taking all other
variables as constant. If they change, the DD schedule will shift. For instance, an increase in i
reduces D for I goods, which shifts DD downward. *goods market equilibrium and
*equilibrium GDP
Firms use their inventories as a buffer to meet temporary changes in demand; the accounting
identity remains verified off equilibrium because inventory changes are treated as demand –
positive when inventories raise, negative when they decline – and demand, and therefore sales,
may differ from output.
The Keynesian model explains how output fluctuations are driven by exogenous changes in
demand.
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*Keynesian demand multiplier: Effect that explains that GDP increases by a multiple of the
initial demand increase (process that may take several months to complete). ‘Everybody’s
additional spending is someone’s income.’ The Keynesian multiplier is not infinite because, at each
step, some fraction of income is not plugged back into further consumption (leakages: T, S, and Z).
Theses three leakages represent domestic income not automatically re-spent on domestic goods
and services. In fact, they might trigger new multipliers but, since we consider G, q, and Y* as
exogenous, we cannot logically treat them as responding automatically in the circular flow of
income. In the end, the larger the automatic leakages, the flatter is the DD schedule.
*Estimates of the Bundesbank: Most of the effect occurs within one year, and the multiplier is
indeed larger than 1 in most cases. There is still some impact left over the second year.
Problem of endogenous and exogenous (prices, e.g.) variables in the Keynesian model: Some
variables are exogenous (fixed exchange rate) under a given exchange rate regime, and endogenous
under another one (flexible exchange rate the exchange rate and thus P). So, when the exchange
rate is flexible and endogenously determined by market forces, the CB can control the money
supply, which is then treated as exogenous (M = M). Similarly, when the CB pegs the exchange
rate, the chosen parity S is treated as exogenous, while the money supply M is endogenous.
*IS curve: For given values of exogenous variables, the IS curve represents the combinations of
nominal interest rate i and real GDP that are consistent with goods market equilibrium.
The IS curve’s slope is flatter the greater the sensitivity of C and I to changes in i, as measured by
the vertical shift of the desired demand schedule and the larger the multiplier that translates the
initial exogenous change into higher total demand.
*excess supply and excess demand region in the IS graph
The economy can temporarily stay off the IS curve, while firms use their inventories as a buffer
stock, but fairly soon they will adjust their output, returning the economy to goods market
equilibrium on the IS curve.
Important: No confusion between shifts of the IS curve with movements along it! It describes
how the two endogenous variables, Y and i, are combined to achieve equilibrium, ceteris paribus
(all the variables that we treat as exogenous when we draw the IS schedule). Any change of these
variables delivers another IS curving accordingly (shift). As long as they rest unchanged, we move
along the curve. What exogenous variables are relevant? – G, T, q (affecting I decisions), wealth
(which result from fluctuations in the value of assets such as stocks, bonds1, housing, and foreign
disturbances (change in Y* that affect the IS curve through the PCA), including changes in the real
exchange rate or domestic and foreign prices.
1 Traduction en français : stocks actions ; bonds obligations
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*Over the 1990, US stock prices increased on average more than fourfold (‘information technology
revolution’)!
*Tobin’s q is measured as the inflation-adjusted value of the stock market index. It sometimes
precedes GDP as an indicator for market evolutions (mid-1990s) sometimes it lags GDP (2000
onwards).
*The PCA is not only source of leakages, but also transmits foreign disturbances.
The LM curve is the combination of income and interest rates for which the money market is in
equilibrium, given the price level and the exogenous variables.
*Money market equilibrium: M / P = L(Y, i, c)
The LM curve is steeper the more sensitive the demand for money is to changes in real GDP (large
income elasticity of money) and the more sensitive the demand for money is to interest rate
changes (low interest elasticity of demand).
To summarize, the LM curve is steeper, the more sensitive money demand is to output, and the less
sensitive it is to the interest rate.
All points off the LM curve signal conditions of disequilibrium in the money market. The region
below and to the right of the LM curve represents disequilibrium situations of excess demand
(below) or supply (above) on the money market. Restoration of equilibrium requires either a rise in
the interest rate, or a reduction in GDP.
To avoid confusion between shifts of the LM curve and movements along it, the same rule applies
as for the IS curve: it remains unchanged as longs as the exogenous variables (L, c) do not change.
In international financial markets, the foreign rate of return i* is exogenous and constantly adjusted
worldwide through arbitrage of the sharks interest rate parity condition: i = i*: BP line
Three schedules: IS, LM, BP line: drawn ceteris paribus
*General equilibrium: Goods, money, and international capital markets are in equilibrium.
The open-economy IS-LM model is an efficient way of understanding the working of an open
economy in the short run, when the sticky price assumption is defensible (supply fully adjusts to
demand; this is the traditional Keynesian view2). More precisely, it allows us to ask what happens
to the model’s two endogenous variables (i, GDP), when any of the exogenous variables changes.
Example of expansive monetary policy under fixed rate conditions
(M +) LM shifts to the right i < i* I in domestic assets + danger of depreciation CB:
exchange market intervention (buys domestic currency with its accumulated stock of foreign
exchange reserves M - LM shifts to the left initial general equilibrium point restored.
Monetary policy has no effect under a fixed exchange rate regime!
2 So, if demand exceeds supply, producers won’t rise prices but adjust with increased production. This works quite well for regimes with fixed exchange rates. If prices are flexible, it is rather demand that adjusts to supply.
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Graphically we find that the LM curve is endogenous and must always move to pass through
where the two other schedules IS and BP intersect.
Same procedure on the balance sheet: M0 (liability side) = F + DC (asset side), F being foreign
exchange and DC domestic credit or securities. What the right hand gives – more M0 and more DC
– the left hand takes away – less M0 and F – and M0 must return to its initial level to keep i in line
with i*. This foreign exchange market intervention procedure that follows the initial open market
intervention that expanded MO is called an unsterilized intervention. In principle, the CB could,
instead, conduct a sterilized intervention. This would mean to re-inject in a second step the gained
MO into the market (trading off with DC) which would lead to the situation where the CB has just
reshuffled its balance sheet’s asset side. A sterilized intervention fully shields the monetary base
and, therefore, the domestic supply.
*Capital controls: mean to dissociate i from i*. In practice, however, the rewards to dodging the
controls – exploiting the difference between asset returns – are so high that many investors develop
great skills and invest large amount of resources to circumvent the controls.
Example of G + under fixed exchange rates: IS shifts to the right GDP + money demand +
i + (so crowding out) capital flows in exchange market under pressure of appreciation
government: M0 + LM shifts to the right GDP +
The end result is that the demand disturbance does affect output. A fiscal expansion (G +, T -)
succeeds in raising output. In fact, the expansionary effect is more powerful in a small open
economy than in a closed one. The crowding-out effect vanishes, simply because i cannot depart
from i*. The CB is forced to expand the money supply as it intervenes on the foreign exchange
market to thwart an appreciation.
One more illustration that monetary independence is lost under fixed exchange rates.
*policy mix: co-ordinated use of monetary and fiscal policies
In a situation of international financial disturbances (i* + or -), economy with fixed rate is not
shielded LM to the left GDP -, while a flexible rate quickly depreciates X + IS to the
right GDP +
*Devaluations and revaluations can restore certain monetary policy independence.
Parity change is not merely a declaration of intention, but must be backed by action.
Devaluation must be accompanied by a monetary expansion, a revaluation by a monetary
contraction. Thus, monetary and exchange rate policies are just two sides of the same coin.
This important observation qualifies the previous, radical conclusion that monetary policy is lost
under fixed exchange rates when capital is freely mobile.
Flexible Exchange Rates: IS to the right The CB doesn’t intervene in the foreign exchange
market and can therefore control the money supply. Put differently, the position of the LM curve is
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exogenous i > i* K flows in S +, the real exchange rate as well PCA - demand for
domestic output - IS to the left
The return to the GE is not instantaneous, the effect of S on trade and the CA needs time to
complete.
Aggregate demand disturbances leave output unaffected! Increases in D entirely leak abroad as
a result of the loss of competitiveness. So, domestic demand impulses are eventually neutralized by
exchange rate changes and, beyond a transitory period, the economy is insulated from foreign
demand disturbances. The IS curve is now endogenous and moves to meet the two other
schedules, LM and BP.
Monetary expansion: LM to the right K flows out nominal exchange rate depreciates
external competitiveness + demand for domestic goods + CA + IS to the right
Works! Monetary policy works entirely through its effect on the exchange rate and the CA, rather
than through the interest rate, which remains governed by foreign returns.
*beggar-thy-neighbour policy: policy that diverts world demand away from foreign goods and
toward domestic goods. This unfriendly policy is one of the historical reasons of the Euro.
The firms that benefit from a monetary expansion are those that are export oriented, while the
policy mix favours firms that cater primarily to domestic customers. Depreciation benefits firms,
but hurts customers. Plus, policy mix doesn’t hurt the foreign competitors.
International financial disturbances K flows out depreciation external competitiveness
and CA + IS to the right. Monetary contraction has thus an expansionary effect at home, which
results from the fact that their exchange rate appreciation is our depreciation. This is called a
negative transmission. This feature is important to international monetary cooperation.
The exchange rate regime is best understood through the prism of monetary policy.
Among the countries that adopt the freely floating exchange rate regime are those that have
developed sufficient economic and political stability to entrust the CB with the task of delivering
price stability. Other countries let their exchange rate float for the opposite reason, because
inflation is so high that any peg would quickly lead to over-evaluation or countries that have been
bruised by speculative attacks against a previous peg (Argentina, Brazil, Chile, Russia, etc.).
*The PCA improves when income and output in the rest of the world expands and the real
exchange depreciates, and worsens when the domestic GDP and absorption rise at home.
*When the exchange rate is fixed, demand disturbances affect domestic GDP while monetary
disturbances, including fiscal policy, have no effect on real GDP. The exchange rate is set
exogenously and the money supply becomes endogenous, hence the LM curve moves to meet the
IS and BP schedules.
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*When the exchange rate is freely floating, the economy is shielded from demand disturbances,
while monetary policy is effective. The exchange rate is now endogenous while the central bank is
able to set money supply exogenously. It is the IS curve that moves to meet the LM and BP
schedules.
*Monetary and exchange rate policies are just two side of the same coin: the CB can control the
money supply or the exchange rate, not both. Under fixed exchange rates, the CB controls the
exchange rates and must give up the control money supply, under flexible rate regime it retains
control of the money supply and lets the exchange rate be determined by the market.
Chapter 11: Output, Employment, and Prices
The sticky price assumption is clearly not tenable in the long run. It is the flexible-price assumption
that provides the tool to understanding. Prices will thus be made endogenous in this chapter. It
shows that when all prices, including wages, are flexible, the GDP is determined by the supply
side. Demand-side disturbances, the usual source of business cycles, have no effect. The classical
approach has another way to achieve equilibrium, the equality between demand and supply of
goods and services: through the flexible prices. It argues that firms do not have to adjust supply to
demand. They will do so only if it is in their interest.
*Capital stock is not exogenously given in the long run, but for sake of simplicity it is here. This
assumption leads us to an interesting observation: Equilibrium in the labour market determines
the equilibrium level of output supplied by firms.
The IS/LM model shows complementarily how much households, firms, and the government want
to spend on today’s output Y given prevailing interest rates (aggregate demand). The position of
the supply line in the IS/LM graph is found by ‘reflecting’ the output level found in the production
function using the 45° line. S is vertical because the supply side here is independent of the
demand side: it is determined by labour productivity – itself determined by the existing capital
stock – and labour supply behaviour of workers and their representative organizations.
Plus we introduce flexible prices in the money market. As long as the price level is constant, the
nominal and real money supply behaves identically. But the CB controls nominal, not real money
supply. So, when prices rise, the purchasing power of money declines and real money supply with
it. Putting real and nominal money supply into one graph allows us to determine the price
level.
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We thus have considered three markets (goods and services, money, and labour), and we now have
a way of finding the output level, interest rate and price level that corresponds to the simultaneous
equilibrium in these markets. It is important to recognize that there has been no assertion that the
price level is explained – or caused – by the conditions described. Causality would imply that the
price level is endogenous, an assertion not yet made.
But the just described three markets need not be a priori in equilibrium. In the neoclassical view, it
will be the price that steps into the game at this point. When it is flexible, all three markets will
always be jointly in equilibrium.
Example of a case where the level of demand and income compatible with goods and money
equilibrium Y is less than output Y produced and supplied by firms, given labour market
equilibrium. Excess supply P- At unchanged money supply M, the real money supply M / P
increases LM shifts to the right.
This process starts to work once the firms stop to pile their inventories and under the assumptions
that the CB doesn’t change money supply and that nominal wages adapt to the market (real wages
staying the same). So price flexibility restores general equilibrium.
For the neoclassical approach to work, it is not just the price level that must be flexible, but
all prices. This includes the price of L, but also the price of foreign currency, the nominal
exchange rate. If one of these prices is sticky, the whole process breaks down.
That nominal wages are sticky, at least downward, was at the centre of Keynes’ critique of
classical economics.
We conclude that under full price flexibility, output is supply determined. Price adjustments restore
equilibrium through the real value of money (S > D P - real value of money + real i -
D +
2 important conclusions of the neoclassical model:
1. Real variables (real GDP, employment, relative prices, including the real exchange rate) are
unaffected by the level of the money supply. (IS and S schedules both describe the real side of
the economy, respectively the goods market and the labour market, while the LM curve
describes the nominal side of the economy, the money market. The general equilibrium is
entirely determined by the real side).
2. Changes in the money supply affect all nominal variables (i.e. those denominated in terms of
the domestic currency) by the same proportion.
Example of M + real money supply + LM to the right D > S P + real money
supply - LM shifts back. The prices increase thus necessarily in the same proportion
than M did. Nothing changes. (In an open economy nominal exchange rate would have to
change as well to leave the PCA unchanged and the IS curve on the spot.)
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The property that money does not affect the real side of the economy is known as monetary
neutrality.
When the price level adjusts immediately in order to maintain the economy in general equilibrium,
the classical dichotomy principle holds: nominal variables do not affect real variables. Only
real disturbances, changes in technology and tastes or in public spending and taxes, can affect the
real side (growth, employment, real consumption, etc.). Monetary factors, such as the money
supply and nominal interest rates, play no role.
This seems to be a good assumption for the long run. At the same time, the wealth of evidence
suggests that strict monetary neutrality does not obtain for the short run, say from year to year.
Changes in nominal money do not lead to instantaneous price changes.
The Keynesian approach turns around the neoclassical view: fixed prices and variable
output. (Common day-to-day experience suggests that firms do not change prices every day. Why
this is so is not entirely well understood.) Consequently real money supply is exogenously fixed
and the LM curve cannot move.
Example: D < S Supply adjusts to the left less labour employed (w are also fixed)
unemployment + disequilibrium on the labour market
We find that the GE is not achieved. The labour market becomes the escape valve for
disequilibria that arise in the market for goods and services. A key message from the
Keynesian view is that unemployment, over and beyond its collectively determined equilibrium
level, becomes the only available margin of adjustment. With sticky prices, the flexible-price
GE does not occur, except by chance. Goods and money markets are in equilibrium, but the labour
market is not. This seems realistic.3
*Non neutrality of money, the classical dichotomy no longer holds. Changes in the nominal
money surplus shift the LM curve, and thereby affect output, employment, and all the other
real variables. When the price level is fixed, it is money demand that adjusts to money supply.
Changes in nominal money have thus real effects.
Chapter 12: Aggregate Supply and Inflation
Phillips curve: Negative relationship between unemployment and inflation. The message of the
Phillips curve to policy-makers was simple and appealing: pick a point on the Phillips curve, i.e.
choose a politically acceptable combination of unemployment and inflation, and then steer the
economy to that point (either by moving LM of IS curves depending on the exchange rate regime). 3 ‘Sticky price GE is sometimes called non-Walrasian equilibrium.
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Okun suggests an inverse relationship between output and unemployment. More precisely, we look
at fluctuations of output around its long-run trend. The distance between actual and trend output is
called the output gap. The inverse relationship between the gap and unemployment is known as
Okun’s law.
U – U = -g(Y – Y)
Bringing Okun’s law and the Phillips curve together implies the positive relationship between the
output gap and inflation. This schedule is called the aggregate supply curve. The intuitive logic is
the following: The Keynesian assumption is that supply responds to demand, but what are the
economic incentives behind it? When demand expands, for instance, under what conditions are
firms willing to supply the extra output and employees willing to work more to produce that extra
output? The short answer is: inflation must increase to boost wages and profits.
The Phillips curve was attacked by Phelps and Friedman. They argued that, assuming neutrality of
money, the trade-off between inflation and unemployment was only possible if workers and firms
suffered from money illusion. In the long run, inflation is just a growth in nominal money supply
which has no impact on the real side of the economy. The supply curve and the Phillips curve must
thus be perfectly elastic (vertical) in the long run.
And indeed, in the mid-1970s and early 1980s, both inflation and unemployment started to rise
(stagflation). So, policy-makers started to put greater emphasis on long-run monetary neutrality as
a guiding principle for monetary policy.
Nearly everywhere inflation and unemployment increased sharply, first around 1973-4, and then
around 1979-80, precisely at the time of the two oil shocks. Interestingly, in between the oil
shocks, and after the second oil shock, Phillips curves re-emerged, each time further above and to
the right of the previous one.
If we view prices as sticky in the short run but flexible in the long run, then their medium-run
behaviour holds the key to understanding the disappearance of the Phillips curve. To study the
medium run, we break down inflation into its most important components. Consolidating price-
setting and wage-setting shows not only why the Phillips curve exists, but also under which
conditions it can disappear.
Behind each price decision – and therefore behind the price level – lie two components: the profit
objective, constrained by competition, and production costs. Price-setting, the firm’s capacity to
mark-up prices above nominal production costs, is only possible with market power (customer’s
loyalty, monopoly, extreme differentiation).
*Unit costs (UC) = unit labour costs + unit non-labour costs
*Nominal unit labour costs
= (total labour costs / output)
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= (gross hourly wages / average labour productivity)
Or, formally: Nominal unit labour costs
= WL / Y = W/ (Y/L)
*Real unit labour costs
= Labour share of output = SL
= (wage bill / nominal GDP) = WL / PY
Mark-up pricing means that firms set the price of goods as much as they can above their nominal
unit costs.
P = (1 + )(WL / Y), where > O is the price mark-up.
In collective negotiations both sides bargain directly over the nominal wage W and indirectly over
the expected labour share WL / PeY.
A simple way of describing the outcome of the negotiations is to consider that they mark up the
labour share over its ‘normal’ level SL, with the mark-up depending on the situation at the time
negotiations are held:
SL = WL / PeY = (1 + ) SL, with as the wage mark-up (which can be positive or negative and is 0
on average if the historical pattern of income distribution is preserved).
Another way of describing the negotiation outcome is to note that agreeing on the expected labour
share is the same thing as agreeing on unit labour costs.
We have described prices as a mark-up over unit costs, agreed to ignore all non-labour costs and
therefore to focus on unit labour costs, and found that the expected labour share is a mark-up over
its normal level. In the end, prices depend on wages and wages depend on expected prices.
P = (1 + )(1 + )SLPe
*Battle of the mark-ups: in the end actual prices depend on expected prices. Expected prices will
be the central determinant of inflation in the medium run.
*Changes in labour productivity influence costs
* Labour share is stable in the long run is stable (productivity gains and real wages cancel each
other). Firm can offer higher wages when these are paid for by higher productivity, and they can do
so without facing higher labour costs. This is how technical progress continuously generates higher
incomes.
What determines the two mark-ups? They tend to move over business cycles, to rise during
boom years and decline in recession. The battle of the mark-ups shows that the expected price
level drives wages via the wage mark-up, that wages drive labour costs, which drive prices via the
price mark-up. Theses mark-ups tend to move together over the business cycle and, the higher they
are, the more the actual price level tends to rise above its expected level.
(mark-ups) = a(Y - Y) = -b(U – U)4 = + a (Y – Y) = - b (U –U)
The dissection of the rate of inflation shows that it depends on the core rate of inflation and
the state of the business cycle.
Core inflation is anticipation and indexation of past mistakes. The risk of mistakes of this kind
explains why, during periods of high inflation, wages are set for short periods because forward-
looking guesses are too difficult and errors lead to very significant distortions; indexation then can
become automatic.
It is now time to look at the non-labour costs of production (K, T, intermediate inputs: unfinished
goods, materials, and energy). The costs of intermediate inputs to a firm are the prices charged by
another firm so, at the country level, they are automatically reflected in the overall inflation rate.
However, this logic does not apply to imported intermediate goods and raw materials, which are set
abroad and translated into domestic costs via the exchange rate. As long as PPP remains
approximately true, the costs of imported intermediate goods simply follow domestic inflation. So,
in normal circumstances this analysis can be neglected.
Exceptions are the supply shocks. Examples are sharp oil price rises, deep devaluations that move
clearly away from PPP, tax hikes, or additional regulation that raises production costs. For this case
we add an additional component s for supply shock to the equation.
Further supply shock can be: Changes in the labour share, tax changes5
The original Phillips curve claims that inflation depends only on the level of unemployment. The
inflation account shows that that cyclical labour market conditions do indeed matter, but so do core
inflation, equilibrium unemployment, and occasional supply shocks. For a Phillips curve to be
visible, the latter factors must be stable. The Phillips curve’s demise reflects the emergence of core
inflation and supply shocks as additional explanatory factors of inflation, over and beyond cyclical
fluctuations.
As long as the exogenous variables remain constant, the curve does not move, but it will ‘vanish’
when they change. This modern interpretation of the Phillips curve is often called augmented
Phillips curve (real inflation equals core inflation if s = 0 and U equals its equilibrium level.)
The core rate and equilibrium unemployment are thus exogenous; they determine the position of
the curve. As long as they remain unchanged, the curve does not shift and we move along the
curve.
Core inflation must be guessed. More often than not, the guesses are wrong. Although forecasts are
almost never correct, the errors are largely unsystematic and average to zero. This implies that
there must be a link between real inflation and core inflation. The backward-looking component
4 b = a / g5 It is important to note that all of these government-induced costs affect only the price level; to have an effect on the rate of inflation, they would have to increase continuously, which is unlikely.
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implies that core inflation lags behind actual inflation, but the forward-looking component implies
that core inflation leads actual inflation.
The second implication related to the long run. As business cycles unfold and GDP moves around
trend, actual unemployment U fluctuates around its equilibrium level U. This is Okun’s law (output
+ unemployment -). This allows us to think about the long run. Inflation is driven by money
growth. This is why the long-run Phillips curve is vertical. How long is the long run? It is the time
it takes for core and actual inflation to catch up with each other and stabilize at whatever rate
monetary policy allows for. In the long-run as the vertical curve implies, there cannot be a long-
lasting trade-off between unemployment and inflation. But the equilibrium level can very well shift
over time, for instance as labour markets undergo structural changes. It has massively increased in
the Euro-area over the 1970s and 1980s and modestly declined in the late 1990s.
The aggregate supply curve follows the same logic like the Phillips curve. Is output above trend,
unemployment is below its equilibrium rate, and inflation, fuelled by the mark-ups, rises above its
current core rate. The aggregate supply curve conveys two messages. In the short run, it is possible
for GDP to fluctuate about its trend growth path, and such fluctuations are accompanied by
movements of inflation about the core rate. In the absence of supply shocks, output and inflation
move in the same direction. In the long run, GDP must return to its growth path, regardless of what
the inflation rate is. Example: D+ U- (le long de la courbe Phillips) inflation + mark-ups
curve shifts upwards equilibrium U restored in the long run, but higher inflation rate.
3 reasons why the aggregate supply curve shifts:
1.) Change in the core or underlying inflation rate
2.) Equilibrium unemployment and trend GDP change.
3.) Supply shock
*In the long run the Phillips curve and aggregate supply schedules are vertical. The economy is
dichotomized, growth and real rigidities determine the GDP and unemployment, money growth
determines inflation, and there is no trade-off between inflation and unemployment.
*The Phillips curve describes the supply side and can be transformed into an aggregate supply
curve using Okun’s law. The supply curve says that, for increased output to be supplied, inflation
increases because production – mainly labour – costs rise faster than anticipated, or than is
reflected in core inflation. The core rate of inflation and the equilibrium unemployment rate
determine the position of the short-run Phillips curve. The position of the aggregate supply curve is
determined by the core rate of inflation and trend GDP. Any change in one of theses variables
leads to shifts in the short-run schedules.
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Chapter 13: Aggregate Demand and Aggregate Supply
Assumption: PPP is constant over the long run (domestic and foreign inflation as well)