PI 1322 – Melanie Gräser

International
Macroeconomics

• Introduction CH1-2
• The Goods Market CH3
 Motivation

 Macroeconomics (Greek: makro = ’big’) describes and explains

economic processes that concern the whole economy.
 Microeconomics treats economic processes that concern individuals,
such as households or firms. It usually focuses on one type of market
structure.
 By the end of this course you should be able to understand real world
macro-economic dynamics, such as:

Source: The Economist, 30.09.2019

2
Source: The New York Times, 07.01.2022
How do Economists work to answer questions?

Economic models
 Reality is too complex for us to understand everything. Models simplify
reality.
 The purpose of models is to:
 Understand specific questions (usually regarding causes and effects)
 They contain 2 types of variables:
 Exogenous: defined outside the model (they do not follow model dynamics)
 Endogenous: determined within the model

3
Useful Definitions

 GDP = aggregate production = aggregate income (Economists often

denote it as “Y”)
1. Value of final goods and services in a given period
2. Sum of value added in the economy (value of production minus
value of intermediate goods used in production)
3. Sum of incomes in the economy
 Nominal GDP
 Sum of quantities of final goods produced times their current price (in EUR, USD
of the given year)
 Nominal GDP = Real GDP × Prices
 Real GDP (quantity produced)
 Sum of quantities of final goods produced times constant prices
 Corrected for inflation (divided by CPI or GDP deflator)
4  Real GDP = Nominal GDP / Prices
World‘s Largest Economies

 The level of production in a country tells Economists how well a country

is doing from an economic point of view.

5
Source: Focus Economics, March 2019
Useful definitions

Short, medium, and long run:

 Short run (few years):
 Year to year movements in output are determined by demand
 There are no restrictions to production (no supply constraints)
 Price level is fixed
 Equilibrium in the goods and financial markets (IS-LM model)
 Medium run (decade):
 Output is determined by supply factors (capital stock, labour force, technology)
 Price expectations, wages and level of employment adjust
 Equilibrium in the goods, financial and labour markets (IS-LM-PC model)
 Long run (a few decades or more):
 Output is determined by human capital (education) and quality of government… not
covered in this class.

6
Overview:
Lectures 1 & 2

Goods market Money and

Consumption C financial
IS-LM market
Investment I
Government
Model Money M
Expenditure G Interest rate i

•IS Curve •LM Curve

Applications:
•How does fiscal policy
work?
•How does monetary
policy work?

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The Goods Market

Blanchard, Chp 3
Aggregate Demand: Austria

600

500

400

300

200

100

-100

-200

-300
1999 1998 1997 1996 1995 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

C I G
Based on Statistik Austria, nominal values, billion EUR
9
Goods market:
Aggregate Demand (Z)

𝑍 ≡𝐶+𝐼+𝐺 Austria 1976-2012, billion €

200

150

 C: Consumption by households 100

C
(+) 50

 Assumptions: 𝐶 = 𝐶(𝑌𝐷 ) 𝑌𝐷 ≡ 𝑌 − 𝑇
0
0 100 200 300
Y-T
 I: Investment by firms Source: Statistik Austria
Non-residential investment: new plants, machines, and computers
Residential investment: the purchase by households of new houses or apartments
𝐶 = 𝑐0 + 𝑐1 𝑌𝐷
(+) (-)
 Assumption: 𝐼 = 𝐼(𝑌, 𝑖) 𝐶 is a positive, linear function of 𝑌𝐷
 G: Government expenditure

 Assumption:
𝐺 = 𝐺ҧ
10
Goods market:
Equilibrium
Demand (Z);
Production (Y)
Production 45o line
 Equilibrium condition: (supply) (Production Function,
Production = Income)
Slope = 1

Y (production) = Z (aggregate demand)

Y  C (Y  T )  I Y , i  G
Z

 
A Demand
Slope = 𝑐1

Equilibrium:
Y=Z
Autonomous
spending

Income (Y)

Note:
Y = real GDP= Quantity of production (therefore changes in prices are taken out)
11
Goods market:
The multiplier
45o Line

Demand (Z), Production (Y)

(Production Function,
Production = Income)

Y  C (Y  T )  I Y , i  G
 

ZZ’
 Possible shock:
A’
Z’
B ZZ
C

 Process:
Z
A

 Result:

Y Y’ Income Y
12
Exercise

Source: The Economist, 30.09.2019

• Using the graph for the goods market, discuss the effect of
an increase in taxes on the Japanese economy. What are
the effects on output?

13
Exercise

Y=Z
Y  C (Y  T )  I Y , i  G
 

T C Z Production (Y) Income (Y) Z…

Demand (Z), Production (Y)

45o Line

ZZ
ZZ’

Y’ Y Income Y
14
Goods market:
Deriving the IS Curve
Y  C (Y  T )  I Y , i  G
45o Line

Demand (Z), Production (Y)

  ZZ’(𝑖 ↓)

ZZ for i

 Demand is determined in the goods market,

and therefore production.
 To draw the goods market in the (Y,i) diagram,
Income Y
you have to change i. i

 ∆𝒊 → ∆𝑰 → ∆𝒀 → ∆𝒁 → ∆𝒀 …
 There is a negative relationship 𝒊𝟎

𝒊𝟏

IS

𝒀𝟎 𝒀𝟏 Income Y

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Goods market:
Slope of IS curve
 IS curve describes:
 All possible equilibria in the goods market at different levels of interest rate

 Slope: negative, in closed economy: ∆𝒊 → ∆𝑰 → ∆𝒀 → ∆𝒁 → ∆𝒀 …

 Extreme case 1: Investments do not react to changes in interest rate

 IS curve very steep: „Investment trap“

 Extreme case 2: Investments react strongly to changes in interest rate

 IS curve very flat
 The more investments react to changes in interest rate, the flatter the IS
curve.

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Goods market:
Shift of IS curve
i

IS’ IS IS’

Y
 Shift to the left/right, not up/down
 Change in factors (other than the interest rate) that lead to a
decrease/increase in demand for goods shift the IS curve to the
left/right
 Decrease in T?
 Increase in G?
 Decrease in consumer confidence?
 What about a movement along the IS curve?
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Goods market:
Alternative equilibrium condition
 Until now, the equilibrium condition in the goods market was Y=Z
 An alternative:
𝑌 =𝐶+𝐼+𝐺
𝑆 ≡ 𝑌𝐷 − 𝐶 = 𝑌 − 𝑇 − 𝐶
𝑆 =𝐶+𝐼+𝐺−𝑇−𝐶
𝑰 = 𝑺 + (𝑻 − 𝑮)

For this reason the equilibrium condition for the goods market is called the
IS relation (“Investment equals Saving”)

SEITE 18
Overview:
Lecture 1 & 2

Goods market Money and

Consumption C financial
IS-LM market
Investment I
Government
Model Money M
Expenditure G Interest rate i

•IS Curve •LM Curve

Applications:
•How does fiscal policy
work?
•How does monetary
policy work?

SEITE 20
Any Questions?
PI 1322 – Melanie Gräser
International
Macroeconomics

• Financial markets (Chp. 4)

• The IS-LM Model (Chp. 5)
• Financial Markets II (Chp. 6)
Financial Markets

Blanchard, chp 4
Overview:
Lecture 1 & 2

Goods market Money and

Consumption C financial
IS-LM market
Investment I
Government
Model Money M
Expenditure G Interest rate i

•IS Curve •LM Curve

Applications:
•How does fiscal policy
work?
•How does monetary
policy work?

SEITE 3
Money demand
▪ Money has different functions:
▪ Medium of exchange (instead of goods against goods)
▪ Unit of account (instead of relation of good 1 to good 2)
▪ Store of value (consumption tomorrow instead of consumption today)

▪ Assets can be held in two different forms in the IS-LM model:

▪ Money: can be used for transactions (e.g. buying/selling goods)
But: no interest revenue!
→ (lost) interest rates = (opportunity) costs of holding money
▪ Bonds: cannot be used for transactions, but pays a positive interest rate

▪ Nominal money demand (Md) therefore depends…

▪ …positively on the nominal GDP (PY) = Prices x Final products = transaction volume
▪ …negatively on the interest rate (i) → „liquidity peferences“ L(i)

M d = PYL( i )
−

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Money demand
▪ Decreasing function
▪ The higher the interest rate, the
lower the demand for money.
▪ If income rises, money demand
rises: the curve shifts to the right.
▪ If the interest rate changes, then
the equilibrium moves along the
curve.

SEITE 6
Money supply & Equilibrium interest rate

▪ Central bank supplies money M equal to:

▪ 𝑀𝑠 = 𝑀
▪ Equilibrium in financial markets requires:
▪ 𝑀 𝑠 = 𝑀𝑑
▪ M = $𝑌𝐿(𝑖)

9
Setting the interest rate and equilibrium in the model

▪ Central bank sets the interest rate instead of setting the money supply
▪ Money supply is endogenous, dependent on respective interest rate

Interest rate in equilibrium i0

Md (i0)=Ms

SEITE 10
Money supply by Central Banks:
Determining interest rate I

▪ CB conducts “open market operations”

Central Bank Balance Sheet (heavily simplified)

Assets Liabilities

Bonds (from open market operations) Money (currency)

▪ Expansionary open market policies: CB buys bonds & increases supply of money &
decreases the interest rate (since the price of bonds rises)
▪ Contractionary open market operations: CB sells bonds & decreases supply of money &
increases the interest rate (since the price of bonds falls)

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Money supply by Central Banks:
Determining interest rate II

Commercial Bank Balance Sheet

Assets Liabilities

Reserves Checkable deposits

Loans
Bonds

Central Bank Balance Sheet

Assets Liabilities
Bonds (from open market operations) Central bank money = Money (currency) +
Reserves

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 Money supply by Central Banks:
Determining interest rate II

▪ Demand for central bank money (𝐻 𝑑 ) has

two components
1. Demand for currency (checkable deposits)
2. Demand for reserves

1. Demand for checkable deposits 𝐻 = 𝜃$𝑌𝐿(𝑖)

▪ 𝑀𝑑 = $𝑌𝐿(𝑖)
2. Demand for reserves (CB money) by
banks
▪ 𝐻𝑑 = 𝜃𝑀𝑑 = 𝜃$𝑌𝐿(𝑖)
▪ 𝜃 = minimum required reserve ratio

SEITE 13
The Federal Funds Rate in the U.S.

▪ Demand and supply of reserves determine the Federal Funds Rate in the US
▪ The Federal Funds Rate is the interest rate commercial banks pay for overnight
borrowing of reserves in the federal funds market
▪ The Federal Reserve sets a target range for the Federal Funds Rate
▪ The Federal Funds Rate is used by the Federal Reserve to influence other interest
rates

14
Financial market:
Deriving the LM curve
▪ „LM“… „Liquidity (demand) equals Money (supply)“
M
i
= YL(i )
P

M/P Y

▪ If the income and hence the money demand increases, the CB adjusts the supply to the
increased demand so that the desired interest rate is met. The LM curve is therefore flat.

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Financial market:
Shift of the LM curve
i

𝒊𝟎 LM

𝒊𝟏 LM’

▪ Terms in newspapers that describe expansionary monetary

policy:
▪ CBs have “flooded markets with liquidity“.
▪ “Big bond purchases“ of the CB.
▪ “ increases the money stock“ / “is lowering the interest rate“
▪ …

SEITE 18
reuters.com 17.08.2018
 The Liquidity Trap

Interest rate – effective tool of the CB. Can CB always use it?

When the zero lower bound binds => the economy is in the
liquidity trap

Interest rate is zero:

▪ People are indifferent between money and bonds
▪ Banks are indifferent between reserves and bonds

19
 The IS-LM model

Blanchard, Chapter 5

SEITE 20
Overview:
Lecture 1 & 2

Goods market Money and

Consumption C financial
IS-LM market
Investment I
Government
Model Money M
Expenditure G Interest rate i

•IS Curve •LM Curve

Applications:
•How does fiscal
c policy
work?
•How does monetary
policy work?

SEITE 21
So far

▪ Goods market (CH 3)

− how production (Y) is determined by the demand for goods (Z).

▪ Financial markets (CH 4)

− how the Central Bank sets the interest rate (i)

22
IS-LM model:
Goods and Financial Markets
▪ IS equation:
IS
Y = C (Y − T )+ I (Y , i )+ G
i

+ + −

▪ LM equation: i LM
i=i

▪ Intersection:
all markets are in equilibrium Y Y

SEITE 23
 IS-LM model:
Fiscal policy
Y = C (Y − T )+ I (Y , i )+ G
▪ Short-term analysis of contractionary fiscal + + −
policy (also called fiscal austerity, fiscal i=i
consolidation):
i IS’ IS

i LM

▪ What is the effect on GDP and all

components of demand?

Y’ Y Y

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IS-LM model:
Monetary policy
▪ Short-term analysis of contractionary Y = C (Y − T )+ I (Y , i )+ G
+ + −
monetary policy:
i=i

i IS

i’ LM’
i LM

Y’ Y Y

SEITE 25
The effects of the Coronavirus Pandemic

Source: bbc

26
A first analysis of crisis management in the
IS-LM model
▪ The fall in demand leads to: i
IS’ IS’’ IS

𝒊𝟎 LM

▪ Countermeasures of the central bank:

𝒊𝟏 LM’

𝒀𝟏 𝒀𝟐 𝒀𝟑 𝒀𝟎 Y

▪ Countermeasures of the government:

SEITE 27
IS-LM model:
Fiscal + monetary policy
▪ Policy Mix: combination of various measures (eg. Expansionary monetary policy +
contractionary fiscal)
▪ necessary if more than one goal wants to be reached (e.g. lower government debts at a constant GDP)

Income
Shift IS curve Shift LM curve
= Production Y

Increase of taxes (T↑) to the left - decreases

Increase of taxes (T↓) to the right - increases

Increase of government spending (G↑) to the right - increases

Decrease of government spending (G↓) to the left - decreases

Lowering of the interest rate (i↓) - down increases

Increasing the interest rate (i↑) - up decreases

SEITE 40
Summary chp. 3-5

What does the IS curve describe?

▪ Equilibrium on the goods market
▪ i → Investitments → Y (decrasing function)
What does the LM curve describe?
▪ Equilibrium on the financial market
▪ Controlling the interest rate via the CB (supply is adjusted to the demand)
What is the overall economic equilibrium?
▪ IS-LM intersection: Equilibrium on the goods and the financial market
▪ “Equilibrium“ is a theoretical concept (model!)
What is fiscal policy?
▪ Fiscal policy: State wants to influence income via taxes and government spending
▪ Shifts the IS curve to the left/right
What is monetary policy?
▪ Monetary policy: CB sets key interest rate (i) and conducts open market operations
▪ Shifts the LM curve up/down

SEITE 30
 Financial Markets II

Blanchard, Chapter 6

SEITE 38
Financial Markets II

▪ Until now, we assumed that there were only two financial assets:
Money and Bonds
▪ and just one interest rate:
the rate on bonds, i, determined by monetary policy.

▪ Now we look more closely at the role of the financial system and
its macroeconomic implications.
▪ Nominal vs real interest rate and risk premia
▪ The role of financial intermediaries
▪ The extended IS-LM model and the financial crisis
Nominal versus Real Interest Rates

▪ Nominal interest rate (i) is the interest rate in terms of national currency.
i.e. how much money you give up tomorrow to spend one euro today?
▪ Real interest rate (r) is the interest rate in terms of a basket of goods
i.e. how many consumption goods you give up tomorrow for consumption
goods today
▪ To know how much we effectively pay, we must adjust the nominal interest
rate to take into account expected change in prices (i.e. expected inflation).
▪ Example: Inflation 2% and nominal interest rate 1% → real yield negativ.
Nominal versus Real Interest Rates
Nominal and Real One-Year T-Bill Rates in the United States since 1978

The nominal interest rate has declined considerably since the early 1980s, but
because expected inflation has declined as well, the real rate has declined much
less than the nominal rate.
Nominal/Real Interest Rate and Inflation
The Fisher Parity

▪ Real and nominal interest rates are connected through the Fisher Parity:
𝑒 𝑒
, expected change in price
𝑟𝑡 ≈ 𝑖𝑡 − 𝜋𝑡+1 𝜋𝑡+1
level over duration of loan/bond
▪ 𝑟𝑡 : real interest rate
▪ 𝑖𝑡 : nominal interest rate
𝑒
▪ 𝜋𝑡+1 : expected inflation

▪ Inflation rate: Change in price level between two points in time (%)

𝑃𝑡+1 −𝑃𝑡 𝑒 −𝑃
𝑃𝑡+1
𝜋𝑡 = similarly, expected rate of inflation 𝜋𝑡+1
𝑒
= 𝑡
𝑃𝑡 𝑃𝑡

SEITE 43
Nominal/Real Interest rate and Inflation:
The Fisher Parity

▪ When expected inflation equals zero, the nominal interest rate and
the real interest rate are equal (if 𝑒
𝜋𝑡+1 =0 ֜ 𝑟=𝑖 )

▪ Because expected inflation is typically positive, the real interest rate

is typically lower than the nominal interest rate. (if 𝑒
𝜋𝑡+1 > 0 ֜ 𝑟 < 𝑖)

▪ For a given nominal interest rate, the higher expected inflation, the
lower the real interest rate. (↑ 𝜋𝑡+1
𝑒
֜ ↓𝑟)
Nominal/Real Interest rate and Inflation:
The Fisher Parity

▪ The real interest rate (𝑖 − πe) is based on expected inflation, so it is

also called the ex-ante real interest rate.
▪ The realized real interest rate (i − π) is called the ex-post interest
rate.
▪ The interest rate that enters the IS relation is the real interest rate.
 The role of the CB

▪ The CB wants to set the real interest rate (what matters in the goods market)
𝑟 = 𝑖 − πe

Example: if expected inflation, πe, is 2% and the CB wants the real rate, 𝑟, to be 3%, then it
needs to set the nominal interest rate, 𝑖 , at 5%.

▪ The zero lower bound on the nominal interest rate, 𝑖 ≥ 0, implies that the real interest
rate cannot be lower than the negative of inflation.
if 𝑖 = 0 ֜ 𝑟 = − πe
▪ If 𝑖 = 0, as long as inflation is positive, 𝑟 < 0 .

Example: if πe = 2% the lower bound on 𝑟𝑡 is - 2%.

▪ Note: in a deflationary scenario (π < 0), 𝑟 > 0 even if 𝑖 = 0.

Risk and Risk Premia

▪ Until now we have considered risk free bonds (which is normally the
interest rate on government bonds – in the US: T-Bills)

▪ Some other bonds are risky, so bond holders require a risk premium.

▪ This risk premia (x) are determined by:

▪ The probability of default (p)
▪ The degree of risk aversion of bond holders
Introducing Risky Bonds:
Risk and Risk Premia
▪ In order for investors to be willing to hold a risky bond, the expected
return on the risky bond should be at least equal to the return on the
riskless bond:

risk free rate risk premium probability of default

(1 + i) = (1 – p)(1 + i + x) + p(0)

Expected return on risk free bond Expected return on risky bond

▪ The risk premium that is added to the real interest rate depends on

1. The probability of default

2. The buyers’ risk aversion

Risk and Risk Premia

In September 2008, the

financial crisis led to a
sharp increase in
interest paid on both
AAA and BBB corporate
bonds, and on the rates
at which firms could
borrow.

The rate at which firms can borrow moves together with the policy rate (and the risk free rate)
in times of tranquility, but might diverge largely if risk and risk aversion increase.

The IS-LM model should be extended to allow for this phenomena!

Extension of the IS-LM model

▪ Nominal interest rate/policy rate: i

▪ Real interest rate: r
▪ Borrowing rate: r+x
IS curve: 𝑌 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑟 + 𝑥 + 𝐺
LM curve: 𝑟 = 𝑟ҧ
▪ The CB wants to set the real interest rate through setting nominal
interest rates 𝑟 = 𝑖 − 𝜋 𝑒
▪ Investment decisions in the IS relation depend on real interest rate
𝑖 − 𝜋𝑒 + 𝑥
▪ CB sets r implicitly by setting i

50
Extension of the IS-LM model:
Shock in the financial sector
▪ Financial shock (e.g. investors become
more risk averse; insolvency of bank) : x ↑
▪ Borrowing costs ↑
▪ Investments ↓

Financial crisis becomes a

macroeconomic crisis!

51
The Role of Financial Intermediaries

▪ We have looked at direct finance: Borrowing directly by the ultimate

borrowers from the ultimate lenders.
▪ Much of borrowing and lending takes place through financial
intermediaries:
▪ Financial institutions can be banks and non-banks (mortgage companies, money
market funds, …) that receive funds from investors and then lend these funds to
others
▪ Make profit by charging higher interest rate than the one at which they borrow
▪ They develop expertise about specific borrowers and should increase efficiency
in the financial markets in normal times
▪ But they carry very specific risks…
What is the effect of introducing intermediaries in the system?
Leverage: Definitions

Figure 6-4 Bank Assets, Capital, and Liabilities

Assets: Liabilities:
- Loans to individuals - Deposits
- Loans to firms - Loans from investors
- Government bonds - ….or other banks
- Risky bonds Capital: owners of bank
- Reserves invest their own funds
- Mortgages

▪ Capital ratio (Capital / Assets) = 20/100 = 20%

▪ Leverage ratio (Assets / Capital) = 100/20 = 5
▪ A higher leverage ratio implies:
▪ a higher expected profit rate,
▪ but also a higher risk of insolvency and bankruptcy.
The Role of Financial Intermediaries

Example:
▪ Average return on asset: 5%
▪ Average interest cost on liabilities: 4%
▪ Bank profit: 100 x 0.05 – 80 x 0.04 = 5 – 3.2 = 1.8
▪ Profit per unit of capital: 1.8/20 = 9%
Assume now, capital is 10 and 90 is borrowed. What is the leverage and the profit
per unit of capital?
Lower capital leads to higher profits per unit of capital, but higher leverage
increases risk of insolvency (higher risk that the value of assets becomes
less than value of liabilities)
 From a Housing Problem to a Financial Crisis

▪ The 2000s were a period of unusually

low interest rates, which stimulated
housing demand.
U.S. Housing Prices since 2000
▪ Given steady increase in house prices,
mortgage lenders were increasingly
willing to make loans to risky
borrowers with subprime
mortgages.
▪ In 2006 prices started falling, many
home mortgages exceeded the value
of the house.
▪ Many borrowers defaulted and lenders
faced large losses.
From a Housing Problem to a Financial Crisis

https://www.youtube.com/watch?v=N9YLta5Tr2A
Weak Systems I

The housing bubble burst was the trigger, but the financial system disproportionately
amplified the shock:
▪ Banks had very risky behaviour
▪ speculated on rising housing prices
▪ gave loans to borrowers who were not credit-worthy
▪ Banks circumvented the regulations set out by the banking
supervision (eg regulatory capital requirements)
▪ „structured investment vehicles (SIV)“ -> asset side: securities, liability side: loans from
investors. Typically had insurance from bank that investors would get repaid.
▪ increased leverage ratio even more
▪ Diversification of risk
▪ creation of securities based on a bundle of assets, such as mortgage-based securities (MBS).
▪ difficult to assess risk of MBS.

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Weak Systems II

▪ „collateralized debt obligations“ (CDO)

▪ Difficult to rate by rating agencies
▪ „toxic assets“ were very illiquid
▪ Lehman Brothers 2008 insolvency
▪ „wholesale funding“ → borrowing from other banks in the form of short term debt
▪ Stop in inter-bank lending, financial system paralyzed

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From a Housing Problem to a Financial Crisis

Figure 6-8 U.S. Consumer and Business Confidence, 2007−2011

The financial crisis led to a sharp drop in confidence, which bottomed in early 2009
 From a Housing Problem to a Financial Crisis

▪ Bonds yields increased sharply (risk and

risk aversion increase 𝒙 ↑)
▪ For some firms became impossible to
borrow
▪ Investment decreases (𝑰 ↓)
▪ Consumer confidence decreases (𝒄𝟎 ↓)
▪ The demand for goods decreases (𝒁 ↓)
▪ The IS curve shifts to the left
From a Housing Problem to a Financial Crisis

▪ Monetary policy:
▪ Conventional monetary policy (measures to affect r): lower the policy rate (down
to zero)
▪ Unconventional monetary policy - quantitative easing (measures to reduce x):
buying assets and bonds with higher risk profile to further decrease interest rates

▪ Fiscal Policy:
▪ The European Commission suggested a European Economic Recovery Plan: a
coordinated fiscal stimulus for about € 200 bn (1.5 % of the EU's GDP) in tax
reductions and spending increases
From a Housing Problem to a Financial Crisis

▪ Fiscal Policy:
▪ Tax reductions and spending
increases

▪ Financial Policies:
▪ Deposit insurance was raised
▪ Widespread liquidity provision to
the financial system and increased
assets that could serve as collateral

The financial crisis led to a shift of the IS to the left.

Monetary policy led to a shift of the LM curve down.
Financial and fiscal policies led to some shift back of the
IS curve to the right.
Next week Monday

▪ Mini Quiz 1: chp. 1-6.

Any Questions?
PI 1322 – Melanie Gräser
International
Macroeconomics

• Labour market (Chp. 7)

• The Phillips Curve (chp. 8)
Labour Market

Blanchard, Chapter 7
Chapter 7: The Labor Market

▪ We have focused on the short run by assuming a constant price

level in the IS-LM model. We assumed that firms were able to
supply any amount of output at a given price level.
▪ We now turn to the medium run and explore how prices and
wages adjust over time, and how this in turn affects output.
▪ The labor market is the center of this.
Data:
Austria (3. Quarter 2021)

Total population:
8,78 million

15-64 years old (working age population): ≤14 or ≥65 years old:
5,84 million 2,94 million

Labour force (L): Out of the labour force:

4,57 million 1,27 million

Unemployed (U): Employed (N):

0,24 million 4,32 million

𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
Unemployment rate: = 5.2%
𝐿𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒
𝐿𝑎𝑏𝑜𝑢𝑟 𝑓𝑜𝑟𝑐𝑒
Participation rate: = 78.3%
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑎𝑔𝑒 𝑝𝑜𝑝.

Source: Statistik Austria

http://www.statistik.at/web_de/statistiken/menschen_und_gesellschaft/arbeitsmarkt/erwerbsstatus/062859.html
Data:
Unemployment rate EU

https://ec.europa.eu/eurostat/documents/2995521/11156668/3-30072020-AP-EN.pdf/1b69a5ae-35d2-0460-f76f-
12ce7f6c34be
Unemployment rate:
Different situations
▪ The same unemployment rate can portray two different situations:
1. Active labour market:
▪ Many separations but also many new hires

2. Stagnant labour market:

▪ Few separations but also few new hires
▪ Many long term unemployed

▪ Unemployment rate does not say anything about the population that is out of the labour
market group
▪ Discouraged workers
▪ Low participation rate of women
▪ Students
▪ Retired
Movements in Unemployment

▪ When unemployment is high, workers are worse off in two

ways:

1. Employed workers face a higher probability of losing their job.

2. Unemployed workers face a lower probability of finding a job; or
they can expect to remain unemployed for a longer time.
How are wages determined?

▪ In Austria the ÖGB (Austrian Trade Union Federation) is the umbrella

association of all workers’ unions in Austria.
▪ 1.4 million employees are union members
▪ Workers’ unions represent the political, economic, and social
interests of employees vis-à-vis their employers
▪ Main tasks:
▪ Negotiation of collective agreements; implementation of social
improvements; safeguarding real wages
How are wages determined?

▪ USA: often through market competition (only 25% through collective bargaining)
▪ Europe: less through market competition, more through collective bargaining

▪ Workers normally paid a wage higher than their reservation wage

▪ “Reservation wage”: The wage that makes workers indifferent between working and being
unemployed
▪ Reservation wage is higher the more goods you can buy without employment
▪ Reservation wage is lower the more you value free time

▪ Two explanations for why wage > reservation wage

1.Bargaining power
2.Efficiency wages
How are wages determined?

1. Bargaining power
▪ Workers have bargaining power which depends on:
▪ The nature of the job & cost to replace worker (required skills)
▪ Labour market conditions (probability that a worker can find an alternative job)
▪ Labour rights (eg unemployment insurance, employment protection)

2. Efficiency wages
▪ Firms want to pay higher wages because:
▪ Higher wages mean higher worker productivity
▪ Firms’ wish to retain workers

Due to this:
▪ Wages > reservation wage
▪ Higher unemployment rate → lower wages
Wage Negotiations by Bargaining Parties

Nominal wage setting: W = P e F (u , z )

− + u, z determine bargaining power of workers
Nominal wage (W) depends on:
▪ Expected price level ( 𝑃 𝑒 )
▪ Unemployment rate (u)
▪ A catch-all variable z: stands for all other variables that may affect the outcome of wage setting
▪ Unemployment benefits; employment protection; minimum wage; collective bargaining
Assumption:
▪ Actual price level = expected price level, 𝑃 = 𝑃 𝑒 holds in equilibrium (price determination
equation)

Wage setting (WS):

= F (u , z )
W
P − +

Real wage
Price Determination by Firms

▪ Prices (P) of goods and services are set by firms

▪ Prices depend on costs of production
▪ General production function:

Y = Y ( A, N , K )
▪ Y = Output
▪ A = Productivity/ output per worker (Technology, Know-How)
▪ N = Employment (workers)
▪ K = Capital

▪ Simplification: Can ignore A and K in short and medium run

Y = N

▪ Empirical relevance:
Fluctuations in production correlate strongly with fluctuations in employment.
Price Determination by Firms

Y = N
▪ This implies that a firm needs one worker to produce one unit of output (one car).

▪ This also means that the marginal cost of production (the cost of producing an additional
unit of output), is the cost of employing one additional worker – i.e. the nominal wage (W)
Marginal cost of production = W

▪ Under perfect competition:

P = MC = W
▪ Imperfect competition:
▪ Firms have some market power so that they can charge a price that is higher than the
marginal cost:
𝑃 = 1+𝑚 𝑊
𝑊 1
Real wage: =
𝑃 1+𝑚

where m is the markup of the price over the cost (m > 0)

Price Determination – The Equilibrium

To find the equilibrium in the labour market, we need to take into account both the bargaining
power of workers and the market power of firms

To do so, we need two curves:

1. a wage-setting relation (WS)

2. a price-setting relation (PS)

Wage-setting and price-setting determine the natural rate of unemployment (i.e. the rate of
unemployment in equilibrium)
Price Determination – The Equilibrium

= F (u , z )
W
1. Wage-setting curve:
P − +

▪ Is it downward or upward sloping with respect to unemployment (u)?

▪ Shifts of the wage-setting curve?

▪ z (all factors associated with the institutional framework of the labour

market that increase bargaining power of workers)
The equilibrium

= F (u , z )
W
1. Wage-setting relation:
P − +

𝑊 1
2. Price-Setting relation (PS): =
𝑃 1+𝑚

Note that the PS relation does not depend on

unemployment! Firms do not take
unemployment into account when
determining prices.

Careful assumption:
P=Pe
The equilibrium (natural rate of
unemployment)
Equilibrium is when
WS = PS

1
𝐹(𝑢𝑛 , 𝑧) =
1+𝑚

The value of u (unemployment) that satisfies this condition is called the natural rate of
unemployment (𝑢𝑛, ) – i.e. equilibrium unemployment rate in the medium run

▪ 𝑢𝑛 depends on 𝑚 and z
▪ 𝑢𝑛 does not depend on fiscal policy nor on monetary policy
The equilibrium

What happens if unemployment benefits increase? PS: P=W (1+m)

Which variable is affected ? WS: W=P F(u,z)

↑z

At any unemployment level, the bargaining power of workers increases and workers can now negotiate and obtain
higher nominal wages
=> upward shift of the WS curve
▪ In the new equilibrium, there are better worker conditions but higher unemployment!
▪ Real wages do not change (all the increase in nominal wages is passed on to consumers through prices)
▪ Only once unemployment rate has increased, meaning there was a decrease in workers’ bargaining power, a
new equilibrium natural rate of unemployment is reached at the same level of real wages
Model –The equilibrium

↑z

▪ For every given unemployment rate

workers demand higher real wages
W/P
▪ WS shifts upwards
▪ However, m remains unchanged
▪ Therefore, real wages W/P are
unchanged
▪ Only at a higher level of
unemployment rate are workers
willing to accept W/P
▪ Why does 𝑢𝑛 increase? The cause of
the increase in 𝑢𝑛 will be explained
using the IS LM PC model
The equilibrium

▪ What happens if competition laws become less stringent?

Competition laws (antitrust laws in the USA) are laws that promote or
maintain market competition by regulating anti-competitive conduct by companies
↑m

▪ If competition laws are relaxed, firms can increase their mark-up

▪ At any given level of unemployment, firms will be able to set higher prices and then real wages in the economy
will be lower
⇒ shift downward of the PS relation
▪ In the new equilibrium, 𝑢𝑛 is higher and real wages lower
The equilibrium

↑m

▪ At a higher rate of natural

unemployment, workers have less
bargaining power and therefore must
accept lower real wages.
▪ Why does 𝑢𝑛 increase? The cause of the
increase in 𝑢𝑛 will be explained using the
IS LM PC model
▪ If we have a higher natural rate of
unemployment, what will happen to
medium run Y?

Y = N
Wrap up…

▪ What role do price expectations play?

▪ Wage negotiations are positively related to price expectations (real wage!)
▪ What do wages depend on in the wage setting relation?
𝑊
▪ Real wage depends on unemployment u and the catch-all variable z
𝑃
▪ WS curve has a negative slope: negative relationship between real wages and unemployment
▪ What do wages depend on in the price setting relation?
𝑊
▪ depends on the mark up m
𝑃
▪ PS curve is horizontal: Willingness to pay by firms depends only on market power
▪ What is the natural rate of unemployment?
▪ 𝑢𝑛 is the unemployment rate that is determined by the equilibrium in the labour market
▪ WS=PS: Results of wage negotiations = willingness to pay by firms
▪ Does the natural rate of unemployment equal the actual rate of unemployment?
▪ No, in the short run it does not, since 𝑃 ≠ 𝑃𝑒
The Phillips Curve, the
Natural Rate of
Unemployment, and
Inflation
Blanchard, Chapter 8
Why are stable prices important?

▪ Stable prices: prices should not go up significantly (inflation) and an ongoing period of decreasing
prices should also be avoided (deflation)
▪ Stable prices improve people’s welfare
▪ What’s wrong with high inflation?
▪ Loss of purchasing power (income and savings do not buy as much as they used to)
▪ Goods become more expensive -> workers ask for increased wage -> employers react by
increasing their prices to fund increases in wages… spiral of increased prices continues
▪ What’s wrong with extended periods of deflation?
▪ Purchasing and investment is deterred -> economy slows down due to fall in demand -> firms
cannot sell their products -> reduction in wages or cut staff numbers -> increase in
unemployment… spiral of falling prices continues
Phillips Curve:
Original Version

Alban W. Phillips (1958, Inflation rate and unemployment rate

USA, 1900–1960
Economica) & Paul
Samuelson/Robert Solow (1960,
American Economic Review):
▪ Negative relationship between
the rate of inflation and the rate of
unemployment
▪ Empirically: Negative correlation
(at least in data back then)
▪ Theory: Negative relationship due
to wage and price setting
Phillips Curve:
Derivation
Recall:

▪ Price-Setting (PS): 𝑃 = 1+𝑚 𝑊

𝑃 = 𝑃𝑒 1 + 𝑚 𝐹 𝑢, 𝑧
− +
▪ Wage-Setting (WS): 𝑊 = 𝑃𝑒 𝐹 𝑢, 𝑧
− +

Rewrite as Phillips Curve:

1. Specific form: 𝐹 𝑢, 𝑧 = 1 − 𝛼𝑢 + 𝑧 𝑃 = 𝑃𝑒 1 + 𝑚 1 − 𝛼𝑢 + 𝑧
− +

2. Divide by last year‘s price, Pt-1; rewrite Pt /Pt-1 as 1+πt and transform

𝜋 = 𝜋 𝑒 + 𝑚 + 𝑧 − 𝛼𝑢
Phillips Curve:
Connections
𝜋 = 𝜋 𝑒 + 𝑚 + 𝑧 − 𝛼𝑢

▪ Increase in expected inflation 𝜋 𝑒 , leads to increase in actual inflation 𝜋

𝜋𝑒 ↑ ⟹ 𝜋 ↑
▪ In detail:
▪ “Expected inflation rate” = expected percentage increase in the price level
▪ “Increase in expected inflation” = stronger expected percentage increase in the price level
▪ a proportional increase in the nominal wage is demanded in wage setting, to achieve the
desired real wage
▪ In the firms‘ price-setting process correspondingly increased prices are set, to compensate
for the higher labor costs
Phillips Curve:
Connections

𝜋 = 𝜋 𝑒 + 𝑚 + 𝑧 − 𝛼𝑢
▪ Given expected inflation 𝜋 𝑒 , an increase in the markup 𝑚 or an increase
in the factors that affect wage determination 𝑧, leads to an increase
in actual inflation 𝜋
𝑚↑ ⟹ 𝜋↑
▪ Reason:
▪ An increase in the markup 𝑚 leads to an increase in prices
▪ A higher level of the catch-all variable 𝑧 leads to an increase in wages and consequently to an
increase in prices
Phillips Curve:
Connections

𝜋 = 𝜋 𝑒 + 𝑚 + 𝑧 − 𝛼𝑢

▪ Given expected inflation 𝜋 𝑒 , 𝑚, and 𝑧, a decrease in the unemployment

rate 𝑢, leads to an increase in actual inflation 

𝑢 ↓⟹ 𝜋 ↑
▪ Reason:
▪ A lower unemploment rate 𝑢, leads to increased bargaining power of workers. Therefore,
wage increases are higher and consequently prices rise more strongly.
Phillips Curve:
Original Phillips Curve & Anchored Expectations

𝜋 = 𝜋 𝑒 + 𝑚 + 𝑧 − 𝛼𝑢

How is expected inflation 𝜋 𝑒 formed?

Original Phillips Curve: “anchored” expected inflation, 𝜋 𝑒 = 𝜋ത
▪ Typical, if inflation fluctuates around 𝜋ത
▪ i.e. sometimes inflation is higher, sometimes lower, but on average = 𝜋ത

𝜋 = 𝜋ത + 𝑚 + 𝑧 − 𝛼𝑢

▪ Negative relationship between unemployment rate and inflation (Phillips, 1958)

Phillips Curve:
Original Phillips Curve before 1970

Before 1970: Original Phillips Inflation versus Unemployment in the United States,
1961–1969
Curve
▪ i.e. the lower the
unemployment rate, the higher
the inflation rate
 Phillips Curve:
Original Phillips Curve “Disappears”
Inflation versus Unemployment in the United
States,
1970–1995
Starting in 1970s: Relationship
disappears
1. Change in expectations
formation
▪ Inflation became more persistent
▪ High inflation this year indicates high
inflation next year
▪ As a result: inflation expectations no
longer anchored, but equal to last year‘s
inflation
▪ De-anchoring of inflation
expectations
Anchored & de-anchored expectations

▪ The relation between inflation and unemployment depends on how wage

setters form expectations of inflation:

Inflation expectation: 𝜋𝑡𝑒 = (1 − 𝜃)𝜋ത + 𝜃𝜋𝑡−1

▪ Expected inflation this year depends partly on a constant 𝜋, ത with weight

(1 − 𝜃), and partly on inflation last year, 𝜋𝑡−1 , with weight 𝜃.
▪ The higher the value of 𝜃, the greater the role of last year’s inflation in
wage setters' expectation formation of what inflation will be this year
Anchored & de-anchored expectations

1. Inflation expectation: 𝜋𝑡𝑒 = (1 − 𝜃)𝜋

ത + 𝜃𝜋𝑡−1

2. Phillips Curve: 𝜋𝑡 = 𝜋𝑡𝑒 + 𝑚 + 𝑧 − 𝛼𝑢𝑡

▪ Original Phillips curve with anchored inflation expectations:

▪ 𝜃 close to 0
▪ Phillips curve given by: 𝜋𝑡 = 𝜋ത + 𝑚 + 𝑧 − 𝛼𝑢𝑡
▪ High unemployment leads to low inflation rate,
low unemployment leads to high inflation rate

▪ Phillips curve with de-anchored inflation expectations

▪ 𝜃 close equal to 1
▪ Phillips curve given by: 𝜋𝑡 −𝜋𝑡−1 = 𝑚 + 𝑧 − 𝛼𝑢𝑡
▪ Negative relationship between unemployment rate and change in inflation
▪ High unemployment leads to a decreasing inflation rate,
low unemployment leads to an increasing inflation rate
Phillips Curve:
De-anchoring of inflation expectations
Change in Inflation versus Unemployment in the United
States,
▪ 1970-1995: negative relationship 1970-1995

between unemployment rate and

change in inflation
▪ Regression line for the USA:
𝜋𝑡 − 𝜋𝑡−1 = 7.4% − 1.2𝑢𝑡

▪ Example: If u increses from 2% to

3% then the change in inflation
goes from 2ppt per year (e.g.,
0,2,4,6) to 0.8ppt per year (e.g.,
0,0.8,1.6,2.4,…). All starting rates
are made up in this example.
 The re-anchoring of inflation expectations

▪ In the 1990s: Phillips curve relation

Inflation versus Unemployment in the United States,
changed yet again 1996-2018

▪ Change in monetary policy: Central banks

committed to maintaining low and stable
inflation at an inflation target of 2%
▪ Stable inflation for over a decade
▪ Inflation expectations changed yet again:
expected inflation became roughly
constant
▪ Re-anchored inflation expectations =
back to original Phillips curve
Example: If u increses from 2% to 3% then the inflation rate
▪ 𝜽 went back down to zero, original Phillips goes from 2% per year to 1.84% per year. All starting rates
Curve: are made up in this example.

𝜋𝑡 = 𝜋ത + 𝑚 + 𝑧 − 𝛼𝑢𝑡
Phillips Curve:
Summary

1. Original Phillips curve from 1960s: 𝑢𝑡 ↑ ⇒ 𝜋𝑡 ↓

▪ Anchored expectations
▪ i.e. trade-off between unemployment and inflation

2. Phillips curve between 1970-1995: 𝑢𝑡 ↑ ⇒ 𝜋𝑡 − 𝜋𝑡−1 ↓

▪ De-anchored expectations
▪ i.e. trade-off between unemployment and change in inflation

3. Phillips Curve from 1996 onwards: 𝑢𝑡 ↑ ⇒ 𝜋𝑡 ↓

▪ Anchored expectations again

→ Relation between inflation and unemployment depends on how wage setters form
expectations about inflation.
Phillips Curve and connection to the
Natural Rate of Unemployment

▪ “Natural” (“structural”) rate of unemployment (Un) =

unemployment rate such that the actual inflation rate is equal to the
expected inflation rate
▪ Un is the employment rate which does not depend on fluctuations in
aggregate demand
𝜋𝑡 = π𝑒𝑡
Compare Un to Chapter 7
𝑚+𝑧 Labour market, intersection
⟹ 0 = 𝑚 + 𝑧 − 𝛼𝑢𝑡 ⟹ 𝑢𝑛 =
𝛼 between WS-curve and PS-
curve

𝑚+𝑧
▪ Rewrite: 𝑢𝑛 = ⇒ 𝛼𝑢𝑛 = 𝑚 + 𝑧
𝛼
▪ Plug in: 𝜋𝑡 − 𝜋𝑡𝑒 = 𝑚 + 𝑧 − 𝛼𝑢𝑡 ⟶
𝜋𝑡 − 𝜋𝑡𝑒 = −𝛼 𝑢𝑡 − 𝑢𝑛
Phillips Curve and connection to the Natural Rate of
Unemployment

𝜋𝑡 − 𝜋𝑡𝑒 = −𝛼 𝑢𝑡 − 𝑢𝑛

▪ The more the unemployment rate deviates from its “natural” level, the more the actual inflation rate deviates from
the expected inflation rate

𝑢𝑡 > 𝑢𝑛 (𝑟𝑒𝑐𝑒𝑠𝑠𝑖𝑜𝑛) ⟶ 𝜋𝑡 < 𝜋𝑡𝑒

𝑢𝑡 < 𝑢𝑛 (𝑏𝑜𝑜𝑚) ⟶ 𝜋𝑡 > 𝜋𝑡𝑒
𝑢𝑡 = 𝑢𝑛 ⟶ 𝜋𝑡 = 𝜋𝑡𝑒
Difference cyclical (𝑢𝑡 ) vs.
structural unemployment (𝑢𝑛 )

▪ Cyclical unemployment (𝒖𝒕 ): Due to changes in demand

▪ Structural unemployment (𝒖𝒏 ): Determined by structural policies/rigidities (policies that
affect m and z in our model)

▪ Demand shocks (fiscal and monetary policy, financial shocks) affect the business
cycle and the cyclical unemployment in the short run.
▪ Supply shocks (labour market, market power, etc.) have medium run consequences
on structural unemployment.

▪ Political reactions to unemployment need to depend on the type of

unemployment:
▪ Structural unempl.: structural reforms/rigidities (eg Tax schemes, social security, etc)
▪ Problem: structural unemployment is not easily measured – it must be estimated
On Thursday, 10.02.2022

▪ Mini quiz 2
▪ Homework 1 due (before 2 pm on MyLearn)
Any Questions?
PI 1322 – Melanie Gräser

International
Macroeconomics

• The IS-LM-PC model (chp. 9)

The IS-LM-PC Model

Blanchard, Chapter 9
The IS-LM-PC Model:
Phillips curve with output gap
𝜋𝑡 − 𝜋 𝑒 = −𝛼 𝑢 − 𝑢𝑛
𝑈 𝐿−𝑁
 Definition unemployment rate: 𝑢 = = ⟹ 𝑁 =𝐿 1−𝑢
𝐿 𝐿

 Given production function: 𝑌 = 𝑁 ⟹ 𝑌 = 𝐿 1 − 𝑢 and 𝑌𝑛 = 𝐿 1 − 𝑢𝑛

 ⟹ output gap: 𝑌 − 𝑌𝑛 = −𝐿 𝑢 − 𝑢𝑛

(𝑌−𝑌𝑛 )
 Rewrite as 𝑢 − 𝑢𝑛 = … and plug into Phillips curve: 𝜋 − 𝜋 𝑒 = −𝛼 𝑢 − 𝑢𝑛 :
−𝐿
𝛼
𝜋 − 𝜋𝑒 =
𝑌 − 𝑌𝑛
𝐿
 With anchored expectations 𝜋𝑡𝑒 = 𝜋:
ത
𝛼
𝜋𝑡 − 𝜋ത = 𝑌 − 𝑌𝑛
𝐿
The IS-LM-PC Model:
Phillips curve with output gap

𝛼
𝜋𝑡 − 𝜋ത = 𝑌 − 𝑌𝑛
𝐿 Assumption: 𝜋𝑡𝑒 = 𝜋ത
(anchored inflation
 Positive output gap: 𝑌 − 𝑌𝑛 > 0 expectations)
 𝑌 > 𝑌𝑛 : output is above potential
 𝜋𝑡 > 𝜋ത : inflation is above target inflation

 Negative output gap: 𝑌 − 𝑌𝑛 < 0

 𝑌 < 𝑌𝑛 : output is below potential
 𝜋𝑡 < 𝜋ത : inflation is below target inflation

 No output gap: 𝑌 − 𝑌𝑛 = 0
 𝑌 = 𝑌𝑛 : output is equal to potential
 𝜋𝑡 = 𝜋ത : inflation is equal to target inflation
Output gap and inflation:
The Phillips Curve Diagram

𝛼
𝜋 − 𝜋𝑒 = (𝑌 − 𝑌𝑛 )
Inflation rate is at target
𝐿
𝜋𝑡 − 𝜋ത inflation rate
 In the example: anchored
expectations

Inflation rate minus target

 Production lies above potential. PC

 At point A inflation is higher than

target inflation
𝜋𝑡 > 𝜋ത A
 In this situation there is 0
„overheating“.
 𝑢 < 𝑢𝑛 → 𝑊 ↑→ 𝑃 ↑→ 𝜋𝑡 > 𝜋ത 𝑌
𝑌𝑛 𝑌
At point A, inflation is constant
Production
but at a higher level than target
inflation
Output gap and inflation:
The Phillips Curve Diagram

Inflation is constant at an “unknown” inflation

𝛼 rate. Presumably, it is at target inflation rate, but
𝜋 − 𝜋𝑒 = (𝑌 − 𝑌𝑛 ) we cannot read this from the graph
𝐿
𝜋𝑡 − 𝜋𝑡−1
 In the example: adaptive
expectations
 Production lies above potential. PC

Change in inflation rate

 At point A inflation is higher in the
last period.
𝜋𝑡 > 𝜋𝑡−1 A
 In this situation there is 0
„overheating“.
 𝑢 < 𝑢𝑛 → 𝑊 ↑→ 𝑃 ↑→ 𝑃𝑒 ↑→ 𝑊 ↑→ 𝑃 ↑→ 𝑌
𝜋𝑡 > 𝜋𝑡−1 𝑌𝑛 𝑌

Production
At point A, inflation is increasing
The IS-LM-PC Model:
Equilibrium in the short run

IS: 𝑌 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑟 + 𝑥 + 𝐺
LM: 𝑟 = 𝑟; 𝑟 = 𝑖 − 𝜋𝑒
𝛼
PC: 𝜋 − 𝜋 𝑒 = (𝑌 − 𝑌𝑛 )
𝐿

Top graph:
 The lower the real interest rate, the higher is output

Bottom graph:
 The higher the output, the more inflation will be above
target

In point A: short run equilibrium

 𝑌 > 𝑌𝑛 : positive output gap
ത Inflation above target
 𝜋 > 𝜋:
 “overheating” economy
The IS-LM-PC Model:
Equilibrium in the medium run

Move from A to A’:

 Central bank wants to stabilize inflation
 Increases policy rate: 𝑟 ↑ (LM shifts upwards)

⟹𝐼↓ ⟹ 𝑍↓ ⟹𝑌↓ (move along IS)

⟹ 𝜋𝑡 − 𝜋ത ↓ (move along PC)

 Economy converges to potential; inflation at target rate

In point A’: medium run equilibrium

 𝑌 = 𝑌𝑛 and 𝜋 = 𝜋
ത (stable inflation)
 𝑟𝑛 : “natural", “neutral", “Wicksellian“ rate of interest
Short- and medium run equilibrium

 Short run: 𝜋 ≠ 𝜋 𝑒 , 𝑌 ≠ 𝑌𝑛 , 𝑢 ≠ 𝑢𝑛 is possible

 Medium run equilibrium: 𝜋 = 𝜋 𝑒 ↔ 𝑌 = 𝑌𝑛 ↔ 𝑢 = 𝑢𝑛

 How does the economy move from short to medium run

equilibrium?
 Without economic policy or other shocks not at all.
 Central bank/ monetary policy becomes active if inflation misses the
target rate. Inflation rate above target will lead to central bank
interventions.
Fiscal consolidation:
Short run and medium run effects
IS: 𝑌 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑟 + 𝑥 + 𝐺
LM: 𝑟 = 𝑟;ҧ 𝑟 = 𝑖 − 𝜋 𝑒
Starting point (Point A): 𝛼
PC: 𝜋𝑡 − 𝜋𝑡𝑒 = (𝑌 − 𝑌𝑛 )
𝐿

 Medium run equilibrium

 i.e. 𝑌 = 𝑌𝑛 and 𝜋𝑡 − 𝜋
ത =0

Short run (AA’):

 𝐺 ↓ ⟹ 𝑍 ↓ ⟹ 𝑌 ↓ (IS to the left)
 ⟹ 𝜋𝑡 − 𝜋ത ↓ (along PC)

Medium run dynamics (A’A’’):

 In point A’: recession and decreasing inflation
𝝅𝒕 𝝅𝒕−𝟏
 Threat of deflation ⟹ CB lowers policy rate
 𝑟 ↓ (LM shifts downwards)
 ⟹ 𝐼 ↑ ⟹ 𝑍 ↑ ⟹ 𝑌 ↑ (move along IS’)
 ⟹ 𝜋𝑡 − 𝜋ത ↑ (along PC)
Fiscal consolidation:
Short run and medium run effects

Medium run equilibrium (Point A’’):

 Output is equal to potential: 𝑌 = 𝑌𝑛
 Inflation is back at target inflation rate
 Real interest rate decreased: 𝑟𝑛 → 𝑟′𝑛

Composition of demand:
 Comparison starting and end point (A vs. A’’):
𝑌=𝐶+𝐼+𝐺
𝝅𝒕 − 𝝅𝒕−𝟏
 𝐺 lower, but 𝐼 𝑌, 𝑟 + 𝑥 higher, because
𝑟 decreased due to monetary expansion 𝝅𝒕 − 𝝅𝒕−𝟏

 𝑌, and 𝐶 𝑌 − 𝑇 do not change

Conclusion:
 Temporary recession
 Permanent change in composition of GDP
IS-LM-PC Model:
Different kinds of “shocks”

Differentiating between
“Demand shock”:
 Change in Demand 𝑍
 Shifts of the IS-curve
 e.g. Financial crisis from 2007: 𝑌 decreases temporarily (recession) and 𝜋
decreases (disinflation, possibly even deflation)

“Supply shock”:
 Change in potential output 𝑌𝑛 due to changes in 𝑚 or 𝑧
 Shift of PC-curve, followed by move along (adjustment mechanism)
 e.g. oil price increase in 1970s: “stagflation”
 𝑌 decreases permanently (stagnation) and 𝜋 increases (inflation)
Increase in firms‘ market power:
Medium run equilibrium

New medium run equilibrium:

 An increase in the markup
(𝒎)

𝑊
 𝑚↑ ⟹ 𝑃↑ ⟹ ↓
𝑃
(PS shifts downward)

 ⟹ 𝑢𝑛 ′ > 𝑢𝑛 ⇔ 𝑌𝑛 ′ < 𝑌𝑛
 Increase in Price of Oil:
Adjustment mechanism

 A  A’: mark-up increases price level increase (PC

shifts up)
 In point A’: 𝑌 > 𝑌𝑛 ’ and 𝜋𝑡 > 𝜋 ത
 As long as central bank keeps real interest rate constant,
inflation is higher than target inflation in the short run at the
same level of output

 A’  A’’ (adjustment mechanism)

 To lower inflation, the central bank has to increase the real
interest rate (LM upwards) 𝝅𝒕 −
𝝅𝒕𝝅−𝒕−𝟏
𝝅𝒕−𝟏

 Output decreases to new medium run equilibrium (Point A’’)

 During the adjustment process the economy is in

“stagflation” (= lower output & higher inflation)
Conclusions

 Shocks or changes in policy typically have different effects in the short

run and in the medium run.
 Disagreements about the effects of various policies depend on how fast
you think the economy adjusts to shocks.
 Movements in output around its trend are called output fluctuations
(business cycles).
 Economic fluctuations are the results of shocks and their dynamic
effects, called the propagation mechanism.
 Normally the economy returns to the trend level (potential output).
Looking at the zero lower bound, this adjustment can take a long time.
Next week Monday, 14.02.2022

Mid term in room TC.0.01 ERSTE in presence

 Chapters 1-9
 2 single choice questions
 2 open questions
Any Questions?
PI 1322 – Melanie Gräser
International
Macroeconomics

• CH 17
• The Open Economy
Overview

Until now:
▪ Closed economy:
▪ Z=C+I+G
▪ Closed goods market
▪ Only domestic goods consumed
▪ Production only sold domestically
▪ Closed financial market
▪ Wealth only invested in domestic financial assets
▪ Foreigners cannot invest in domestic financial assets

From now on:

▪ Open goods market → Trade of goods and services
▪ Real exchange rate
▪ Open financial markets→ Trade in assets
▪ Nominal exchange rate, interest rate
Growth in advanced and emerging economies
 Exports globally

Global exports of goods & services in trillion USD Global exports of goods & services as % of global GDP

Source: World Bank national accounts data and OECD national account data files
Three aspects of globalization:

1) Openness in goods markets

▪ Export and Import (X and IM)
Trade policy: tariffs and quotas (restriction on the quantity of goods that can be
imported)

2) Openness in financial markets

▪ Purchase of foreign assets by nationals (or domestic assets by foreigners)
International transactions of bonds
3) Openness in factor markets
▪ Foreign Direct Investment – FDI
firms choosing where to locate production or controlling foreign enterprises by buying stock
shares
▪ Labour:
migration (permanent) and temporary movement of workers
Open Goods Markets

Measures?
Volume of trade: X+IM/GDP

Others:
▪ Import ratio: Imports to GDP ratio
▪ Export ratio: Exports to GDP ratio
Open goods markets:
Trade balance (Exports & Imports as % of GDP)
60
50
40
30
USA
Imports
20
10
Exports
0

1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
60 60
50 Austria Exports 50 Germany
Exports
40 40
Imports
30 30
20 20 Imports
10 10
0 0

Source: World Bank WDI

Openness to trade

Determinants of openness (X and IM):

1. Presence of trade tariffs or quota
2. Domestic and foreign demand for goods
3. Price of domestic and foreign goods

Others:
1. Size of a country: big countries such as the US, Brazil, and China
have a low export ratio
2. Distance to economic centres: countries close to economic centres
tend to trade more
Choice Between Domestic and Foreign Goods

Consumption Foreign goods

Income
Domestic goods
Savings

In order to choose between domestic and foreign goods:

1. Price of domestic goods relative to that of foreign goods,
2. Exchange rates
Nominal exchange rate

The nominal exchange rate is the relative price of currencies (denoted by E)

It can be defined either as:

(1)the price of domestic currency (EUR) in terms of the foreign currency

(USD)

(2) the price of foreign currency (USD) in terms of the domestic currency (EUR)

We will use (1)

Nominal exchange rate

The nominal exchange rate is:

The price of domestic currency (EUR) in terms of the foreign currency (USD)

1 x EUR = E x USD

E = EUR/USD = 1.18

the price of one euro is 1.18 US dollars

1 EUR = 1.18 $
Nominal exchange rate

▪ EUR/USD

Source: ECB
Nominal exchange rate

Appreciation of the domestic currency ↑E

is an increase of the price of the domestic currency in terms of the foreign

currency (need more dollars to buy one euro)

Depreciation of the domestic currency ↓E

Is a decrease of the price of the domestic currency in terms of the foreign

currency (need less dollars to buy one euro)
From Nominal to Real Exchange Rates

Real exchange rate is the relative prices of goods

▪ the price of domestic goods in terms of foreign goods

▪ denoted by ε - epsilon
From Nominal to Real Exchange Rates
Real ER Nominal ER
Real exchange rate:
E = Price of Euro in $
EP
  P = Price of goods in €
P EP = Price of EU goods in $
P* = Price of US goods in $

▪ P typically refers to the price of a basket of products and services and is

described in terms of a price index (CPI)
▪ Note: from now on foreign variables are denoted by *
 From Nominal to Real Exchange Rates

▪ Example: how is the price of European apples relative to that of US apples?

▪ Express both goods in the same currency and then compute the relative price
▪ Nominal exchange rate: E = 1.18
▪ European apples cost 1 EUR
▪ US apples cost 2 USD
▪ To compare the cost of apples, we need prices in terms of the same currency
=> the price of European apples in dollars: E = EUR/USD
=> 1.18 x 1 EUR = 1.18 USD

▪ Now, we can compare the price of European apples relative to that of US apples
(ɛ)
ɛ = price of EU apples in USD / price of US apples in USD
ɛ = 1.18 USD / 2 USD = 0.59
From Nominal to Real Exchange Rates

ε=0.59 => Apples are 41% cheaper in the EU than in the US.
▪ The EU is more competitive producing apples
▪ The EU will export apples to the US

=> Information on (ε) is relevant when deciding whether consuming domestic

or foreign goods

In general we don’t think in terms of apples but in terms of the overall price
level, P.
 Real Exchange Rate

▪ Real appreciation = an increase in the real exchange rate ↑ε

▪ Real depreciation = a decrease in the real exchange rate ↓ε

▪ The level of the real exchange rate is uninformative, but the rate of change of the
real exchange rate tells us how goods became cheaper or more expensive over a
period of time:
▪ 10% increase in the real exchange rate => domestic goods are 10% more expensive
 Important

▪ Movements of ɛ are fully explained by movements of E if, and only if:

1. the price level in both countries is constant (that is, 𝜋=𝜋*=0)
2. foreign and domestic inflation rates are identical (that is, 𝜋=𝜋*)

=> in those cases, ε and E follow the same trend

▪ Real exchange rate is normally used to assess the competitiveness of a country’s

exports

=> the country with the lowest ɛ will export

(ex: EU will export apples)
 Openness in Financial Markets

Closed economy: choice between money (currency) and bonds

Open economy: households can buy foreign assets (stocks, bonds and money), in order to:
1. search of higher return to investment
2. diversify risk
3. speculate

Choice between domestic and foreign assets: the return on domestic bonds
relative to that of foreign bonds

What determines the relative return on domestic vs. foreign bonds?

1. domestic and foreign interest rate
2. nominal exchange rate
Choice between domestic and foreign assets

Remember the IS-LM model: choice between currency and bonds

What do we care about in the open economy?
We do not need foreign currency for daily transactions (no demand for foreign
money), but we can choose between domestic and foreign bonds:

Domestic
Expected return
for every $ you
Foreign invest today

For every $, you get Et pounds

Et = price of domestic currency (US dollars) in terms of the foreign currency (UK pounds)
1/Et = price of foreign currency (UK pounds) in terms of domestic currency (US dollars)
Choice between domestic and foreign assets

▪ Arbitrage: Exploitation of variations in price of similar assets to make profit

▪ Equilibrium is achieved when:
▪ Return on domestic bonds = expected return on foreign bonds

Et
(1 + it ) = (1 + it )
Ete+1

▪ This relation is called the interest parity condition

Approximation of previous formula

Et
(1 + it ) = (1 + it )
Ete+1

When interest rates and expected appreciations are small, we can

approximate the previous formula to:

𝑒
∗
𝐸𝑡+1 − 𝐸𝑡
𝑖𝑡 ≈ 𝑖𝑡 − Expected appreciation
𝐸𝑡
The second equation is the approximation of the interest parity condition:
arbitrage implies that the domestic interest rate equals the foreign interest
rate minus the expected appreciation of the domestic currency (or plus
the expected depreciation!)
Example

▪ Interest rate in US (domestic country): 5%

▪ Interest rate in UK (foreign country): 3%
▪ For the interest parity to hold, there must be an expected depreciation of
USD by 2% in the future. A financial investor will be indifferent between
investing in US or UK only if she expects the higher profit from 5%
interest to be balanced out by the loss of the 2% depreciation of USD in
the future.

𝑒
∗
𝐸𝑡+1 − 𝐸𝑡
𝑖𝑡 ≈ 𝑖𝑡 −
𝐸𝑡
The Balance of Payments (BoP)

Definition:
The balance of payments (BoP) is a record of all transactions of a country
with the rest of the world over a given period of time

It includes:
▪ international trade (X and IM)
▪ financial assets (foreign assets and bonds)
▪ other transfers (international aid)
Balance of Payments

Main Components:

▪ Current account (trade balance + net income and transfers)

Measures of a country's foreign trade and net factor income (earnings on
foreign investments minus payments made to foreign investors).

▪ Financial account
Represents the net change in ownership of national assets. A surplus
means money is flowing into the country, increasing borrowings or sales of
assets. A deficit means money is flowing out of the country, increasing its
ownership of foreign assets.
The Balance of Payments
 The Balance of Payments

Current account (INCOME)

1. Trade balance
Exports and imports of goods and services
If X>IM, trade balance surplus;
If X<IM, trade balance deficit.

2. Net income
Income received from holding foreign assets – (minus) income paid on
domestic assets held abroad

1 + 2 = Current Account balance (surplus or deficit)

The Balance of Payments

Financial account
Purchase and sale of assets, stocks or bonds

▪ If positive, you are borrowing from abroad (SURPLUS)

▪ If negative, you are saving and lending to others (DEFICIT)

Increase in capital flows comes from either:

▪ an increase in domestic assets held by foreigners, or
▪ a decrease in foreign assets held by domestic residents

Decrease in capital flows comes from either:

▪ an increase in foreign assets held by domestic residents, or
▪ a decrease in domestic assets held by foreigners
Trade between USA and Rest of World
Summing up

Goods Markets in the Open Economy

The choice between domestic and foreign goods
The relative price of goods => real exchange rate (ɛ)

Financial Markets in the Open economy

The choice between domestic and foreign assets (bonds)
The relative expected returns on foreign and domestic assets, which,
in turn, depends on:
1. nominal exchange rate, both current (E) and expected (Ee)
2. domestic and foreign interest rate (i and i*)
Any Questions?
PI 1322 – Melanie Gräser
International
Macroeconomics

• CH 18
Goods Market in Open Economy:
Aggregate Demand

Demand in closed economy:

Z C  I G
Demand for domestic Domestic demand
goods for goods

Demand in open economy:

Z  C  I  G  IM   X

Demand for domestic Domestic Exports (foreign demand for

goods demand for domestic goods)
goods, D
Value of imports
(in terms of domestic goods)
Open Goods Market:
Determinants

 Domestic demand for goods: 𝐷 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑟 + 𝐺

+ (+, −)

 Same as for closed economy

 Domestic demand for foreign goods (Imports): IM  IM Y ,  

 
 Y↑  Demand increases  given ε, demand for imports increases

 ε↑: foreign goods cheaper relative to domestic goods  Demand for imports increases

 Foreign demand for domestic goods (Exports): 

X  X Y *,
 

 Y*↑: Demand increases in foreign economy given ε, demand for exports increases

 ε↑: domestic goods more expensive in terms of foreign goods  Demand for export decreases
Open Goods Market:
Domestic demand for domestic goods
Z D
 Domestic demand for (foreign and domestic) goods
(D-curve)
 D=C+I+G, consumption and investment depend positively on income Y.

 Domestic demand for domestic goods (A-curve) Z D

 A flatter than D: 𝐼𝑀 Value of imports in terms
If Y↑  Increased demand D for foreign goods 𝜀
of domestic goods

 D − A = IMΤε increases with income

A
 ε determines which fraction of the domestic demand will be
satisfied through imports

 As income increases, domestic demand for domestic goods Y

increases less than total demand
Open Goods Market:
Demand for domestic goods
Z D
 Demand for domestic goods (Z-curve) Z
 We add exports to domestic demand for goods +X

 Same slope as A, since demand for exports X does not depend A

on domestic production Y

 Net exports: 𝑁𝑋 = 𝑋 − 𝐼𝑀Τ𝜀 NX

 NX-curve: 𝑁𝑋 = 𝑍 − 𝐷
𝐼𝑀
𝑋>
 NX-curve cuts the axis at NX=0 (where exports equal 0
𝜀
Y
imports). This is the case where Z and D intersect. 𝑋<
𝐼𝑀
𝜀

NX
Open Goods Market:
Equilibrium
Y=Z

 Equilibrium in goods market: Z D

Z
Domestic output (Y) = demand for domestic goods (Z)

Y  C Y  T  I Y , r  G  X Y *,   IM Y ,   
  
    
 
NX
Y

 An equilibrium in the goods market does not necessarily

NX
imply that trade is balanced (Exports = Imports).
 In this example, the equilibrium in the goods market
shows a trade surplus.
0 Y
Y

NX
Change in Demand:
Exogenous determinants

 What determines demand for domestic goods?

Y  C Y  T  I Y , r  G  X Y *,   IM Y ,   
  
    
 
NX
 Exogenous determinants:
 Domestic demand (especially G, T)

 Foreign demand (depending on foreign income Y*)

 Real exchange rate, ε

Do not confuse:

 Y=Z : Equilibrium in the goods market

Y  C Y  T  I Y , r  G  X Y *,   IM Y ,   
  
    
 
NX
 D=Z : Trade balance (NX=0)
Three applications

1. Increase in domestic demand ↑G

2. Increase in foreign demand ↑Y*

3. The effect of depreciation ↓ℇ

 Application 1:
↑ in domestic demand
Y=Z
D`
For example increase in goverment exp. (G↑) Z
Z‘
 Increase in production (like before) D
 NX-curve does not shift, as there is no change in exogenous determinants of
Z
this curve. D and Z must shift upwards by the same amount since G is part of
both curves.
 Increase in trade deficit

Reason: NX

 Parts of the goods demanded by government will be imported

 Parts of increased income will be spent in the foreign country 0 Y

Y
 Multiplier is smaller than in the closed economy
Y‘
NX
Application 1:
↑ in domestic demand
Multiplier in an open vs. closed economy

Is G↑ more effective in an open or in a closed economy?

Increases in domestic demand have a smaller effect on output in the open

economy than in the closed economy

The multiplier is smaller in an open economy!

Application 2:
Increase in foreign demand (↑ G*)
 Z* ↑
 Y*↑
 Foreigners will demand more
 Not only their own products but also foreign products
 IM* ↑
 Exports at home increase (X)

What shifts?
 Shift upward of the demand for domestic goods
 From Z to Z’ (X’>X or Y*’>Y*)
 Shift upward of the net exports (NX)
 From NX to NX’ (Y*’>Y*)
Application 2:
Increase in foreign demand (↑ G*)
Y=Z

 Increase in foreign demand (Y*↑) Z D Z‘

 Exports increase by ∆X (Z  Z’)
 Production and income increase (YY’)
Z

 Effect on trade balance?

 NX-curve shifts up (NX’) Y
 Increased income Y’ means imports increase
NX
  trade balance increases by ∆NX
(there by less than ∆X)
Effect on GDP? Increase Y* -> Increase X->Increase
Y->Increase C,I,IM->Increase Y-> Increase 0 Y
C,I,IM…Increase Y’ Y‘
Y NX‘
Effect on NX? X and IM increased. But X increased
NX
more than IM  Trade surplus.
Application 2:
Increase in foreign demand (↑ G*)

 Booms and recessions in the foreign Solution is coordinated actions, with all
country affect the domestic economy! countries increasing G at same time.
 Contagion effect across countries
 If all countries are hit by a recession Remember: running a trade deficit
 Countries wait for the reaction of
means that you are borrowing from
neighbour (they wait for ↑G*) abroad (paying interest payments to
other countries)

When ↑G When ↑G* This may not be sustainable over time

(↑Y*)
Y↑ but NX↓ Y↑ and NX↑
Depreciation:
Marshall-Lerner-Condition
Trade balance: NX  X Y *,   IM Y ,   
   

 Real depreciation (ε↓) leads to

1. Increased exports (X↑)
2. Decreased imports (IM↓)
3. Increase in relative price of foreign goods in terms of domestic goods, ε↓ = (1/ε)↑

IM 
NX ?  X   ?  Effect on trade balance remains unclear

Marshall-Lerner(ML)-Condition:
 Real depreciation leads to (given Y and Y*) improved trade balance (NX↑), if:
 Exports increase sufficiently (1)
 Imports decrease sufficiently (2) to compensate increased prices of imports (3)
 Therefore quantity effect > price effect
Application 3:
Effect of real depreciation (↓ℇ)
Under the Marshall-Lerner condition

↓ℇ  NX ↑  Y ↑  NX ↑

 Shift upward of Z,
from Z to Z’(ℇ’ < ℇ or NX’ > NX)
 Shift upward of NX,
from NX to NX’(ℇ’ < ℇ)

Similar to G*↑ (Y* ↑), but…

Depreciation makes imports relatively more

expensive

 Problem for least developed countries that are

net importers of food
 Though, good for countries that are net
exporters
 J-Curve (effect of depreciation over time)

Dynamic analysis of a real depreciation:

 Short term:
 Prices adjust faster than goods
 Therefore ε↓, but 𝐼𝑀, 𝑋ത constant
 Price effect > quantity effect
(therefore ML condition does not hold in SR)

IM
NX  X  

 Medium run:
 After some time: IM↓ and X↑
 Therefore quantity effect > price effect
(if ML condition holds)
IM 
NX  X   

Net exports

Summary of the determinants of NX

Net exports = NX(Y; Y*; ε )

1. Y(-), movement along the NX curve
2. Y*(+), when Y* ↑, shift upwards of the NX and Z curves
3. Ε(-), impacts on X, IM and 1/ε
I. Because of Marshall Lerner condition when ε↑, shift downwards of the NX and Z
curves
Trade balance:
Saving and investments
S  Y T C
Y  C  I  G  X  IM  NX  S  (T  G )  I Assumption:
NX=CA
 
NX
 Increase in investments (I↑) means…
 Increase in private savings, S↑
 or increase in public saving, (T-G)↑
 or deterioration in trade balance, NX↓
 -> A country, which wants to invest more, must either save more or be indebted to a foreign country

 Increase in government budget deficit (T-G decreases!) means…

 Increase in private savings, S↑
 Or decrease in investments, I↓
 Or deterioration in trade balance, NX↓
 -> A government can only spend more than it earns if it can run private or foreign debts.

 A country with a high private (S) or public (T-G) savings rate, has either…
 High level of investments(I)
 Or high trade surplus (NX)
 -> Saving makes it possible to invest in domestic and foreign countries.
Summary

What is the difference between the demand for domestic goods and the domestic demand for
domestic goods?
 Domestic demand for goods: 𝐷 = 𝐶 + 𝐼 + 𝐺
 Demand for domestic goods: Z = 𝐶 + 𝐼 + 𝐺 − 𝐼𝑚Τ𝜀 + 𝑋
What do net exports depend on?

 NX  X Y *,  IM Y ,     NX Y , Y *,  (If ML condition holds!)

      
What does the ML Condition tell us?
 Increase in real exchange rate leads to decrease in net exports (and other way round)

What does the J Curve show?

 The dynamic reaction of net exports to a change in the real exchange rate
 Real depreciation leads first to a decrease in net exports (=price effect), then to an increase in net exports (=quantity
effect)

What is the relationship between NX, I und S?

 Net exports (current account) = private saving – investments + government budget
Additional things

 Possibility to view midterm exam on Wednesday 2:30-4:00 pm

 Write me an email to arrange meeting (online)
 Mini Quiz on Thursday: chapters 17 & 18
 Online Single Choice Questions
 Homework 2 is due on Friday
 Final exam in person on 1st March 2022 at 2 pm
Any Questions?
PI 1322 – Melanie Gräser
International
Macroeconomics

• CH 19 & 20
• The Mundell-Fleming Model
• Exchange Rate Regimes
Open Goods Market

▪ Equilibrium in open goods market: Y=Z

+ +, − 𝐼𝑀 +, + (+, −)
𝑌 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑟 + 𝐺 − 𝑌, 𝜀 + 𝑋 𝑌 ∗ , 𝜀
𝜀

▪ If Marshall Lerner condition holds, then:

+ +, − −, +, −
𝑌 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑟 + 𝐺 + 𝑁𝑋 𝑌, 𝑌 ∗ , 𝜀

▪ Additional assumptions are made:

▪ In the short run, domestic and foreign price levels are given:
𝑃
=1 → 𝜀=𝐸
𝑃∗
▪ In the short run, inflation and inflation expectations are 0
𝜋𝑒 = 0 → 𝑟 = 𝑖
▪ IS-function in Mundell-Fleming model

𝑌 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑖 + 𝐺 + 𝑁𝑋 𝑌, 𝑌 ∗ , 𝐸
Open Financial Market

▪ Equilibrium in open money market: 𝑀 𝑠 = 𝑀𝑑

▪ Assumptions:
▪ Exports and imports are paid in domestic currency (or changed right away to the other currency)
▪ Domestic currency is demanded mostly in domestic country

▪ Central bank sets the policy rate

▪ LM-curve in Mundell-Fleming model

𝑖=𝑖
Open Financial Market

▪ Decision between domestic and foreign bonds

𝐸𝑡
▪ Interest parity: 1 + 𝑖𝑡 = (1 + 𝑖𝑡∗ ) 𝑒
𝐸𝑡+1

Return on Expected return on

domestic bonds foreign bonds

▪ Assumption: expected future exchange rate is constant, 𝐸𝑡+1

𝑒
= 𝐸ത 𝑒
▪ Simplification is justified since the focus does not lie on expectations here.
▪ This gives the interest parity condition in Mundell-Fleming-Model
1+𝑖 𝑒
𝐸= 𝐸
1 + 𝑖∗

▪ If domestic interest rate or expected future exchange rate increase, the currency appreciates.
▪ If the foreign interest rate increases, the currency depreciates.
Interest parity condition:
Examples

1+ i e Ee − E
E= E it  it −
1 + i E

▪ Example 1: Increase in domestic interest rate (i↑)

▪ Starting point: 𝐸 = 𝐸ത 𝑒 = 1, 𝑖 = 𝑖 ∗ = 5%
▪ i increases to 8% → 𝐸 = 1,08Τ1,05 ∗ 1 ≈ 1,03
▪ Increases in interest rate leads to instant appreciation
▪ This also means: Expectations of a future depreciation, as 𝐸ത 𝑒 < 𝐸
▪ Instant appreciation must be exactly so high, that the expected future depreciation balances out the difference in
interest rates! (Only then are investors indifferent and the interest parity condition holds)

▪ Example 2: Expectation of an appreciation (𝐸ത 𝑒 ↑)

▪ Starting point: 𝐸 = 𝐸ത 𝑒 = 1, 𝑖 = 𝑖 ∗ = 5%
▪ 𝐸ത 𝑒 increases to 1,1 → 𝐸 = 1,05Τ1,05 ∗ 1,1 ≈ 1,1
▪ Expectation of an appreciation leads to instant appreciation
 Interest parity condition:
Graphic depiction

1+ i e
E= E
1 + i

▪ Change in 𝑖
→ Movement along curve
▪ Change in 𝑖 ∗ or 𝐸ത 𝑒 𝑖 = 𝑖 ∗ , 𝐸 = 𝐸ത 𝑒
→ Shift of curve
IS-LM Model in Open Economy

i→Y: 2 channels  E 

+
Y = C (Y − T ) + I (Y , i ) + G + NX (Y , Y  ,
1 i
IS: E e)

+ +,− 1+ i
− + −

LM: i=i

IP: 1+ i e
E= E
1 + i

“Mundell-Fleming Model”
Effects of policy in an open economy with flexible
exchange rate

a)Fiscal expansion
b)Monetary contraction

Starting point: Government has a balanced budget (T-G)=0 and

net export is equal to zero (X-IM=0)

The government increases G without increasing taxes (↑G)

Fiscal expansion

E= E(i; i*, Ee)

• What are the effects on

the components of
demand (C,I,G,NX)?

An increase in government spending leads to an increase in output. If the

central bank keeps the interest rate unchanged, the exchange rate
also remains unchanged.
Monetary contraction
Figure 19-3 The Effects of an Increase in the Interest Rate

• What are the effects on

the components of
demand (C,I,G,NX)?

An increase in the interest rate leads to a decrease in output and an

appreciation.
Exchange Rate Regimes

▪ Flexible exchange rate

▪ The nominal exchange rate (E) moves freely (endogenously determined)
▪ No explicit/implicit exchange rate targets
▪ USA, UK, Japan, and Canada

▪ Fixed exchange rate

▪ A country's official currency exchange rate is tied to another country's currency
▪ Pegs. Example: Argentina (1991 – 2001), peso pegged to dollar (Ē = 1)
▪ Crawling Pegs. Ex: fixed depreciation against the dollar
▪ Bands. Ex: European Monetary System (1978-1998)

The Central Bank intervenes in the financial markets in order to adjust to the value of
the nominal exchange rate Ē (exchange rate target)
Fixed exchange rate

Definition:

▪ A decrease in the nominal exchange rate under a fixed exchange rate

regime is called
↓E, devaluation

▪ An increase in the nominal exchange rate under a fixed exchange rate

regime is called
↑E, revaluation
Fixed Exchange Rate:
Monetary Policy
▪ Interest parity
𝐸𝑡
1 + 𝑖𝑡 = (1 + 𝑖𝑡∗ ) 𝑒
𝐸𝑡+1
▪ With fixed exchange rate 𝐸:
ത
𝐸ത
1 + 𝑖𝑡 = 1 + 𝑖𝑡∗
𝐸ത
𝑖𝑡 = 𝑖𝑡∗
▪ A central bank that wants to fix exchange rate to another currency needs to keep its interest rate at the
same level as the foreign country‘s interest rate it ties its exchange rate to. Then interest parity is fulfilled.
▪ Fixed exchange rate → CB gives up monetary policy as a policy instrument!
▪ The CB needs to make sure that the E is constant over time. It cannot change 𝑖𝑡 = 𝑖𝑡∗ , and thus cannot
change I nor NX in order to stimulate the economy.
Fixed exchange rate:
Fiscal policy
▪ Expansive (contractionary) fiscal policy will lead to increasing (falling)
inflation: see IS-LM-PC-Model.
▪ We have argued in previous examples that the CB will change interest
rate to reach its goal of stable inflation.
▪ With fixed exchange rates, CB cannot change interest rate without
giving up interest rate parity.
▪ Expansive fiscal policy will lead to an increase in trade deficit. The fixed
exchange rate does not allow adjustments that would lead to a decrease
in trade deficit.
▪ These are short run mechanisms. To understand why some countries
have fixed exchange rate regimes nonetheless, we need to look at the
medium run. This we will do in chapter 20.
Summary

▪ Mundell-Fleming model: extension of the IS-LM model to the open economy

▪ Assumption: prices do not change
=> zero inflation
=> real interest rates = nominal interest rates
=> real exchange rate = nominal exchange rate
▪ NX as a function of E, through the IP condition
(IP: positive relationship between i and E)
▪ Two channels through which interest rates affect output in the open
economy
▪ Effects of policy with flexible exchange rate vs Effect of policy with fixed
exchange rate
Chapter 20:
Exchange Rate Regimes
The Medium Run

▪ The real exchange rate is:

which can adjust either:

▪ through a change in the nominal exchange rate, E: If the domestic price level and
foreign price level do not change in the short run, this is the only way to adjust the real
exchange rate in the short run.
▪ through a change in the domestic price level relative to the foreign price level: In
the medium run, as prices adjust, this option is open even to a country with a fixed
nominal exchange rate.
The Medium Run

▪ Since in the medium run prices and price expectation can change, the
simplifications in chapter 19 do not hold any more:

i≠r
E≠ɛ
(nominal and real variables are different)

We need to come back to the full specification for r and ɛ

r=i-𝜋
ɛ = EP/P*
Fixed Exchange Rates
Fixed Exchange Rate:
Monetary Policy
▪ Interest parity
𝐸𝑡
1 + 𝑖𝑡 = (1 + 𝑖𝑡∗ ) 𝑒
𝐸𝑡+1
▪ With fixed exchange rate 𝐸:
ത
𝐸ത
1 + 𝑖𝑡 = 1 + 𝑖𝑡∗
𝐸ത

𝑖𝑡 = 𝑖𝑡∗
▪ CB that wants to bind currency to foreign currency, needs to hold interest rate at the same
level as foreign country. Then interest parity is fulfilled.
▪ If the CB policy is seen as trustworthy, expectations remain constant.
▪ Fixed ER → No autonomous monetary policy!
Short & Medium Run:
Recession

Recession: 𝑌 < 𝑌𝑛
▪ Short run:
▪ With flexible ER (𝐸 ): Counter-act recession through expansive monetary policy
ത ): 𝑖 = 𝑖 ∗ and fixed ER (𝜀)ҧ → Monetary policy not possible
▪ With fixed ER (𝐸
→ Argument against fixed ER

▪ Medium run:
▪ Also with fixed 𝐸ത real ER, 𝜀 = 𝐸𝑃Τ𝑃∗ , can change if 𝜋, 𝜋 ∗ are not the same
▪ → Recession can also be counteracted with fixed exchange rates
 Fixed Exchange Rate in Medium Run:
Phillips Curve

▪ Phillips Curve with anchored inflation expectations (𝜋 𝑒 = 𝜋):

ത
𝛼
𝜋 − 𝜋ത = 𝑌 − 𝑌𝑛
𝐿
▪ Assumption about foreign country: production is equal to potential
𝑌 ∗ = 𝑌𝑛∗ ⇔ 𝜋 ∗ = 𝜋ത ∗
▪ With fixed exchange rate 𝐸:
ത domestic inflation rate must equal inflation rate of foreign country to which
the domestic country pegs its exchange rate:
𝜋 = 𝜋∗
𝑃
▪ Otherwise: constant real de/re-valuation 𝜀 ↕ = 𝐸ത ↕ → constant deviation from 𝑌𝑛
𝑃∗

▪ Therefore, inflation targets (=anchor 𝜋)

ത must harmonize (CB cannot independently determine inflation
rate!):
𝜋ത = 𝜋ത ∗
Fixed Exchange Rate in Medium Run

▪ Phillips Curve with fixed ER (𝐸) ത with anchored inflation expectations (𝜋 𝑒 = 𝜋ത ∗ ):

𝛼
𝜋 − 𝜋ത ∗ = 𝑌 − 𝑌𝑛
𝐿
▪ In recession (𝑌 < 𝑌𝑛 ) therefore:
𝜋 < 𝜋ത ∗
▪ Domestic prices increase more slowly than foreign prices → real ER falls:
𝑃↑
𝜀 ↓ = 𝐸ത
𝑃∗ ↑↑

▪ Real devaluation until 𝑌 = 𝑌𝑛 (and 𝜋 = 𝜋ത ∗ ) is reached again:

ML
𝜀↓ 𝑁𝑋 ↑ ⟹ 𝑍 ↑ ⟹ 𝑌 ↑
Fixed Exchange Rates:
Exchange rate crises
Exchange Rate Crises:
Role of expectations
Situation: International financial investors expect a nominal devaluation (𝐸𝑡+1
𝑒 ത
< 𝐸)
Reasons:
1. Government wants faster adjustment process to potential output

2. Overvalued currency:
▪ Higher domestic inflation than foreign inflation→ constant real revaluation→ trade balance ↓ (𝑁𝑋 ↓)
→ forced to adjust nominal exchange rate (𝐸ത ↓)

3. Asymetric shocks, different ∆𝑌 in different countries

▪ eg recession only in domestic country, need decrease domestic interest rate (𝑖 ↓)
→ Would need to leave fixed exchange rate system

▪ eg boom only in foreign country 𝑌 ∗ ↑ → foreign CB increases interest rates 𝑖 ∗ ↑

→ Because of interest parity: 𝑖 ↑ ⟹ 𝐼 ↓ ⟹ 𝑍 ↓ ⟹ 𝑌 ↓, Recession
Exchange Rate Crises:
Role of expectations

4. Unfounded expectations 1 + it
Et = Ete+1
▪ „self-fulfilled prophecy" of exchange rate expectations: 1 + it
▪ if 𝐸𝑡+1
𝑒
< 𝐸ത → 𝑖 must increase, to keep 𝐸𝑡 = 𝐸ത constant
▪ Problem: i↑ → Investment↓ …
▪ → high economic and social cost of keeping fixed ER
▪ → devalue (Et↓) to avoid costs
▪ Ungrounded expectations of devaluation lead to actual
devaluation!
Exchange Rate Crises Under Fixed Exchange Rates

What are the options?

• Persuasion: persuade investors that the central bank is committed to keep the
fixed exchange rate
• Fight parity: Increasing domestic interest rate (through open market
operations)
– But this is painful as it leads to lower production levels (lower investment and
recession)
• Trying to keep E fixed: the central bank might use its foreign currency
reserves to buy domestic currency to keep E fixed…
– but reserves are not infinite. Thus investors might soon fear that the CB will run out of
reserves and thus increase their fears of devaluation
• Sooner or later the only option is to devalue and/or abandon the fixed
exchange rate regime
Exchange Rate Crises

▪ Mexico (1973-82) EMS Crisis 1992/1993

▪ Argentina (1978-81)
▪ European Monetary System
(EMS) (1992/93):
→Fixed parity with bands
▪ Mexico (1994/95)
▪ East Asia (1997/98)
▪ Russia 1998
▪ Brazil (1999)
▪ Turkey (2000/01)
▪ Argentina (2001/03)
Exchange Rate Crises:
EMS 1992

▪ September 1992: Financial markets expected a change in nominal E (devaluation)

▪ Reason: German unification: G↑, therefore CB feared P↑, Reaction: i↑
▪ However: other countries would have needed low i
▪ Sept: many waves of speculations, financial investors selling currencies in anticipation of
devaluation
▪ 5.-6. Sept: EMS-Finance minister announce that fixed exchange rate will be kept

▪ Asset market intervention by CB to keep exchange rate fixed:

→ Massive loss in foreign currency reserves: Italy, UK

▪ Increase in i to keep exchange rate constant:

France by 2,5%, England by 15%, Ireland short term by 300%, Sweden short term by 500%
Exchange Rate Crises:
EMS 1992

▪ One-time devaluation, therefore keep lower E

▪ Spain: 5% devaluation, Italy: 7% devaluation (vis a vis Germany)

▪ Leave EMS and devalue

▪ Finland, Italy, England (Devaluation of 15%)

From July 1993 onwards: larger fluctuation bands (+/- 15 %)

Flexible Exchange Rates
 Flexible Exchange Rates:
Role of Expectations

▪ Current nominal exchange rate 𝐸𝑡 depends on:

1 + it
▪ Current interest rates in foreign and domestic country Et = Ete+1
1 + it*
▪ Expected interest rate in domestic and foreign country 1 + ite+1
Ete+1 = Ete+ 2
▪ Expected exchange rate 1 + it*+e1
1 + ite+ 2
Ete+ 2 = Ete+ 3
1 + it*+e2
▪ → Flexible exchange rate can be very volatile
▪ → Argument against flexible exchange rate Ete+ 3 = 

(1 + it )(1 + ite+1 )...(1 + ite+ n )

Et = Ete+ n +1
(1 + it* )(1 + it*+e1 )...(1 + it*+en )
Flexible Rate Regime

One disadvantage of choosing a flexible exchange

rate regime:

exposure to substantial exchange rate

fluctuations overtime!
Pros & Cons:
Fixed vs Flexible Exchange Rate
Regimes
Different Exchange Rate Regimes:
fixed ↔ flexible
• Choice of ER-Regime is important
• Fixed ER:
No independent monetary policy, Risk of exchange
SR rate crises
Y≠Yn • Flexible ER:
Volatile

• Choice of ER-Regime not so important

• Reason: real ER (ε) is independet of type of regime
MR
• Careful: different dynamic short run → medium run
Y=Yn
Choice of Exchange Rate Regime

Pros Cons
▪ Easier to plan for firms ▪ No independent monetary policy
▪ No foreign exchange transaction costs ▪ Risk of „unfitting“ fiscal policy in anker
country
▪ Risk of speculative attacks and high costs to
Fixed ER protect from these attacks
▪ Costs from interventions of CB on foreign
exchange market

▪ Independent monetary policy ▪ Potential of high volatility

▪ No speculative attacks ▪ Transaction costs because of this insecurity
(eg for firms)
▪ ER can be used as adaption mechanism
Flexible ER ▪ Need: Developed capital markets
Choice of Exchange Rate Regime

In general, flexible exchange rate is preferred. This has two exceptions:

▪ If a group of countries is very integrated, a common currency can be useful
▪ If the CB cannot be trusted to follow a responsible monetary policy under a
flexible ER regime.
Choice of Exchange Rate Regime

In general: flexible ER better

Exception 1: Irresponsible monetary policy in the past

▪ E.g. Government finances expenditure through money creation (M↑) → high inflation

▪ Decides: Reduction of Inflation (M↓)

▪ Needs: fixed ER to seem convincing

▪ Options:
▪ Currency Board, fixed ER through independent agency

▪ Dollarization: Replace domestic currency with foreign currency (e.g. US$ in Zimbabwe)
Choice of Exchange Rate Regime

Exception 2: Well integrated group of countries

▪ Same currency (e.g. €) decrease transaction costs of trade

„Theory of optimal currency area":

▪ One of two conditions need to be satisfied for common currency:
1. Countries must experience similar shocks. Otherwise, the common central bank
will have problems in choosing the appropriate monetary policy, as no policy can
suit all countries and situations
2. If countries do not experience similar shocks, they must have high factor mobility
- Labour mobility from countries with high unemployment to countries with lower
unemployment
▪ USA: a not met, b is met
▪ EU: ??
Some important points

▪ Tomorrow: Revision class

▪ Complete homework 2: 1.5 bonus points if you upload comprehensive
answers on Learn before the class
▪ 1st March, 2:00 pm: Final Exam
▪ In person in room TC.0.01
▪ You can only write the final exam if you reached a total of 15 points
during the course!
▪ Bonus points count.
▪ If you are retaking the midterm, this will be after the final exam
in room TC 5.15
Any Questions?