MACROECONOMÍA

TEMA 1: INTRODUCTION TO MACROECONOMICS

1.1. INTRODUCTION TO MACROECONOMICS

Macroeconomics: “Macroeconomics is the study of whole economies the part of economics concerned
with large scale or general economic factors and how they interact in economies”. – Federal Reserve. It
focuses on the big indicators (GDP, unemployment, inflation, etc.).

We use time frequencies (years evaluate the structure and the performance / months assess the
dynamics). We can predict future changes of these indicators.

Macroeconomics builds upon a set of theories that allows economist to analyze the behavior of these
indicators as well as their potential changes once a certain economic policies or shocks are applied.

Types of economic policies:

- Monetary: Policy Interest rate determination.

- Fiscal: policy Taxes and government spending.
- Currency: policy interventions in the foreign currency market.

1.1.1. LONG RUN

GDPt (nominal GDP)

The study of the long run focuses on a variable = the GDP per capita =
Population t

‘In the long run, productivity is almost everything’- Krugman. (Get more with the same production
factors).

GDP is used to see how economies are evolving over time

1.1.2. SHORT RUN (BUSINESS CYCLE)

Time variables usually have a trend (average behavior in time, ‘tendencia’) and cycle (fluctuations over a
trend, ‘ciclo económico’). Expansions last longer than recessions in general.

Short and mediums runs of the GDP are considered as the Business Cycle (BC). BC distinguishes between
economic crises and economic booms.

- In the short run  There are not changes in prices (IS-LM model)
- In the medium run  There are changes in prices (AS-AD model)

Dynamics in the short run is mostly captures by growth rates. Where g refers to the growth rate and t
indicates the time period. T could be years, quarters, months.

gt −1, t=
( GD Pt −GDPt −1
GD Pt −1 )
Growth in average terms through the geometric average. Where g refers to the growth rate, y is the
economic variable, T is the total number of years and t indicates the base year.

( )
1
y t +T T
gt ,t +T = −1
yt

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Ejemplo:

202 3.5B Growth rate 2020-2021 3.7−3.5

0 ×100=5.72 %
3.5
202 3.7B Growth rate 2021-2022 3.8−3.7
1 ×100=2.70 %
3.7

( )
202 3.8B Average geometric rate 3.8 2
1

2 −1
3.5
Growth can be approximated as difference between logarithms. The use of logarithms is recommended
because they get smoother time series and also because they correct for outliers. i is the country.

gi ,t ,t −1 ≈ log y i , t−log y i , t−1

Indicators for the short run:

- Tasa intertrimestral (quarterly rate): Growth rate between two quarters (consecutive). It gives
contemporaneous information.
- Tasa interanual (year-on-year rate or interannual): Same two quarters in two different years. It
gives annual changes.
- Tasa media anual (Average annual rate): Average of the quarters in a year.

1.1.3. THE GDP (GROSS DOMESTIC PRODUCT)

The GDP is the value (the total sum) of the final good and services produced in a country in a given
period. We don’t consider intermediate goods. Periods can be years, quarters, months, etc.

The GDP is a measure of production (output) and a measure of income. Not of wealth.

The GDP is a flow variable:

- Flow variables are measured in a given period of time (Example: GDP for Spain in 2020).
- Stock variables are measured in a given moment of time (Example: Total Capital in Spain in
2020). Is independent of time.

Thanks to the GDP, you can compare:

- Countries for the same year (static comparative, with some caveats ‘advertencias’).
- The same country through years.
- Countries through years.

Actual GDP vs Potential GDP

- Potential GDP: Is an estimate of the level of GDP that a country should have according to their
factors of production. Estimation. All possible people working and factors of production.
- Actual GDP: Is the GDP observed in the official statistics.
- If potential GDP > actual GDP = a country is doing worse than expected, it is underperforming,
so it’s not using all factors at maximum speed.
- If actual GDP > potential GDP = a country is doing better than expected, it is over-performing,
so we could expect a downward correction.

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The goal of economic policies is to make these cycles smoother in time to reduce economic
fluctuations around a trend.

1.2. OTHER MACROECONOMIC INDICATORS

1.2.1. NOMINAL VS REAL GDP

Nominal GDP (GDP at current prices) = Σ i=1 Pi 2020 X i 2020 (normal GDP)

2010 2016 2022

Production Good X 1.000*10 = 10.000 1.200*13 = 15.600 1.500*15 = 22.500
Production Good Y 1.000*2 = 2.000 1.050*2 = 2.100 900*3 = 2.700
Nominal GDP 10.000+2.000 = 12.000 15.600+2.100 = 17.700 22.500+2.700 = 25.200
Price levels are going up or down while quantities are not drastically moving.

The continuous increase (changes) in prices is called inflation.

Real GDP (GDP at constant prices) = Σ i=1 Pi 2010∗X i 2020; We fix a base year (2010) for prices and allow
quantities to change because price effects could create illusory effects. The actual quantity of goods and
services produced.

2010 2016 2022

Production Good X 1.000*10 = 10.000 1.200*10 = 12.000 1.500*10 = 15.000
Production Good Y 1.000*2 = 2.000 1.050*2 = 2.100 900*2 = 1.800
Real GDP 10.000+2.000 = 12.000 12.000+2.100 = 14.100 15.000+1.800 = 16.800
Now we can compare them (con una tasa de variación): They give us information on the capacity for a
country to produce.

2010 2016 2022

Growth nominal GDP - 17700−12000 25000−17700
=47.5 % =42.4 %
12000 17700
Growth real GDP - 14100−12000 16800−14100
(discounting the cost =17.5 % =19.1 %
12000 14100
of inflation)
Growth rate GDP Real = Growth rate GDP Nominal – inflation (growth rate % price level)
- Inflation positive: if nominal GDP > real GDP
- Inflation negative: if real GDP > nominal GDP

Index:

- Laspeyres Index = Fixing prices at the beginning of my period and allow quantities to change.
- Paasche Index = Fix prices at the end of my period.
- Depending on which prices we are fixing, real GDP changes would be different, specially in
longer time series. Is good because technological improvements; If we use old prices at the
beginning of my period, we will not be capturing these improvements.

1.2.2. INFLATION
The price level (IPC) is the average level of prices of an economy.

Inflation occurs when the price level persistently rises. The inflation rate is the percentage change in the
price level. Good 2%.

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Deflation occurs when the price level persistently falls. Increases the purchasing power of money.
Increases the interest rate that a borrower pays. Deflation has a destructive impact on an economy.

Disinflation refers to a marginal slowing process of the inflation rate. Prices increase but inflation is
lower over time (increase less).

Inflation refers to price (in)stability it directly affects to the (purchasing) value of money. Reduces the
value of money. It could be anticipated or unexpected.

Channels through which price changes might lead to inflationary processes in a closed economy:

- Demand inflation = goods and services markets

- Supply inflation = markets of production factors
- Monetary inflation = money market

Inflation in not bad for everyone! Borrowers benefit from unanticipated inflation because the money
they pay back is worth less than the money they borrowed. Lenders are hurt by unanticipated inflation
because they have less purchasing power.

Is bad if you cannot accurately forecast it. Unexpected and unstable inflation is a problem. Extreme case
is hyperinflation (>50%).

Nominal interest rate: The interest rate that banks give you. The nominal interest rate reduces the
negative impact of inflation.

Real interest rate: The interest rate that a borrower pay is effectively lower thanks to inflation. Real
interest rate = Nominal interest rate – inflation.

e
Fisher equation r t ( Real interest rate ) ≈ it ( Nominal interest rate )−Π t +1 ( Inflation)

e
Pt +1
Expected inflation in period t+1: Π et +1= −1; p is price index (level of prices).
Pt

1+i t
Hence: 1+r t = e
1+ Π t+ 1

Consumer Price Index (CPI) is a measure of the average level of the prices paid by a representative
household for a representative “basket” of consumer goods and services. The inflation rate is measured
as the change in the CPI between the reference period and the actual period.

CPI present series of problems:

1. New Goods Bias: New goods are often more expensive than the good they replace. Iphones!
2. Quality Change Bias: Sometimes price increases reflect quality improvements (safer cars,
improved health care) and should not be counted as part of inflation. Housing!
3. Commodity Substitution Bias: Consumers substitute away from goods and services with large
relative price increases. Nutella!

Normal inflation VS Core inflation: Core inflation = Inflation excluding the most volatile components (–
food – fuel). If core inflation > inflation occurs deflation in food and fuel.

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Nominal GDP
GDP deflator t= : Different goods and services in a country (regular CPI in a basket)
Real GDP

GDP Deflator gives a value higher than 1 if Nominal GDP > Real GDP

Regular CPI VS GDP Deflator: Both different goods and services, but regular CPI calculate them in a
basket and GDP Deflator calculate them in a country.

Inflationary is also an indicator of future long-term demand. Anticipate the evolution of economy.

In commodity-oriented economies, prices are key in determining future economic performance. They
can be boom related to these prices. Examples: Ukraine used to produce a lot: the price of the products
have increased because no one is going to create them (because of the war); Panamá channel: stop
traffic.

1.3. NATIONAL ACCOUNTING

Flow circle:

How to compute the GDP (Y)? We have three methods that should give the same GDP:

1. Production or Value-Added approach: Sum of all the value added of agriculture,

manufacturing, construction & service (+ indirect taxes – subsidies). GDP is total amount of X
produced in a year.
2. Expenditure approach: Consumption (C) + Public Expenditure (G) + Investment (I) + Exports (X)
– Imports (M). GDP is total amount of X sold in a year. Demand approach or aggregate demand
= sum of expenditure. National aggregate demand (C+I+G) is for close economies, such as North
Korea and International demand (XN = X-M) are for open economies. If XN is near zero is a
close economy.
3. Income approach: Wages + profits (+ indirect taxes – subsidies). GDP is the total income earned
by the N workers plus the profit made by firm Y.

GD Pi =∑ GV Ai +( Indirect Taxes i−Subsidies i )

i=1

GVA refers to the Gross Value Added and i stands for firm. We do NOT include taxes or subsidies when
measuring value added. The sum of GVA is the GDP.

GVA=Σ Total Output −Intermediate inputs− ( Indirect Taxes−Subsidies )

NVA (GDP)=Σ GVA+ ( Indirect Taxes−Subsidies )

The Net Value Added (NVA) include taxes and subsidies.

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National account indicators:

- Factor cost prices: Prices when accounting only for the cost of production factors. They do not
include taxes and subsidies. Examples: What you buy in USA.
- Purchaser prices: Final prices at the selling point. They include taxes and subsidies.
Normal GDP ( Purchaser price ) =GVA(Factor costs)+ ( Ind . Tax−Subsidy )

The Gross National Product (GNP) = Gross National Income (GNI) measures the total production of
goods and services produced by national factors. It’s based in the nationality, not in the geographical
location. RNR stands for Rents of National Residents obtained abroad and RFR stands for Rents of
Foreign Residents obtained in the country.

GNP∨GNI=GDPt + RN Rt −RF Rt

We can also get the Net National Product (NNP) and the Net National Income (NNI):

NN P t=GN P t−Depreciationt

NN I t =GN Pt −Depreciationt −Net Indirect Taxest

In general, we can move from Gross to Net Magnitudes by filtering out by depreciation and net indirect
taxes. We can get the Net Domestic Product (NDP) that is a measure of all the goods and services
produced in an economy net of depreciation. NO ENTRA EN EL EXÁMEN

ND Pt =GD Pt −Depreciationt

Resumen:

1.4. GDP COMPONENTS

GDP = Y = Aggregate demand = C + I + G + (X - M)

Investment (I) seems to be the most volatile component (a bit more in emerging economies) while
consumption fluctuate like the GDP.

1. Consumption: Represents the higher % of the GDP and is the most important variable. When we are
in crises in consumption, we probably will enter in a recession. Income is the main explanatory variable
of consumption pattern. Income is not only consumption but also savings, known as national income
(NI).

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C=f ( Y D )
D
Y =Y −T +TR=C+ S
2. Investment: Firms must invest in things in order to produce the goods and services. Depend on the
level of production (Y) and interest rates (i). Investment can be divided into investment in physical
capital (Fixed gross capital formation and changes inventories) and residential investment. Investment is
the most volatile component because it depends on expectations.

I =f ( ⅈ , Y D )

3. Public Expenditure (G): All the goods and services that the government are offering, and they are paid
with taxes. There is a trend to constant increase the public spending in relation to the GDP.

FB=T −( G+TR )

If FB < 0: The government is running into a Fiscal deficit. If FB > 0: The government is running into a
Fiscal surplus.

If they increase G or decrease T (or increase TR) = Expansive fiscal policy.

If they decrease G or increase T (or decrease TR) = Contractive fiscal policy.

Public Debt
Public Debt=Σ Fiscal Balance ; Ratio=
GDP

Risk premia: Difference that you are paying for your debt in relation to Germany. If the interest rate is
similar to 0, you are solvent.

FB=T −G−TR+ Interests(bonds)

4. International trade: Trade balance = X – M. If TB > 0 there is a trade surplus (means that X > M). If TB
< 0 there is a trade deficit (means that X < M).

Resume:

( S−I ) =( G−T )+ ( X−M )

( S−I )  Private sector balance. If savings > investment, we have a surplus.

( G−T )  Public fiscal balance (public expenses – taxes). If G > T, the government is in a deficit.

( X −M )  Trade balance (only in an open economy)

1.5. LABOR MARKET INDICATORS

Economies care about employment stabilization. It aims to achieve full employment. Unemployment
occurs when someone who wants a job cannot find one. There is a direct relation between GDP growth
and unemployment rates (is a loss of personal wellbeing), called Okun`s law (negative correlation).

Total population:

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 Working age population: All the population on working age (16-67 years old).
o Active population (=Labor force): Want and are able to work.
 Occupied: Active people that are actually working.
 Unemployed: Want to work but are not able to do so.
o Inactive population: Not actively look for a job.
 Non-working age population: Young and retire people.

Unemployment rate = (Nº Unemployed people / Nº Active people) * 100

Employment Rate = (Nº Employed people / Working age population) * 100

Economic activity rate (labor force) = (Active population / WAP) * 100

Natural rate of unemployment:

1. Frictional unemployment: When you are fired and incorporate in other job. These workers are
searching for jobs. Ex.: Undergrad looking for a job.
2. Structural unemployment: that arises when changes in technology or international competition
change the skills needed to perform jobs or change the locations of jobs. Difficult to learn new
skills. Ex.: Industrial worker in an age of 50 who is having problems to relocate.
3. Cyclical unemployment: Unemployment induced by changes in the business cycle.
4. Seasonal unemployment: Caused by changes in the hiring process attached to changes in the
season. Ex.: After summer season.

What might affect unemployment levels?

- Age distribution of the Population: More young people, more job seekers every year.
- Scale of Structural Change: Technological change, unemployment rises.
- Real wage rate: Increase in the minimum wage, unemployment rises.
- Unemployment benefits

Phillips curve: Relationship (inverse) between unemployment and inflation. Stagflation is the
combination of high inflation rates and high unemployment rates.

1.6. INEQUALITY AND CLIMATE ISSUES

Poverty exists in all countries of the world, but it is most severe in low- and middle-income countries.
Poverty is deprivation of basic capabilities rather than merely a lowness of incomes.

There is a poverty trap (Asia and Africa) = vicious cycle of poverty.

- Absolute poverty: less than 1.9$/day

- Relative poverty: % of population that earns less than 60% of the median income.

Why is inequality bad?

- Economic inefficiency and curtails growth.

- Undermines social stability and solidarity.

What can be done?

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- Pre-inequality: guarantee equal opportunities.

- Post-inequality: tax redistribution.

Indicators of measuring inequality:

1. Gini index: 0 is perfect equality and 1 is extreme

inequality.
2. Lorentz curve: The 45º line shows the perfect
equality while the other curve shows the actual
distribution of income. The difference between
them is the inequality gap.

Taxes tend to correct the inequality.

Exercise: The 50% of the population has the 25% of the income and the rest of the population has
the 75% of income.

A = (50*25) / 2 = 625

B = (100-50) * 25 = 1250

C = (75*50) / 2 = 1875

Triangulo entero (A+B+C+D) = 100*100 / 2 = 5000

D (Area of inequality) = 5000 – (A+B+C) = 5000 – (625+1250+1875) = 1250

Gini index = D / Total = 1250 / 5000 = 0,25

More unequal countries are showing lower GDP dynamics than more equal ones.

Climate change have a negative effect on economic growth. Extreme weather can also affect inflation.
There are also adaptation costs to the new situation.

DICE models by William Nordhaus = interrelation between macroeconomic activity and climate change.
The representative agent’s consumption problem production side of the economy climate equations.

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CHAPTER 2: MARKET FOR GOODS & SERVICES AND THE IS CURVE

2.1. MARKET FOR GOODS & SERVICES

~
Business cycle: Actual output (Y) = long run trend (Y ) + short run fluctuations ( Y ).

1. The consumer function:

- Assumptions: Fixed prices, static model (no depend on time), no borrowing (no consume more
than what they have), closed economy. So, Y = C + I + G.
- Consumption depends on disposable income: C=C ( Y D ) =C (Y −T )
ΔC
- C=C 0+ C1 ( Y D ); where c1 is the propensity to consume (parameter 0<c1<1) c 1=
ΔY
2. Investment: Exogenous variable for the moment (not depend on another variable) I =I
3. Public expenditure: Exogenous variables G∧T

The total demand of goods and services Z=C 0+C 1 (Y −T )+ I +G

When the economy is in equilibrium Z = Y.

1 1
Y=
1−C 1
( C 0−C 1 ⋅T + I + G ); where
1−C 1
is the Keynesian multiplier K > 1 and the rest is the

Autonomous spending (A).

What happens when there is an increment in a variable?

Always an increment in A is going to increase Y, but we have an exception: c1*T > Co+I+G an increase in
A is going to decrease Y.

1 1
ΔY = ⋅ΔI ; ΔY = ⋅ Δ G;
1−C 1 1−C 1
1 −C1
ΔY = ⋅ Δ C 0 ; ΔY = ΔT
1−C 1 1−C 1

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If A increases, Y is not going to increase the same amount because they have the Keynesian multiplier.

Changes in Autonomous spending are moving the curve in a parallel way.

Changes in c1, are changing the slope.

Government has a huge fiscal superavit when Fiscal multiplier of public spending (G) > Fiscal multiplier
of Taxes (T). Δ G> ∇ T .

Government has a huge fiscal deficit when ∇ G> Δ T .

Also, ( S−I ) =( G−T ) when ( ΔS −I ) =( ΔG−T )

Now: Taxes are not exogenous (depend on parameter). Tax depends on the level of income T =t ⋅Y .

1
Y= ⋅ ( C 0+ I +G )
1−C 1 (1−t )

If the Fiscal balance remains constant, the policy of the government does not have effect. There is a
crisis: Government wants to increase Y. The government does not want to increase the public deficit -->
Fiscal Balance = T-G. ΔG = 100 Expansionary fiscal policy (Increase Y) and ΔT = 100 Contractionary
fiscal policy (Decrease Y). So, we will increase G.

2.2. MARKET FOR GOODS & SERVICES II

Savings (S) are part of the disposable income: Y D=C + S and Y D=Y −T , so C+ S=Y −T .

S=−C0 + s ( Y −T ) ; where s = (1 – c1) is the propensity to save.

What happens when there is an increment in a variable?

1
ΔY = ⋅ Δ G ; ΔC =c 1 ⋅ ΔY ; ΔS =s ⋅ ΔY
1−C 1

−C1
ΔY = ΔT ; ΔC =c 1 ⋅(ΔY −ΔT ) ; ΔS =s ⋅(ΔY − ΔT )
1−C 1

Paradox of Thrift: The propensity to save (s) rises, so c1 reduces, leading to a final reduction in Y! When
there are changes in s or c1, the slope of Z changes. Because, as Y falls, aggregate S will fall afterwards as
a result of lower economic activity. As Y falls, S will fall, so the increase in the propensity to save, does
not translate into higher aggregate savings.

Absolute Income by Keynes: Individuals decide which part of their income they allocate to
consumption. A change in income (Y) is translated to changes in consumption.

Permanent Income ( Y p ) by Friedman: Individuals not only take the decision based on their current
incomes but also based on future levels of incomes.

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Life-Cycle Hypothesis: Individuals take decisions on their consumption and savings levels depending on
the expected income obtained across their whole lives. Early stages no work and not able to sabe much.
In working life, the consume and save for their retirement. In retirement, they will consume their
savings and wealth.

2.3. THE IS CURVE

Equilibrium in goods and services = IS curve.

The cost for investing is called real interest rates (r) vs nominal interest rates (i).

If expected rate of return (profits/costs) > real interest rate, it is profitable to invest.

I =I −b ⋅r ; where I is an autonomous component, r is the real interest rate and b indicates how
sensitive is investment to changes in interest rates. It’s a negative relationship (costs of loans are higher
when companies invest less).

Fisher equation: r = i – Inflation. Expansionary monetary policy when we decrease r and contractionary
monetary policy when we increase r.

Changes in autonomous investment shifts the

curve.

For the slope, if b is very large, the investment is

very sensitive to the interest rate.

The closer to zero sensitivity of the investment

to the interest rate, the more inelastic the curve
will be.

New aggregate demand function (Z): Z=C 0+ c1 ( y−T ) + I −b ⋅r +G

In equilibrium: Z=Y = A+ C1 ⋅ y−b ⋅r

1
Is curve = Y = ⋅ [ C0 −c 1 ⋅T + I −b ⋅r +G ]
1−c1

1
r = ⋅ ( A−Y ⋅ ( 1−c1 ) )
b

Changes in r reflect movements along the IS curve: Parallel shift to the right when
Δ G , Δ C 0 , ΔI , ∇ T ∧ΔTR and inverse.

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The higher the b, the flatter the curve (slope smaller)

The higher the c, the flatter the curve (slope smaller). If

increment in c, we will increment Y.

ⅆy −b
If Δ∨∇∈r : =
ⅆr 1−c 1

TEMA 3: MONEY MARKET & LM CURVE

3.1. MONEY MARKETS

Money is a social convention and is accepted as payment. Is the sum of physical currency and deposits
(they hold in banks, can be converted into currency, and can be used to settle debts).

Money functions (JPP and W. Stanley):

1. A unit of account for the pricing of goods and services. Is a measure across the economy.
2. A method of storing value. Money should have relatively the same value over time.
3. A medium of exchange that facilitates economic and financial transactions. Is a method of
payment widely accepted.
4. EXTRA = Standard of deferred payment: It enables purchasing goods and services in the
present by paying back debt in the future. (Poder pagar aplazado).

To meet these four functions, money must be durable, portable, divisible, and difficult to counterfeit
[dificil de falsificar], (Shirai, 2019, ADBI Working Paper).

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The function of medium of exchange gives the concept of fiat money which is money that does not have
intrinsic value and does not represent an asset in a vault somewhere. [Dinero fiduciario: Es valioso
porque el gobierno dice que tiene valor y el resto de gente lo acepta como método de pago].

In any market, we have:

S
Money Supply ( M S ); we have to differentiate between nominal and real (
M , that accounts
- )
P
the inflation.
- Demand for Money ( M D or L); is the money that we are holding to pay for something
[mantener un inventario de dinero, no de recibir dinero].

Monetary Base ≠ Money Supply: The money supply is the amount of total money available in the
economy while the monetary base is the sum of total currency in circulation and reserves (are the
deposits of electronic money that commercial banks have at the central bank), is just a fraction of the
money supply. There is an increase in base money over time.

Money supply includes:

- Legal creation money (liquid money or cash): this money is created directly by the Central
bank.
- Money from bank creation (mostly deposits): this money is created by commercial banks
throughout lending (endogenous money creation: loans create deposits).

Monetary aggregates refer to the amount of money in circulation in the economy (money supply).
Classification (by the ECB):

1. M0: Monetary base, which is the sum of banknotes and coins in circulation and bank reserves.
Smallest aggregate and which the central bank has more control.
2. M1: M0 + overnight deposits [depositos de un día para otro].
3. M2: M1 + deposits with an agreed maturity of up to two years and deposits redeemable at
notice of up to three months [depositos que tienes que sacar dinero avisando con tres meses
de antelación, suele ser de un banco a otro].
4. M3: M2 + other types, such as repurchase agreements, money market fund shares/units and
debt securities with a maturity of up to two years issued by monetary financial institutions.

M3 = Money Supply as it is the last one and includes everything. Always M2 > M1 > M0. If you put M0 >
M2 cannot be possible.

Money creation. Who creates money?

- Central Banks: They can increase M0 (Monetary base) thought increasing money in circulations
or changing the reserve requirements. They can force banks to deposit some money at the own
central banks as reserves.
Desired reserve ratio VS the required level of reserves. The required level of reserves consists
of notes, coins and its deposit at the CB while the desired reserve ratio is what the bank plan to
hold (excess of revenues). Reserves = Min revenues required + excess of revenues.
- Commercial Banks: They create mostly of the money. Endogenous money creation = banks
create deposits when they make loans, and the new deposits create money.
Money creation process:
1. How much to lend depending on the profitable lending opportunities available to
them (depend on the interest rate set by CB):

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2. These lending decisions determine how many bank deposits are created by the
banking system.
3. The amount of bank deposits in turn influences how much central bank money banks
want to hold in reserve.

A bank makes a loan (to someone taking out a

mortgage to buy a house). The bank does not
give thousands of euros worth of banknotes.
Instead, it credits their bank account with a
bank deposit of the size of the mortgage. At
that moment, new money is created.

The loan creates a deposit of the same

amount.

The new deposits increase the assets of the

consumer (here taken to represent households
and companies) the extra red bars and the new
loan increases their liabilities the extra white
bars. New broad money has been created.
Similarly, both sides of the commercial banking
sector’s balance sheet increase as new money
and loans are created.

Destruction of money is repaying that loans.

Banks cannot create all the money they want. Face limits:

1. Market forces constrain lending. If there is no demand of loans, it is not possible to lend.
2. Banks have to take steps to mitigate the risks. They are not going to lend people that are not
going to be able to give back the money.
3. Regulatory policy to avoid risk that could pose a threat to the stability of the financial system.
- Money creation is constraint by the behavior of the money holders (if people no want loans).
- Monetary policy: Changes in interest rates affect the ability of banks to lend and how much
households and companies want to borrow.

3.2. DEMAND FOR MONEY

CB may affect the money supply through monetary policy decisions:

1. Changing the interest rate.

2. Open market operations. Intervene
in the market of bonds that is going
to affect interest rate.
3. Changing the reserve ratio. No
longer relevant policy in a world with
ample reserves! Reserves are
deposits that commercial banks have

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 MACROECONOMÍA

at the CB and the reserve requirement is the % in reserves from your total amount of deposits.
In the past, if IRR increase you were able to create less money. Now, the IRR no effect on the
economy.
Ample reserves = reserves are much higher than the require reserves.

Main central banks pushed the policy rate to near zero and turned to balance sheet policy, "quantitative
easing", to put downward pressure on longer term interest rates. This action increased reserve balances.

When reserves are plentiful, small changes in their level, such as via open market operations, cannot
affect the key interest rates.

The money supply:

1. OLD VIEW: The money supply is represented as a vertical line.

The CB decides the amount of money in circulation. Is exogenous
= not depend in the interest rates. They money supply will move
parallel to the right if the increase in amount of money in
circulation.

2. IN REALITY: the monetary policy is expressed in terms of a

short-term nominal interest rate. Targeting the interest rate
directly, the central bank automatically adopts a policy that
will adjust the money supply to accommodate shocks to
money demand.

In terms of a supply and demand diagram, the money supply schedule

is effectively horizontal at the targeted interest rate. We only use one
instrument: interest rate or money supply, and one affects the other.

The CB puts the interest rate by the willingness to supply at that

amount of money that is demanded. Shifts in the money demand
curve will not change the interest rate.

The demand for money:

s
Demand for money is just how much money individuals hold as currency. * Real money demand (
M
)
P
no change if the nominal and the price (P = price level) increases by the same amount.

Reasons to demand money:

1. Price Level (purchasing power): The quantity of nominal money demanded is proportional to

( )
D
the price level
↑ M and if there is inflation we will demand more money.
↑P
2. Transaction motives: Individuals want to make more transactions, so they need more money.
There is a positive relationship between demand of money and transactions (Y = income).
3. Financial innovation: More financial innovation, more opportunity to demand money.
4. Speculative motives: The higher the nominal interest rate (r), the lower the demand of money
(because they are different investment opportunities).

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 MACROECONOMÍA

D
M =f ( +Y ,−r ) ;Demand for real balances will positively depend on income level (they demand
money so grow the level of income) and negatively on interest rates (increase in r, decrease the demand
for money as people will put more wealth into bonds).

D
M
Money demand function: =k ⋅ y−h ⋅r ; where k measures the sensitivity of demand for money
P
to changes in income level and h measures the sensitivity of demand for money to changes in interest
rates.

D
M
=a+k ⋅ y−h⋅ r ; The function could also include a constant ‘a’ which is caution (= autonomous
P
demand of money). If a = 0, individuals are incautious.

( )
D D
M M
=k ⋅ y−h ⋅r ; h ⋅r=k ⋅Y − ;
P p

[ ( )]
D
1 M
r = ⋅ k ⋅Y − ;
h p

dr −1
Slope of the curve : =
( Mp )
D h
ⅆ

If Y : an increase in r, decreases the M/P (moves along the curve)

D
M
Increase Y: If r is fixed and M/P changes: ↑ =k ⋅↑ Y −h ⋅r (shift
P
c)

Increase Y: If M/P is fixed and r changes:

( ) MD
P
=k ⋅↑ Y −h⋅↑ r

S D S
M M M
In equilibrium: = =k ⋅Y −h ⋅r ; ↑ =k ⋅Y −h ⋅↓ r
P P P

We are not in equilibrium.

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 MACROECONOMÍA

The CB can target either the money supply or

the interest rate, not both.

Movements from the demand VS Movements from the supply

3.3. MONETARY POLICY

The Central Bank aim to supervise and regulate the banking system, to have policy targets, performing
monetary policy operations and operating as a lender of last resort.

Economic targets:

1. Control inflation (2%)

2. Economic growth
3. Credit growth (to be a more intermediate target)
4. Financial stability
5. BIG ROLE OF CB: monetary policy (to set new levels of monetary supply).

Expansionary monetary policy (reduces the interest rates or increase the monetary supply) VS
Contractionary monetary policy (increase r, decrease I, decrease Y, decrease monetary supply).

CB’s tools of monetary policy:

- Conventional measures: Zero lower bond (ZLB) means that the interest rates have a limit, and
that limit is equal to zero. The ppal element of ECB are the interest rates until they are zero.
When r=0% ECB must apply non-conventional measures.

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 MACROECONOMÍA

1. Key interest rates (interest rates > 0):

a. The interest rate on the main refinancing operations (the main interest rate of the
ECB) to finance operations on a weekly basis.
b. The rate on the deposit facility to make overnight deposits.
c. The rate on the marginal lending facility to make overnight credit (daily basis) to
refinancing operations (igual que el primero pero diario).
2. The ratio of reserves but is an irrelevant instrument these days.

- Non-conventional measures: When r=0% ECB must apply non-conventional measures.

3. Open market operations (OMO): Purchasing private and public financial assets. They affect the
interest rate in the market for bonds. The CB intervenes: buying bonds (more money in the
system and increases the monetary supply) or selling bonds (takes out money from the system
and decreases the monetary supply). Monetary financing can create inflation, that’s why ECB
cannot buy bonds in the primary market, but they are allow in the secondary market.
4. Offering long-term loans to banks (longer bonds)
5. Forward guidance: CB tell the market what they are going to do, making clearer intentions for
monetary policy because expectations are key.

Market for bonds: For the same nominal

value, the price of the bond increase (Bo)
when the yield decreases.

If the demand of bonds increases, will lower

the yield (interests) and the financing costs are
lower.

If Bo increases, the yield will fall. If the interest

rate increases, the price of the bonds (Bo)
decreases.

Balance sheet of the CB:

El dinero que emite el CB siempre es un pasivo

para el banco. If CB buy a bond, they create
money. And the monetary base has increase as
a result of higher reserves, and therefore, the
monetary supply increases.

Buying or selling bonds, the CB will be

modifying the short-term interest rate of the
bonds.

Other instruments of the monetary policy:

1. Two-tier system for remunerating excess reserve holdings:

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 MACROECONOMÍA

2. Funds interest rates: Banks lend extra reserves to other banks. These other banks have to an
interest rate called EURIBOR (es la media de interest rates que los bancos estan prestando). In
times of uncertainty, the EURIBOR is really high because banks prefer to have reserves than
lending to other banks.

These are extra tools not directly controlled by the CB, but which affect the monetary supply of the
whole system.

Other functions of the CB:

1. Lender of last resort (como última defensa): The CB is going to save the banks from bankruptcy.
As Mario Draghi said: “Whatever it takes”. This reduces panic in the banking system but also it
can create moral hazard problems (banks take too many risks because they assume they will be
bail out [rescatado]).
2. Forward guidance (preaviso de las acciones que vas a hacer). Como la economía funciona por
expectativas, hay efecto.

Summary:

3.4. MECHANISMS AND THE LM CURVE

Assuming that the monetary supply it’s controlled by the CB, they can use the discount rate, the ratio of
reserves (not now) and open market operation (changes in the market for bonds).

S D
M M
Equilibrium in the money market: = =k ⋅Y −h ⋅r ; where k and h are sensitivity of demand.
P P

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 MACROECONOMÍA

The LM curve (Liquidity Money curve) shows every income and interest rate combinations that match

the supply and demand of real monetary balances. The equation is r =

1
h ( m
)
k ⋅ Y − . The slope is
P
ⅆr k
= .
ⅆY h
A = equilibrium in monetary market (LM)

B = equilibrium in goods and services market (IS)

C = equilibrium in both markets

Changes in money supply shifts the curve (because

they are not the variables of the axis Y and r)

The LM flatter (slope menor = horizontal) when h increases or k decreases. The LM steeper (slope mayor
= vertical) when h decreases and k increases.

In reality, the LM is horizontal because CB choose an interest rate and adjust the money supply so as to
achieve it.

Conventional monetary policy has some limits: The Zero Lower

Bound (ZLB). The nominal interest rate set by the CB cannot go much
time below zero. When the interest rate is down to zero, the
economy is said to be in a liquidity trap. Liquidity trap = when
individuals are indifferent with respect of holding cash on deposits or
bonds (les da igual como tener su dinero). Both pay zero interest.
Therefore, the demand for money (Md) becomes horizontal beyond
point B.

In the Great Financial Crisis, many CB decrease interest rates to 0 and even negative. ZLB = people are
indifferent between holding money or bonds. This assumes that holding cash is not costly.

But holding cash is costly (you have to pay security to have it in your house), and that is why sometimes
is better having money in the bank with a negative interest because you lose less money than having
cash (which is costly). People are able to tolerate a small negative interest rate in bonds instead of
holding cash = Effective lower bound (ELB). How banks put negative interest rates? If r is negative,
should banks keep their deposit rates at 0%  negative net returns  profitability would fall  lower
financial intermediation capacity.

Reversal interest rate = when r is no longer expansive (+) to be contractionary (-) for lending.

( ) ( )
D S
M M
Changes in Y: movements along the curve. Increase Y, increase , fixed .
P P

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 MACROECONOMÍA

( )
S
M
Changes in . Increase Ms, CB buys bonds, influencing r. Now, at a given Y, decreases r, so LM
P
shifts.

Changes in k: Increase k, Y more pronounce, increase in Md, fixed Ms. Change in k or h moves the slope.

4. THE IS-LM MODEL

4.1. THE IS-LM MODEL: GRAPHICAL ANALYSIS

The IS-LM model deals with the relation between Y and r.

A = equilibrium in monetary market (LM)

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 MACROECONOMÍA

B = equilibrium in goods and services market (IS)

C = equilibrium in both markets

Regla de Taylor: i t =it +θ Π ( Π t −Π t ) +θ y ( y t − y t ); es una regla monetaria del CB. El CB no fija el tipo
¿ ¿ p

de interés que ellos quieren, lo fijan en función de variables (objetivos). Por ejemplo, las variables de la
inflación o el output. En esta ecuación cuanto mayor sea la inflación, el CB incrementará el tipo de
interés.

If the LM is horizontal. If interest rates increases (curve moves

upwards), there is a new equilibrium, people will invest less and
the output (Y) decreases.

Possible shocks exogenous:

1. Consumption shock: Increase in Co, shift the curve IS to the right. Remember that consumption
could also depend on the interest rate.
2. Investment shock: Increase in I, shift the curve IS to the right. Remember that investment could
also depend on the interest rate.

Fiscal policy cases:

1. Government is trying to reduce fiscal deficit. They achieve this fiscal contraction through an
increase in taxes. If ∆ T , ∇ G is a contractionary fiscal policy.

2. Crisis time. The government increases public spending or reducing taxes. If ∇ T , ∆ G is a

expansionary fiscal policy, higher disposable income (Y) and at the end, we are going to
consume less (c).

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 MACROECONOMÍA

3. Reduction of the government investment (∇ G ) subsidy to firms (assume that the LM has a
positive slope = r depends on Y). Cuando LM > 0 asumimos que M/P es vertical. Si baja G, la
keynesian cross (Z) baja, y subimos el punto hacia arriba. Si el tipo de interés no cambia el E1 no
será nuestro equilibrio sino el punto E2 será nuestro equilibrio porque es donde nuestras rectas
cortan ahora. Lo que pasa es que nuestro nuevo equilibrio tiene menos r (r1), por lo que la
grafica de la derecha también disminuye. M/P constante = k*↓Y – h*↓r. Entonces en E2, se
recupera un poco de output que habíamos perdido (baja a Y1 y luego se recupera a Y2). Menos
r, mas investment, menos ahorro y mas output (Y).

4. Increase public spending (LM positive slope). It pushes aggregate demand up and set a higher Y.

Si aumenta r, más tipo de interés, disminuye la inversión porque mas ahorro y menos Y.

Si la LM fuera horizontal, incrementaría mas nuestro Y, el efecto seria mayor.

Reduction in taxes or increase in G: Tiene un efecto en cuanto a magnitud mayor.

Monetary policy:

1. Expansionary monetary policy (decrease r):

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 MACROECONOMÍA

2. Contractionary monetary policy (increase r): Decrease inflation. Increase in r, decrease in I and
decrease in Y.

25