Macro 1: National Accounts

1. Introduction to National Product Counting

• Assuming an economy produces 100 kilograms of wheat annually and no other

things are produced in this economy. The price of wheat is $1 per kilogram.

• What is the total value of the wheats prodeced is in this economy?

• Who gets this $100 assuimg none of it is thrown away?

a. Some of it may go to pay the workers in the form of wages, say $60.
b. Some of it may go to pay the landlords in the form of rent, say $10.
c. Some of it may go to pay for the capital used in the production of the wheat,
say $20,
d. and some of it is the profit of the producers, say $10.

• What is the sum of all these payments?

• This argument is just as valid with cars, and shoes and symphony concerts and
every other good and service produced in an economy; all the things that make up
the output of the economy.

• So in aggregate we say that the real income of an economy is equal to its

output.

2. Net National Product (NNP)

• If there is only one firm in the economy, the value-added by this firm is the
difference between its Sales and its Purchase from other firms:

VA = S − PF

• If we define GNP (Gross National Product) as the total sum of Values Added
contributed by all firms in the economy, then,

GNP = ∑ VA = ∑ ( S − PF )

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• Where does the Values Added go to?

• A portion of the Values Added goes to pay for Wages to workers, a portion of the
Values Added goes to pay for the Interests, and portion of the Values Added goes
to pay for the wears and tears or Depreciation. What is left will be the firm’s
Profit.

• Hence, we have,

∑VA = ∑ ( S − PF ) = ∑ (W + IN + DP + P )
• If we subtract Depreciation from the total Values Added, we have the Net National
Product, NNP.

NNP = GNP − ∑ DP = ∑ ( S − PF ) − ∑ DP

∑ ( S − PF − DP ) = ∑ (W + IN + P )
• On the left hand side of the equation, we have the NNP which is the total amount
of resources produced and are available for various uses in the economy.

• On the right hand side, we have total incomes generated in the economy.

• Notice that total amount of resources available exactly equals to total income
generated in the economy.

NNP = Y

Question: When government offers services for free or below market price, e.g.,
education, the value of sales for these services is less than what government spends to
purchase from other firms in order to provide these services. Therefore, the value
added of these government services is negative, and hence, existence of these services
subtracts NNP. T/F, explain?

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 3. National Accounts - A Closed Economy without a Government

• NNP are used for Consumption and Investment:

NNP = C + I

• Y is used for Consumption or Savings:

Y=C+S

• As NNP = Y, then,
I=S

Notice that actual investment always equals actual savings in equilibrium.

• Implication from I = S: those things which we refrain from consuming now may
be used as means of production in the next period which increases the potential
output of the economy.

Y Y

PPF0 PPF1 PPF1 PPF0

X X

• If investment - the flow of new capital goods - is greater than the rate of
depreciation (i.e. the amount of capital (machines) which became unusable during
that period), total means of production for the next period will be greater. This
would mean an expansion of the Production Possibilities Frontier, i.e. growth.

• If, however, the amount of investment - the flow of new capital goods - is less
than what is required to replace the capital which became unusable, total means of
production for the next period will decrease. This would mean a contraction of the
Production Possibilities Frontier, and the economy will be declining.

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4. Consumption

• In the study of Microeconomics, demand for a good, say X is a function of prices

and income. That is:
Xd (Px, Py, I)

• In Macroeconomic level, we are interested in the aggregate consumption levels.

Assuming prices are given, and national income Y is defined in real terms, then:

C = C(Y)

Recognizing that there are certain level of consumption we want (need) to

consume regardless of how much we earn, we thus have

C =C0 + c1Y

• The above consumption function says two things:

1) There is a level of consumption we need to consume regardless of how much

we earn. This is shown as C0, the autonomous component of consumption. C0
can also be used as to measure the level of consumer confidence.

2) Beyond that, every extra dollar of income we have, we will consume c1 dollar.

• We call c1 the marginal propensity to consume (MPC) and (c1 < 1). Why MPC
is less than 1?

C = C0 + c1Y

C0

The consumption function.

• The intercept with the vertical axis denotes the autonomous component of
consumption.

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• The slope of the consumption curve (dC/dY) denotes the change in consumption
which will follow an increase in income by one unit. If Y increases by one unit,
consumption will increase by c1, which is thus the slope of the consumption curve.

4.1. A close look at MPC

• Assuming there are only two types of individuals in the economy, the poor and
the rich.

• The consumption function for the poor people is:

C P = C0P + c1PY P

• The consumption function for the rich people is:

C R = C0R + c1RY R

• Further , c1P > c1R . Do you agree?

• A proportion ‘α’ of the national income belong to the poor and (1 - α) belong
to the rich.

• Question: what happen to the total consumption when ‘α’ increases, i.e., a
greater share of national income is consumed by the poor? Graphically,

C
C = C0 + c’1Y

C’(Y0)
C = C0 + c1Y

C(Y0

C0

Y0 Y

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Additional Notes on the role of 45 degree line

C
45˚

The 45 degree line helps us to transform the values from the X-axis to the Y-axis.

5. Savings

• In a closed economy without a government, income is used for two purposes.

Y=C+S

• Hence: S=Y–C

• We have shown that C = C0 + c1Y. So,

S = Y – C(Y) = Y – C0 – c1Y = - C0 + (1- c1)Y

• where (1- c1 ) is the Marginal Propensity to Save (MPS).

• Further, in a closed economy with no government,

c1 + (1- c1) = 1 or MPC +MPS = 1

• Graphically, the relationship between the consumption and savings functions

can thus be shown as follows.

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 C, S 45o

C = C0 + c1Y
C (Y2 )

C (Y0 )

C (Y1 )

C0
S = −C0 + (1 − c1 ) Y

Y1 Y0 Y2 Y

−C0

• At Y1, C(Y1) > Y1: consumption is greater than income  the level of savings
is negative  current consumption is financed through borrowing.

• At Y2, C(Y2) < Y2 : income is greater than consumption  the level of savings
is positive.

• At Y0, C(Y0) = Y0 : the level of savings equals to zero.

5.1. Impact of income distribution on Savings

Back to 4.1. (a close look at MPC), what happen to the total savings when ‘α’
increases, i.e., a greater share of national income belongs the poor?

C, S 45o
C = C0 + c1'Y

C = C0 + c1Y

C0
S = −C0 + (1 − c1 ) Y

(
S = −C0 + 1 − c1' Y )

−C0

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6. Investment

[Link] of Present Value

• Suppose the going interest rate in the economy is ‘10%’. With $100 saved in
the bank for one year, we would be able to reap $110 one year later.

i.e., 110 = 100 (1 + 0.1)

• The present value of receiving $ 110 after one year with prevailing interest
‘10%’ is the amount of money one must allocate today which is $100. i.e.,

110
PV (110)i =1 = = 100
(1 + 0.1)

• Therefore, 100 is the present value of 110 at prevailing rate of interest ‘10%’.

• What if we put $ 100 in the bank today for two years? Two years later, we will
receive $121. i.e.,
121 = 100 (1 + 0.1)(1 + 0.1)

• The present value of this $121 is thus:

121
PV (121)i = 2 = = 100
(1 + 0.1) 2

• Now, suppose we will receive 110 at the end of year one and 121 at the end of
year 2, what is the present value of this stream of income? (200)

• Now, suppose we can receive 100 at the end of year one and 100 at the end of
year 2, what is the present value of this stream of income? (173.55)

• What is the present value of $T available at the end of each year for 5 years?

PV {T }i =1 =
5

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6.2. Project evaluation:

Assuming a project that yields $100 every year for 3 years. The cost of the
project is I0 = $240 which must be committed now. The going interest rate is
10% per year. Would you choose to invest in this project?

• The PV of $T at the end of each year for three years are

PV {100}i =1 =
3

which is the present value of all the future benefits arising from this
investment.

Can we derive exactly the same future cash flows if we put PV {100}i =1 now
3
•
in the bank? Can you prove that?

So, what is our decision?

• If the amount we have to deposit in a bank to receive the same amount $100
every year for 3 years is greater than I0 (cost of the investment), we should
invest in the project.

• Why? Because the project is a cheaper way of getting $100 for the next 3
years.

• Hence, the general rule is to invest in the project if:

PV {T }i =1 ≥ I0
n

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Exercise: would you invest in the project if the interest rate is 15% instead?

• Note: When the interest rate increases, the present value of any project will
decline. That is, it is cheaper to get $100 per year for the next 3 years by
putting the money in the bank than choosing the project.

• When ‘r’ increase, it could be that:

PV {T }i =1 < I0
n

We hence will reject the project.

Exercise: A rise in interest rates will raise the present value of all proposed projects.
True or false, explain.

6.3. The Investment function

• Demand for investment in the economy is negatively related to the level of

interest rate. That is,

I(r) =I0 - I1r

I0 are some basic investments which will always be required

I1 tells us how the level of investment will respond to changes in the interest
rate.

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 • Why negatively related to the level of interest rate?

Investors/entrepreneurs typically need to borrow money in order to start the

investment projects. Higher interest rate makes borrowing expensive and the
cost of the investment higher. As a result, fewer projects will be accepted if
interest rate is higher as the returns from the investment are less attractive.

6.4. More projects

If we are given two projects to choose, we use the following simple criteria.

1. If both projects offer the same level of benefits, we choose the one that
requires a lower level of cost.

2. If both projects require the same level of costs, we choose the one that offers
higher future benefit.

Example
A project which offers a return of £A a year from the end of this year until infinity will
always be more desirable than a project which offers a return of £B per year for three
year with the first £B starts at the end of this year. True or false, explain.

• Assuming two projects requires the same level of cost.

• The stream of income we will get from the first project is

• In terms of today's money, i.e., the PV of this stream of income, it is

A A A A A
PV {A}i =1 = 0 +
∞
+ + + + + ......
1 + r (1 + r ) 2
(1 + r ) 3
(1 + r ) 4
(1 + r ) 5
 1 1 1 1 
= A + + + + ..........
 (1 + r ) (1 + r ) (1 + r ) (1 + r )
2 3 4


 1 1 1 1 
Note that  + + + + .......... is a G.P. and
 (1 + r ) (1 + r ) (1 + r ) (1 + r )
2 3 4


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  1 1 1 1 
 (1 + r ) + + + + ..........
 (1 + r ) 2
(1 + r ) 3
(1 + r ) 4

∞
1   1  
1 −   
(1 + r )   1 + r  
=
1
1−
(1 + r )
1
=
r

 1 1 1 1  A
So, = A + + + + .......... =
 (1 + r ) (1 + r ) (1 + r ) (1 + r )
2 3 4
 r

• The stream of income we will get from the second project is

• PV of this stream of income is

B B B
PV {B}i =1 =
3
+ +
(1 + r ) (1 + r ) (1 + r )3
2

Assuming both project require exactly the same level of cost, which project is
A
≥ or < PV {B}i =1 .
3
more desirable depends on whether
r
A
≥ PV { B}i =1 , the first project is desirable and should be chosen.
3
If
r

A
• But this is only valid if is more than the PV of necessary cost of investment
r
for the project.

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7. Console Bond

• Console Bond yields a fixed percentage of the Par/Face value of the Bond for
Infinite period of times, say $T at the end of each year from now until forever. (an
infinite maturity date, perpetuities).

• How is the price of a console bond determined?

• Since the bond yields $T at the end of every year from now to infinity. Hence, the
stream of income one will get is

• In terms of today's money, we are looking at the PV of this stream of Income.

∞ T T T T T
PV {T }i =1 = 0 + + + + + + ......
1 + r (1 + r ) (1 + r ) (1 + r ) (1 + r )5
2 3 4

 1 1 1 1 
= T + + + + ..........
 (1 + r ) (1 + r ) (1 + r ) (1 + r )
2 3 4


 1   1 ∞  
 1 −   
 (1 + r )   1 + r   
=T  
1
 1− 
 (1 + r ) 
 
T
=
r

• The price of this console bond is thus T/r.

• Can you provide a rational for this pricing formula?

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Homework

1. If we deposit $354.595 in the bank now, with the prevailing interest rate of 5% per
year, we will be able to receive $100 per year for the following 4 years. At the end
of year 4, there will be no money left in the bank account. Proof the above.

2. "The present value of £1 at the end of every year from now to eternity must be less
than 1'. True or false, explain.

3. A project yields 1000 pounds every year for 2 years. Would you invest 1530
pounds if the interest rate is 20%? Explain.

4. The price of perpetuity of $1 per annum when the interest rate is 20% will be no
more than $10. True or false, explain.

5. What is the consumption function? What is the MPC? How does MPC affect the
consumption?

6. What is the saving function. What is the MPS? How does the MPS affect the
saving?

7. All measures of national income are flawed as we have no means of evaluating the
value added which is generated by government activities. True or false, explain.
Or,
Public services are desperately unproductive as they contribute nothing to the
national income. True or false, explain.

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 Macro 2: the Goods Market – Closed Economy without a Government

• The goods market is the sector in which we look at the demand side of the
economy. That is, the decisions about the quantity of goods and services that
various groups in the economy wish to purchase. We also consider the variables
that affect these decisions.

• One crucial assumption we make when analyzing the goods market is that
unemployed resources exist in an economy. This implies that any quantity of
goods demanded can and will always be produced.

• We define equilibrium as a situation which, if attended, will be maintained. More

specifically, in the equilibrium, no party wants to change their actions and
therefore, there is no tendency for the outcome to change.

1. Aggregate Demand and Aggregate Supply

• Aggregate demand is the total demand for goods and services that firms and
households plan to purchase at each level of prices.

• In the absence of the government and the foreign sector, it consists of demand
from households, Consumption, and demand from firms, Investment. Denoting
aggregate demand by the letter E, we can write it as:

E(Y, r) = C(Y) + I(r)

• As C =C0 + c1Y; and I(r) =I0 - I1r, a more explicit form of the aggregate demand
can be written as:

E(Y, r) = C0 + c1Y + I0 - I1r = (C0 + I0 - I1r) + c1Y

• As the expression in the brackets contains all those elements of the aggregate
demand which are not dependent on national income, Y, we can write the
aggregate demand function as:

E(Y, r ) = A(r)+ c1Y

where A(r) is the autonomous component of demand which is inversely related

to r (why?).

• Aggregate Supply is the total quantity of goods and services produced in an

economy.

• The level of aggregate supply exactly equals the level of national income (why?).
We thus denote aggregate supply as Y.

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• Holding the interest rate fixed at a certain level, we can now draw the aggregate
demand function in the following graph.

E, C , S 45o
E = C + I ( r0 )
E (Y2 ) C = C0 + c1Y
E (Y0 )
A : E (Y0 ) = Y0

E (Y1 )

S
C0

I = I 0 − I1r0

Y
Y1 Y0 Y2

−C0

Note:
• Savings will be zero whenever consumption equals income. If the economy is in
equilibrium, i.e., E(Y) = Y, then S(Y) = I(r).

2. Disequilibrium and Mechanisms of adjustment

• Whenever we have disequilibrium, i.e., E ≠ Y, the system will adjust by itself and
achieve the equilibrium.

• There are two possible mechanisms of adjustment, either through changing output
(Keynesian model) or through changing prices. We study Keynesian model for
the purpose of this topic.

Case 1: Excess Demand E(Y1, r) > Y1

• When the Income is Y1, the demand (planned expenditure) is greater than the
supply.

• Note that at Y1, the savings are below the investment.

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• In such a situation, sellers will increase supply to close the gap between demand
and supply. The disequilibrium will move to equilibrium through increased
output, hence income, according to Keynesian model.

• If the equilibrium is restored through price adjustment, then prices will increase to
adjust the Excess Demand. This requires the price to be flexible, which will be
covered in later topics.

Case 2: Excess Supply E(Y2, r ) < Y2

• When the Income is Y2, the supply is greater than the demand (planned
expenditure). There will be unplanned inventories for producers.

• Note that at Y2, the savings are above the investment.

• In such a situation, sellers will decrease supply to clear the unplanned inventories.
The disequilibrium will move to equilibrium through decreased output, hence
income, according to Keynesian model.

• If the equilibrium is restored through price adjustment, then prices will decrease to
adjust the Excess Supply. This requires the price to be flexible, which will be
covered in later topics.

Case 3: Equilibrium E(Y0, r ) = Y0

• At the equilibrium point, all rational plans materialized. That is, consumers
consumed as much as they had planned, and investment was at the level
anticipated.

• In diagram, we have savings equal investment. Further, consumption plus

investment equals output Y.

3. Characterization of equilibrium and the multiplier

The aggregate demand of a closed economy with no government is,

E(Y, r) = C(Y) + I(r)

Where C =C0 + c1Y and I(r) =I0 - I1. Substituting them into the aggregate demand
function, we have,

E(Y, r) = C0 + c1Y + I0 - I1r = [C0 + I0 - I1r] + c1Y

Or,
E(Y, r)= A(r)+ c1Y

Where A(r)= (C0 + I0 - I1r) is the autonomous component of demand.

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At equilibrium, E(Y, r) = Y. So, A(r)+ c1Y = Y

1 1
Hence: Y = A( r ) and is the multiplier
1 − c1 1 − c1

1
As > 1 , a slight change in A will result in a greater change in the equilibrium
1 − c1
level of Y. This is the Multiplier Effect.

Exercise:
If marginal propensity to consumer is 0.5, how much of national income will increase
following an increase of 1 unit of autonomous component of demand?

4. Working of Multiplier effect - demand management (Keynesian model)

1
• Why increasing A by 1 increases Y by which is more than 1?
1 − c1

• Assuming there is a fall in interest rate from r0 to r1 (r1 < r0), demand for
investment will increase from I(r0) to I(r1).

• The autonomous component of demand will also increase from A(r0) to A(r1) and
A(r1) > A(r0).Let ∆A = A(r1) - A(r0)

• There will thus be an upward shift of both investment and aggregate demand. At
the initial level of equilibrium income Y0* , there is now an excess demand.

• Producers will close the gap between demand and supply by increasing supply and
output will increase.

• As output equals to income, this increase in output will increase income by ∆A.

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 E, C, S 45o
E = C + I ( r1 )

E = C + I ( r0 )

∆I = ∆A

I = I 0 − I1r1
∆I = ∆A
I = I 0 − I1r0

Y0 Y1 Y

−C0 ∆Y > ∆I = ∆A

• Since consumption is a function of income, an increase in income means that

consumption will increase by c1∆A.

• Increase in consumption will result in excess demand and producers will again
close the gap between demand and supply by increasing supply.

• Income will thus increase further. Moreover, this increase in income will equal to
the increase of consumption of c1∆A.

• The increase in income will result in more demand for consumption which will
again lead to excess demand and subsequent increase in supply/income. The
process goes on until it reaches to a new equilibrium in which E(Y1, r1 ) = Y1.

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Home work
1. What are the components of demand in a closed economy without government?
What is A(r)? What does A(r) consist of? Derive E(Y, r ) = A(r)+ c1Y .

2. What is the level of supply? When will be the economy in equilibrium? Show it
with a diagram.

3. Using algebra, show the an increase of investment by ∆I will increase the

1 1
equilibrium income by ∆I . Is ∆I greater than ∆I?
(1 − c1 ) (1 − c1 )

4. Actual investment always equals actual savings (private and government) in a

closed economy, therefore the economy is always in equilibrium. True or false?
Explain your answer.

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 Macro 3: Closed Economy with Government

• The government in an economy provides public goods and services (e.g. health care,
education, public infrastructures and defense, etc.) that the private sector would either under
produce or not produce at all. The government also redistributes resources among households
and firms.

• These activities can be financed either by levying taxes on households and firms, or by
issuing debt, or by creating new money.

• For the purpose of this topic, we focus on two government activities. The first is raising tax
revenues from households and firms. The amount of tax revenue raise is denoted as T. The
second activity is spending on the provision of public goods and services. The size of this
activity is denoted as G.

1. Some Terminologies

a. Budget Deficit: T < G

If the government spending is more than the taxes revenue collected, we say that the
government is running a Budget Deficit.

b. Budget Surplus: T > G

If the government spending is less than the taxes revenue collected, we say that the
government is running a Budget Surplus.

c. Budget Balance: T = G.

When the government spending exactly equals to the taxes revenue collected.

d. Fiscal Policies: the government’s policies on G and T.

Fiscal Policies can be expansionary if the impact of the policies increase aggregate
demand.
E =C + I +G

Fiscal Policies can be contractionary if the impact of the policies decreases aggregate
demand.
E =C + I +G

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2. Implication to National Accounts

• On NNP: The usages of national output include public consumption, denoted by G, as

well as private consumption and investment. That is

NNP = C + I + G

• On Y: National income will be divided between taxes (T), consumption and savings.
That is
Y=C+S+T

• As NNP = Y, i.e., we have

C+I+G=C+S+T
or, I = S + (T - G)

Exercise:
Interpret the above using economic intuition.

3. Impact of Government on Individual Consumption

• With the government imposing income tax on households, consumption decision will be
based on disposable income (Yd), rather than the national income Y.

• The disposable income is the difference between national income and tax, i.e.,

Yd = Y - T

Demand for consumption is thus:

C = C0 + c1(Y – T)

4. System of Income Tax

• Lump sum tax: T = T0, taxes are raised with no reference to income; all individual pay
the same amount of tax, regardless of their level of income.

• Proportional tax: T(Y) = tY, there is a flat rate of tax which is paid by everyone regardless
of level of individual income.

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 • Progressive tax: T(Y) = t(Y)Y, where the rate of tax depends on the income earned. It will
be progressive if the rate of tax increases with income, regressive if rate of tax decreases
with income.

• For the purpose of this course, we do not need to consider progressive tax.

5. Public Consumption/Government Spending (G)

There are various rules the government can use to guide its spending decisions. For example,

• The government’s expenditure can be positively related to national income, i.e.,

G(Y) = G0 + g1Y, for 0 < g1 < 1; g1 is the public marginal propensity to consume.

• The government’s expenditure can be negatively related to national income, i.e.,

G(Y) = G0 – g1Y, for 0 < g1 < 1; g1 is the public marginal propensity to consume.

• The government’s expenditure can be independent of national income, i.e.,

G = G0

• The government can run a budget balance. Depending on the tax system, it could either
be
G = T0 Or G = tY

Exercise:
Work out the following balance budget under a proportional tax system.
a) The government adjusts its spending to ensure the budget is balanced.

b) The government adjusts tax rate to ensure the budget is balanced.

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6. Implication of different tax systems on MPC and MPS

• With a lump-sum tax system, a unit increase in income will go to two usages, consumption
and savings.

Y increase by 1 unit

• With a proportional tax system, the same unit increase in income will lead to an increase in
tax by ‘t’ unit. The income after tax, (1 – t), will be used for consumption and savings
respectively.

Y increase by 1 unit

7. Aggregated Demand

• Assuming G = G0 and T = T0, the aggregated demand for the economy can be written as:

E(Y, r) = C(Y, T) + I(r) + G

As C =C0 + c1(Y – T0), I (r) =I0 - I1r and G = G0

E(Y, r) = C0 + c1(Y – T0) + I0 - I1r + G0

= [C0 - c1T0 + G0 + I0 - I1r] + c1Y

• The autonomous component of demand contains government spending G0 and the effect
of lump-sum taxes on consumption, c1T0.

• We can also write the aggregate demand function as: E(Y, r) = A(T0,G0, r) + c1Y

The complete picture for closed economy with government can be shown in the
following diagram.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 4

 E, C , S 45o

E = C + I +G

S + (T − G )

I = I 0 − I1r0

Y0 Y1 Y

−C0

8. Characterization the multiplier with government

Assuming G = G0 and T = T0, the aggregate demand for the economy is

E(Y, r) = C(Y) + I(r) + G

As C =C0 + c1(Y – T0), I(r) =I0 - I1r and G = G0

E(Y, r) = C0 + c1(Y – T0) + I0 - I1r + G0 = [C0 - c1T0 + G0 + I0 - I1r] + c1Y

This can be written as E(Y, r) = A(T0, G0 , r) + c1Y

At equilibrium, E(Y, r ) = Y. This means A(T0, G0 , r)+ c1Y = Y

1 1
Hence, Y = A(T0 , G0 , r ) and is the multiplier.
1 − c1 1 − c1

1
• As > 1 , if we have a slight change in A, there will be a greater change in the
1 − c1
equilibrium level of Y. This is called Multiplier Effect.

• Notice that the autonomous component A(T0, G0 , r) is now a function of interest rate,
government spending and taxes. Given that the economy's multiplier is greater than 1,
fiscal policies (government policy on G and T) that increase the autonomous component
of demand will increase output. This is main idea of the Keynesian model.

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Exercise:
1
a) Show an increase in the government spending by 1 unit will increase output by units.
1 − c1

c1
b) Show an increase in the tax by 1 unit will decrease output by unit.
1 − c1

c) Show the net impact on the equilibrium output following an increase in government spending
of ‘∆G’ and a simultaneous increase in tax of ‘∆T’ when ‘∆G = ∆T’.

Exercise:
Derive the multiplier in an economy with a proportional tax system assuming G = G0. Compare
the size of the multipliers under a lump-sum tax system and under a proportional tax system.

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Example:
Here is a model of a closed economy:
C(Yd ) = 80 + 0.8 Yd ; I(r0) = 100 (short form of writing I =I0 – I1r); G = 100 where Yd is
disposable income. Consider two tax systems (and a balanced budget policy); a lump-sum tax (G
= T0) and a proportional tax (G = T(Y) = tY). Will the equilibrium level of output be different
under the two tax systems? What will be the level of it?

Solutions:
We assume that Government collects same level of tax under two systems, further, there is a
government budget balance under both system. i.e., tax collected is just enough to pay for
government spending. Specifically,

• Lump-sum tax: G = T0
• Proportional tax: G = tY

In the case of lump-sum tax system, the aggregate demand of the economy is,

E(Y, r) = C(Y, T) + I(r0)+G

C =C0 + c1(Y – T0); I(r0) = I0(r0) and G = G0

Thus,
E(Y0, r0) = C0 + c1(Y – T0 )+ I0(r0) + G0
= [C0 - c1T0 + G0 + I0(r0)]+ c1Y

At equilibrium, E(Y, r0) = Y

So, [C0 - c1T0 + G0 + I0(r0)]+ c1Y0 = Y

1 1
Hence, Y = [C0 - c1T0 + G0 + I0(r0)] with is the multiplier.
1 − c1 1 − c1

As, G = T = 100,

1 1
Y = [C0 - c1T0 + G0 + I0(r0)] = [80 – 0.8 × 100 + 100 + 100] × = 1000
1 − c1 1 − 0. 8

In the case of proportional tax system, the aggregate demand of the economy is,

E(Y, r0) = C(Y, T) + I(r0)+G

C =C0 + c1(Y – tY); I(r0) = I(r0) and G = G0

Thus,
E(Y, r0) = C0 + c1(Y – tY)+ I(r0) + G0
= [C0 + G0 + I(r0)] – c1tY + c1 Y

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 = [C0 + G0 + I(r0)] + c1(1 – t ) Y

At equilibrium, E(Y, r0) = Y

So [C0 + G0 + I(r0)] + c1(1 – t ) Y = Y

1 1
Hence, Y = [C0 + G0 + I(r0)] with is the multiplier.
1 − c1 (1 − t ) 1 − c1 (1 − t )

[C0 + G0 + I(r0)] = 80 + 100 + 100 = 280

But ‘t’ is not given. However, we know that T = G = tY, so, t = G/Y

1 1 1
The economy’s multiplier is thus, = =
1 − c1 (1 − t ) 1 − c (1 − G ) 1 − 0.8(1 − 100 )
1
Y Y
1
So, Y = 280
100
1 − 0.8(1 − )
Y
Solving the above, Y = 1000.

In this economic system, the government sets t and adjusts G to be equal to tY. It is easy to
establish that there is a rate of tax, t = 10%, which will yield exactly the same equilibrium as
before, Y = 1000.

For any t > 10%, equilibrium will be at a lower level of output, while for any t < 10%,
equilibrium level of output will be greater than 1000

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 Macro 4: The IS representation of the goods market equilibria

1. Deriving the IS curve

Assuming G = G0 and T = T0, the aggregated demand for the economy can be
written as:
E(Y, r) = C(Y, T) + I(r) + G

As C =C0 + c1(Y – T0), I (r) =I0 - I1r and G = G0

E(Y, r) = C0 + c1(Y – T0) + I0 - I1r + G0

= [C0 - c1T0 + G0 + I0 - I1r] + c1Y
= A(T0, G0 , r)+ c1Y

In equilibrium, the aggregated demand is also equal to the national income, i.e.,

A(T0, G0 , r)+ c1Y = Y

This suggests that the level of national income is determined in the goods market
through aggregate demand.

Aggregate demand is, among other things, a function of the interest rate. Thus, the
interest rate connects the assets (or money) side of the economy with the real side
of the economy.

E , C, S 45o
E = C + I ( r1 ) + G

E = C + I ( r0 ) + G

S + (T − G )

I = I 0 − I1r1

I = I 0 − I1r0

Y0 Y1 Y

−C0
In equilibrium, when interest rate
falls, income rises. This is the IS.

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 • When the interest rate is r0, the equilibrium level of income in the goods
market will be Y0 (point A in the diagram above).

• When the interest rate falls to r1, demand for investment will increase (demand
for investment is inversely related to interest rate).

• Increase in demand for investment will increase the aggregate demand. The E
schedule will shift up.

• This will create excess demand at point A. With quantity adjustments, there
will be increases in output until equilibrium is restored at point B.

• Transforming the above movements into a space of interest and

output/income, we will have the IS curve shown below.

E , C, S 45o
E = C + I ( r1 ) + G
r
E = C + I ( r0 ) + G

r0 A

S + (T − G ) r1 B

I = I 0 − I1r1

I = I 0 − I1r0
IS ( G , T )
Y0 Y1 Y
Y0 Y1 Y
−C0
In equilibrium, when interest rate
falls, income rises. This is the IS.

• Connecting points A and B produces the inverse relationship between interest

rates and national income.

2. Defining the IS curve ( E = Y ⇒ r = f (Y ) )

• The IS curve is the collection of all pairs of interest rates and national income
for which there is equilibrium in the goods market.

• In algebraic terms, the IS curve describes the relationship between the values
of ‘r’ and ‘Y’ when aggregate demand E equals aggregate supply Y.

• Assuming a Lump-sum tax system, the aggregate demand in the economy is

E(Y, r) = C(Y, T) + I(r) + G

= C0 + c1(Y – T0 )+ I0 - I1r + G0

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 = (C0 - c1T0 + G0 + I0 ) - I1r + c1Y
= A(T0,G0 ) - I1r + c1Y

• Along the IS schedule, E(Y, r) = Y. Hence,

A(T0,G0 ) - I1r + c1Y = Y

A(T0,G0 ) – Y + c1Y = I1r
A(T0,G0 ) – Y(1- c1) = I1r

1 (1 − c1 )
Solving for r, we have r = A(G , T ) − Y
I1 I1

• This is the IS equation. The slope of the IS curve can be found by

dr (1 − c1 )
=−
dY I1

(1 − c1 )
• As c1 < 1 (MPC < 1 ), − < 0. The IS curve has a negative slop.
I1
Therefore, we have an inverse relationship between Y and r.

3. A closer look at the IS curve

1 (1 − c1 )
As r = A(G , T ) − Y and A = C0 − c1T0 + G0 + I 0 increasing A will shift the IS
I1 I1
to the right. Decreasing A will shift the IS to the left.

a. An increase in government spending (G);

• An increase in government spending G increases A(G, T ) and hence Y. This

means that at every level of r, there is a higher level of Y. The IS curve will
thus shift to the right in a parallel manner.

IS (G0) IS (G1)

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b. An increase in taxation (T).

IS (T1) IS (T0)

• An increase in government taxation decreases A(G, T ) and hence decreases Y.

This means that at every level of r, there is a lower level of Y. The IS curve
will shift to the left in a parallel manner.

Exercise:
What will happen to the IS curve when government (G0) spending and tax (T0) all
increase by the same amount?

c. The effect of a change in the MPC

(1 − c1 )
• Slope of IS curve is − . An increase (decrease) in MPC means that will
I1
lead to a flatter (steeper) slope of IS curve.

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 1
• Intuitively, an increase in MPC increases the multiplier .
1 − c1

• We can thus say the greater the multiplier, the greater will be the impact on the
equilibrium level of income Y following a slight change in demand for
investment. And flatter will be the IS curve.

r0 A

r1 B

IS ( G , T )

Y0 Y1 Y

• As interest rates fall, demand for investment will increase.

• With a greater multiplier, the increase in demand will push equilibrium

income further to the right; hence, the IS is flatter the greater the multiplier.

Exercise
1. The slopes of the IS curve of an economy with a lump sum tax system will be
steeper than that of an economy with a proportional tax system. True or false?
Explain.

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Example:
In a closed economy with a lump-sum tax system when the government spending
increases with national income, the aggregate demand is,

E(Y, r) = C(Y, T) + I(r) + G(Y)

where C =C0 + c1(Y – T0); I (r) =I0 - I1 r and G = G0+ g1Y

Substituting them into the aggregate demand function, we have,

E(Y, r) = C0 + c1(Y – T0 ) + I0 - I1 r + G0 + g1Y

= [C0 - c1T0 + G0 + I0 - I1r] + g1Y + c1 Y

Or, E(Y, r) = A(T0, G0 , r) + g1Y + c1 Y

= A(T0, G0 , r) + (g1+ c1)Y

At equilibrium, E(Y, r)= Y; So, A(T0, G0 , r) + (g1+ c1)Y= Y

1 1
Hence, Y = A(T0, G0 , r) and is the economy’s multiplier.
1 − c1 − g1 1 − c1 − g1

If the economy has a proportional tax system when the government spending
increases with national income, aggregate demand of a closed economy with
government is, the aggregate demand is,

E(Y, r) = C(Y, T) + I(r)+ G(Y)

where T = tY, C =C0 + c1(Y – tY); I (r) =I0 - I1 r and G = G0 + g1Y. Substituting them
into the aggregate demand function, we have,

E(Y, r) = C0 + c1(Y – tY)+ I0 - I1 r + G0 + g1Y

= [C0 + G0 + I0 - I1r] + g1Y - c1tY + c1 Y
= [C0 + G0 + I0 - I1r] + [g1 + c1(1 – t )]Y

Or, E(Y, r)= A(G0 , r) + [g1 + c1(1 – t )]Y

At equilibrium E(Y, r)= Y; So A( G0 , r,) + [ g1 + c1(1 – t )]Y = Y

1 1
Hence, Y = A(G0 , r) with is the economy’s
1 − g1 − c1 (1 − t ) 1 − g1 − c1 (1 − t )
multiplier.

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Exercise:
Compare the position of the IS curve between the two economics discussed above.

Homework

1. A cut in the rate of proportional tax will make the IS steeper. True, or false
explain.

2. In a closed economy where a government is committed to increase its expenditure

with national income, the balanced budget multiplier will be independent of (not a
function of) the public's marginal propensity to consume. True or false, explain.
[As G = G0 + g1Y public's marginal propensity to consume is ‘g1’]

3. Show the impact on the IS curve following an increase in the public’s marginal
propensity to consume, g, when the government spending increases with
national income.

4. Show the impact on the IS curve following an increase in the public’s marginal
propensity to consume, g, when the government spending decreases with
national income.

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 Macro 5: Money and Banking

1. What is Money:

• In Macroeconomic analysis, we define money as Stock of Liquid Assets that can

be readily used to make transactions.

• To serve this role, money needs to be liquid. This feature distinguishes money
from other class of assets such as property, which is rather illiquid.

• Bonds are another example of asset. They are issued by governments or

corporations. Bonds pay a positive nominal interest rate but cannot be used for
transactions.

• In general, the less liquid an asset is, the higher the interest rate is paid on it, but
the more difficult is its use as a medium of exchange.

• Broadly speaking, money serves three key economic functions.

1) Money as a medium of exchange: it facilitates transactions since any goods

and services can be exchanged for money at any time.

2) Money as a store of value: it keeps its value over time as it is not subject to
wear and tear or deterioration as most physical goods are.

3) Money as a unit of account: it represents the unit at which all prices are quoted
and firms’ books are kept.

• Monetary aggregates are classified according to their degree of liquidity.

a) Currency, denoted as PC (public cash), refers to all coins and notes in

circulation in an economy.

b) M0 consists of public cash and reserve. The reserve is the amount of hard
currency kept in the bank which cannot be lent out.

c) M1 comprises currency and all those assets that, instantaneously and without
restrictions, can be employed as a means of payments (i.e. interest- and non-
interest-bearing checking accounts, travel checks, etc.).

d) M2 includes all assets classified under M1 plus small-denomination time

deposits and other short-term assets with fixed maturity. M3 and L include, in
addition to M2, long-term deposits, assets and government securities.

• The classification and definition of monetary aggregates may vary across

countries, most importantly, have evolved over time as a result of financial

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 innovations and the vast employment of computer technology to regulate
economic transactions.

2. The Demand for Liquid Assets (Money)

• The liquid assets we are interested in are the real balance, or the real value of
money stock (M/P).

• The demand for liquid assets is basically a function of two major factors: the price
of holding them and income, i.e.,

d
M 
  = L( r , Y )
 P

M 
Note: the M inside   is referred to M1, the total liquid assets.
 P
L(r , Y ) means that demand for money is a function of r and Y.

• The interest rate is the opportunity cost of holding liquid assets. It represents the
return we will receive if we deposit our money in a bank (or lent it to someone
else) instead of keeping it in our pocket. Interest rate is thus the price of holding
money.

• The higher the interest rate, less money will be demanded since we prefer to put it
in the bank and earn the interest payment rather than holding it.

• The higher the income in an economy, the more opportunities will arise for the use
of liquid assets.

L ( r , Y0 )

M
P

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3. The supply of Liquid Assets

• As we use both currencies (PC) and deposits (D) to make payments of

transactions, the total amount of liquid assets in the economy is the aggregate
amount of PC and D.

• The sum of PC and D in an economy is called M1. M1 is also the total supply of
liquid assets in the economy. Thus,

M1 = PC + D

• However, the most liquid form of assets is ‘hard cash’. We called it Money Base
and denoted it as M0.

• M0 consists of ‘Public Cash’ and Reserve. Reserve is the amount of hard currency
kept in the bank and cannot be lent out as loans. Thus,

M0 = PC + R

4. Deriving Deposit Multiplier and Loan Multiplier

• How large is D? The answer for this question leads us to derive Deposit Multiplier
and Loan Multiplier.

• Whenever a commercial bank receives $1 deposit from its customers, it keeps $α

as reserve, and lends out $(1-α), where a (0 < α < 1) is the reserve ratio. ‘α’ is the
reserve ratio and it is set by the central bank.

• Suppose the following, someone (1st person) deposits $K into Bank 1. Bank 1
keeps $αK as reserve and lends out $(1- α)K to 2nd person.

• The 2nd person deposits $(1- α)K at Bank 2. Bank 2 keeps $ α(1- α)K as reserve
and lends out $(1- α)(1- α)K to 3rd person.

• The 3rd person deposits $(1- α)(1- α)K at Bank 3. Bank 3 keeps $ α(1- α)(1- α)K as
reserve and lends out $(1- α)(1- α)(1- α)K to 4th person. And so on…..

• The total deposit created in the economy is:

∞
D = ∑ Di = D1 + D2 + D3 + ....
i =1

= K + (1 − α ) K + (1 − α ) 2 K + .....
= K [1 + (1 − α ) + (1 − α )2 + .... ]
1 + (1 − α ) + (1 − α ) + .... is a sum of Geometric Progression with first term ‘1’
2

and common ration (1- α). The sum of this G.P. is

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 1× 1 − (1 − α )∞  1× (1 − 0 ) 1
= = ; hence,
1 − (1 − α ) α α
∞
1
D = ∑ Di = K [1 + (1 − α ) + (1 − α )2 + .... ] =K
i =1 α

1
is the deposit multiplier (DM).
α

The total amount of deposit is D = K × DM .

The amount of liquid asset in the economy is

1
M1 = PC + D = PC + K × DM =PC + K
α

• The total amount of loans is:

∞
L = ∑ Li = L1 + L2 + L3 + L4 + ....
i =1

= (1 − α ) K + (1 − α ) 2 K + (1 − α )3 K + .....
= K  (1 − α ) + (1 − α ) 2 + (1 − α )3 + .... ]

(1 − α ) + (1 − α ) 2 + (1 − α )3 + .... is a sum of Geometric Progression with first

term (1- α) and common ration (1- α). The sum of this G.P. is

(1 − α ) × 1 − (1 − α )∞  (1 − α ) × (1 − 0) 1− α 1
= = = − 1 ; hence,
1 − (1 − α ) α α α
∞
1
L = ∑ Li = K [ (1 − a ) + (1 − a ) 2 + (1 − a )3 + .... ]= K( − 1)
i =1 α

1 1
is the deposit multiplier (DM), ( − 1) is the loan multiplier (LM).
α α

Thus, LM = DM – 1 . The total amount of loan is L = K × ( DM − 1) .

Exercise
What is the amount of total reserves held by these banks?

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The total amount of reserve R is also the initial amount deposited in Bank 1 by the
first person K.

Example 1:
If liquid asset is the only asset in the economy, can government make people wealthier
by reducing the reserve ratio?

If liquid asset is the only asset in the economy, the wealth we have is the difference
between the values of our assets minus our liabilities. Denoting it as NW, then

NW = PC + D - L

1
Total liquid assets in the economy is M1 = PC + D where D =R×DM= R
α

If the government reduces the reserve ratio, D will increase. Consequently, M1 will be
higher.

1
Total liability is total loans in the economy. And L = R(DM-1)= R( − 1)
α

If the government reduces the reserve ratio, L will increase also.

Thus, whenever there is a reduction of reserve ratio, there will be more lending and
more borrowings. Further, the increase in both will cancel out. The net impact of a
change in reserve ratio will leave the total wealth unaffected. This is shown below,

NW = PC + D - L
1 1
=PC + R − R( − 1)
α α
1 1
= PC + R −R +R
α α
=PC+R
= M0

where M0 is the money base. The change in reserve ratio ‘α’ does not affect the NW
function.

Example 2:
When the reserve ratio is 20%, an increase of £100 in the amount of cash held by the
public together with a reduction of £10 held in the banks will leave the supply of
money unchanged. True or false, explain.

1
Total supply of money is M1 and M1 = PC+ D = PC + R
a

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 1
Let the initial level of money supply be M 10 and M 10 = PC0 + R0 .
α

Let the new level of money supply be M 11 , the impact of an increase of £100 in the
amount of cash held by the public together and a reduction of £10 held in the banks on
money supply will be,

1
M 11 = ( PC0 + 100) + ( R0 − 10)
0.2
1
= ( PC0 + R0 ) + (100 − 50 )
0.2
1
= PC0 + R0 + 50
0.2
= M 10 + 50

The net impact of the two increases total money supply by £50. The statement is false.

Exercise
Due to a series scandal implicating all credit card agencies, ‘plastic money’ which
includes debit cards, cash cards, etc., is no longer a means of exchange. Therefore, the
public loses part of its wealth. True or false, explain.

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5. Central banks

• Every economy has a central bank. The role of a central bank is to be the banker
for the government as well as for the commercial banks. (the banks we referred to
when we derive the deposit and loan multipliers are commercial banks).

• More specifically, the central bank may hold the reserves for commercial banks
and control their activities through the setting of reserve ratios, or interest.

• In addition, the central bank serves the government. Among other things, the
government may borrow money from the central bank. To achieve that, the
government will issue government bonds and sell the bonds to the central bank
which, in turn, will pay for these bonds by creating new money in its balance
sheet. Effectively, this transaction creates more money in the economy and
increases money supply.

6. The conduct of monetary policy

6.1. Open Market Operations

• The conduct of open market operations is based upon the following simplifying
assumptions:

a) The central bank has direct control over money supply through open market
operations.
b) The government issues bonds on behalf of the central bank; the central bank does
not directly issue bonds, but can only create money to buy bonds issued by the
government.
c) Individuals are always willing to trade bonds at some price (i.e. bond demand
from the private sector is unlimited).

• Consider the simplified central bank’s balance sheet in the following table. The
central bank’s assets are represented by bonds, while the central bank’s liabilities
are represented by the currency (money) held by the public.

Central Bank
Assets Liabilities
Bonds Money

Central bank balance sheet in a closed economy

• To increase the money supply, the central bank has to purchase new bonds. This
increases both assets (through the additional bonds) and liabilities (through the
new currency created and exchanged for bonds).

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• To reduce the money supply, the central bank sells bonds for existing currency.
This operation reduces assets (through the sale of bonds) and liabilities (through
the reduction of currency held by the general public).

6.2. Reserve Requirements

1
• M 1 = PC + D = PC + R
α

• An increase in reserve ratio reduces the amount of loan that commercial banks can
lend out. It will decrease quantity of money supplied.

• A decrease in reserve ratio increases the amount of loan that commercial banks
can lend out. It will increase quantity of money supplied.

6.3. Discount Rate

• When commercial banks have insufficient reserve, they are allowed to borrow
from the central bank to meet the reserve requirement.

• Discount rate is the interest rate commercial banks pay to borrow from the central
bank.

• The lower the discount rate, the cheaper it is to borrow from the central bank and
the cheaper is the borrowed reserved. More commercial banks are willing to lend
out more and use borrowed reserve to meet the reserve requirement. Hence,
lower discount rate will increase money supply.

7. Equilibrium in the Liquid Assets Market

• The demand for liquid assets is inversely related to interest rate: the lower the
interest rate, the lower the opportunity cost of holding liquid assets, the more
people will want to have liquid assets.

• The supply of liquid assets is not dependent on the interest rate. It is dependent on
the policy of the central bank.

• Equilibrium means that at the interest rate r, the quantity of liquid assets the public
wants to hold equals the quantity supplied by the banking system. That is,

S
M 
  = L(r , Y )
 P

• Graphically, this can be represented as

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 S
M 
r  
 P

r0
L(r , Y )

M
P
Equilibrium in the liquid assets market

8. Expansionary Monetary Policy—increasing liquid asset supply

• To increase liquid asset/money supply in the economy, the central banks can, for
example,

a. Decreasing reserve ratio

b. Buying bonds issued by the government from money market and paying for
them using new money created.

c. Lower the discount rate paid by commercial banks to the central bank.

S
M 
• Increasing M will shift the supply of liquid assets   to the right.
 P
• At the initial level of interest rate r0, there is now excess supply of liquid assets.

• The excess supply of money will push the price of holding money down. Hence,
the new equilibrium will be obtained at a lower interest rate (r1).

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 9

 S S
 M0   M1 
r  P   
   P 

r0
r1
L(r , Y )

M
P

Why interest rate falls when there is an increase in money supply? There are two ways
to understand this.

• First, an increase of money supply means that people will wish to convert the
excess liquidity (cash) they have into less liquid assets like bonds.

• Buying bonds implies that people prefer future consumption than present
consumption.

• When people increase demand for bonds there will be an excess demand for
bonds. As price of bonds is inversely related to interest rate, when bonds price
increases, the interest rate will decrease.

• Another way of looking at it is the following. Increasing money supply results in

excessive liquidity in the economy. Some people who have excess cash and want
to lend out their money cannot find a borrower.

• The only way to attract borrowers is by charging the borrowers a lower interest
rate.

• A fall in interest rates to attract borrower, which in turn, increases the price of
bonds.

• Hence, the new equilibrium will be obtained at a lower interest rate (r1) and push
the price of bonds to a higher level.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 10

 9. Deriving the LM (the equilibrium in liquid assets market)

LM curve shows the relationship between interest rate and national output when
economy is in equilibrium.
S
 M0 
 P 
r  
r

r1 B
B

rr00
A A C L(r , Y1 )

L(r , Y0 )

M
Y0 Y1 P

S
M 
Assuming that the quantity of money supply is fixed at  0  ,
 P0 

• At point A when national income is at Y0, the equilibrium level of interest is

r0.

• If output increases to Y1, demand for liquid assets will increase to [L(r, Y1)].

• At point C where interest rate still remains at r0, there will be an excess
demand for liquid assets.

• This means that some people will want to sell their bonds and convert them
into cash leading to an excess supply of bonds. Excess supply of bonds will
lower the price of bonds.

• As price of bonds is inversely related to interest rate, a lower bonds price

means that there will be an increase in interest rates.

• At point C, there are more borrowers than lenders. To attract lending,

borrowers need to increase interest rate paid to lenders.

• Subsequently, equilibrium interest rate will rise to r1 (point B in the above

diagrams).

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 • There shows that there is a direct relationship between the levels of national
income and interest rates. This yields equilibrium in the liquid assets market.

When government increases money supply - expansionary Monetary Policy, it causes

the LM curve to shift to the right.

S S
 M0   M1 
 P   
   P 

r0

r1
L(r , Y0 )

Y0 M
P
• The increase in supply of money at any given level of income would cause
excess supply of liquid assets at the going interest rate.

• Hence, there would be excess demand of bonds which would trigger a fall in
equilibrium interest rate.

• There will also be more lenders than borrows which will lead to a lower
equilibrium interest rate.

• LM curve will thus shift to the right.

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With a given level of output, when demand for money increases (an increase in the
desire to hold more liquid assets), the LM shifts to the left.
S
M 
 
 P

r1

r0

L '(r , Y0 )
L(r , Y0 )

M
Y0 P
• The increase in demand for liquid assets at any given level of income would
cause excess demand for liquid assets at the going interest rate.

• There will be more borrowers than lenders which will lead to a higher
equilibrium interest rate.

• There would also be excess supply of bonds which would lead to lower price
of bonds and trigger a rise in equilibrium interest rate.

• LM curve will thus shift to the left.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 13

Homework

1. The deposit multiplier is nothing but the inverse of the reserve ratio. True or false?
Explain.

2. Derive loan multiplier.

3. If the total amount of loans in an economy is 1600bn and the total amount of
deposits is 2000bn a deposit of an extra 10bn in the bank will increase the supply
of liquid assets by 40bn. True or false? Explain.

4. A reduction in the reserve ratio has a greater impact on the overall amount of loans
than it has on the overall amount of deposits. True or false? Explain.

5. What would happen to the LM curve if the government borrows from the central
bank to bail out commercial banks?

6. What would happen to the LM curve if commercial banks refuse to lend to each
other?

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 14

 Macro 6: General Equilibrium and Policies in a Closed Economy when Prices
and Wages are Fixed

1. The macro notion of general equilibrium

• The interaction between the goods market and the money market can be described
in the following simple relationship.

• Y is determined in the goods market for any given level of r.

• r is determined in the money market for any level of Y.

• At the general equilibrium, both markets are in equilibrium and we have the
following relationships between the goods market and the money market.

• At the interest rate r0, there will be equilibrium output Y0 in the goods market.
• In the money market, at equilibrium output Y0, the demand for liquid assets
will be such that, given the supply of liquid assets, equilibrium will occur
when the interest rate is at r0.

2. IS - LM Representation of the General Equilibrium:

• The relationship between the equilibrium values of the goods market (Y) and the
liquid assets market (r) can be analyzed using the IS - LM framework.

r
LM (M0,P0)

r0

IS (G0,T0)

Y0 Y

• The intersection of the two schedules will mark the level of Y and r for which
there is equilibrium in both the goods market and the money market.

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3. Expansionary Fiscal Policy

• Expansionary Fiscal Policy increases the aggregate demand of the goods market in
an economy. One way to increase demand of the goods market is through
increasing government spending.

• When the government decides to increase its spending, it may choose one of the
following methods to finance the spending.

1) Raising taxes
2) Borrowing from the public
3) Borrowing from the central bank

• Only if the total effects from simultaneous increase in government spending

accompanied by the corresponding financing method increases the aggregate
demand, we say that the policies are expansionary.

3.1. Tax financing

• The increase in government spending is financed through an increase in taxation.

In real terms, this is similar to transferring resources from private consumption to
government spending.

Exercise:
Assuming a lump-sum tax system, show that a simultaneously increasing in tax and
government spending of the same amount increases the aggregate demand.

Thus, transferring one dollar from private sector to public sector increases government
spending by one dollar and reduces the demand for consumption by the marginal
propensity to consume. The total impact increases the aggregate demand.

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• In terms of the IS-LM framework, the IS curve will shift to the right.

r
LM (M0,P0)

r1 B

r0 A

IS (G1,T1)

IS (G0,T0)

Y0 Y1 Y

• The effect of the expansionary fiscal policy is an increase in equilibrium output

and interest rate.

• Since the interest rate has increased, and demand for investment is negatively
related to the interest rate, we can conclude that demand for investment must have
fallen.

3.2. Internal debt financing

• The increase of government spending is financed through issue of government

bonds.

• From the public's point of view, the presence of government bonds means an
alternative form of savings.

• This way of financing will have no real effect on the current consumption demand
for goods and services. It will increase the supply of bonds.

• Within the IS–LM model, this does not change any of the parameters influencing
the level of consumption and savings.

• Therefore, the effect of an increase in government spending on aggregate demand

will be positive.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 3

Exercise:
Assuming a lump-sum tax system, show that increasing government spending
financed by borrowing from public increases the aggregate demand. Further, show the
increase in the aggreagate demand when the spending is financed by borrowing from
public is larger than when the spending is finanace by increasing tax.

• Compared to the tax financing case, the IS curve will shift further to the right if
the government spending is financed by borrowing from public.

r LM (M0,P0)

r’1

r1

r0

IS (G1,T0)

IS (G1,T1)

IS (G0,T0)

Y0 Y1 Y’1 Y

Notice that the interest rate has increased substantially to r’. Since demand for
investment is negatively related to the interest rate, we can conclude that demand for
investment must have fallen substantially. This is called crowd out effect, the
increased public borrowing 'crowds out' private investing.

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3.2. Borrowing from the central bank

• When the government borrows from the central bank, it sells the government
bonds to the central banks. The central bank will then create new money to
purchase these bonds.

• Consequently, the total money supply increases and the LM curve will shift to the
right.

• At the new equilibrium, there will be a higher level of national income. However,
the equilibrium level of interest rate will remain more or less at the same level as
the initial equilibrium level of interest rate.

r
LM (M0,P0)

LM (M1,P0)

r0

IS (G1,T0)

IS (G0,T0)

Y0 Y1 Y

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 5

Tutorial Questions for Macroeconomics – 4

Analyses the following situations using the IS-LM framework:

1. The central bank increases reserve ratio.

2. There are more robbers on the street.

3. People lost confidence in using ‘plastic money’, e.g., nets, credit cards.

4. An increase in the desire to hold more liquid assets.

5. The government reduces lump-sum tax.

6. The government reduces proportional tax rate.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 6

 Macro 7 – 1: General Equilibrium and Policies in a Closed Economy with
Flexible Prices and Wages

1. Introduction

• The analysis of macroeconomic policies in the last topic was based on the
assumptions that the price level was fixed.

• Further, the analysis is also based on the strong assumption that there was
sufficient excess capacity in the economy for output to rise proportionately when
aggregate demand increased.

• These assumptions are not very realistic. The supply of output cannot keep on
increasing indefinitely at fixed prices.

• There are constraints on the capacity of the economy to produce output above the
full employment level of output.

• In addition, the assumption of fixed prices ignores the problem of inflation.

• Inflation is defined as the rise in the general price level of goods and services in a
given economy over a period of time. It may also refer to the rise in the prices of
some more specific set of goods or services. In either case, it is measured as the
percentage rate of change of a price index.

• This topic introduces the impact of price level on the analysis of macroeconomic
policies. For example, whether expansionary macroeconomic policies can increase
output or whether they simply lead to inflation.

2. Aggregate demand—derivation

• The aggregate demand (AD) relation defines combinations of the price level and
income such that the goods and money markets are simultaneously in
equilibrium in the short run.

• To derive the aggregate demand (AD) curve, we look at the impact of changes in
price level on equilibrium income.

• One function of money is as median of transactions. If general prices rise, more

money will be needed in order to maintain the same level of purchases in real
terms.

• This suggests that when we decide on the amount of money to hold, we should be
concerned with the real money holding, i.e., the amount of goods and services that
a given nominal supply of money can purchase.

• This, therefore, implies that the real money supply is:

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 1

 MS
P

• Beginning at point A in figure (a), the money market equilibrium schedule

LM(M0, P0) is drawn for a given quantity of money and price level P0. This
corresponds to point A in Fig. (b), with income level Y0 and price level P0.

• If prices fall to P1 while the nominal money supply remains unchanged, the real
money supply would increase.

• In Fig. (a), this leads to a rightward shift of the LM schedule to LM(M0, P1)
resulting to a lower level of interest rate and a higher level of income level at point
B.

r LM ( M 0 , P0 )

LM ( M 0 , P1 )

r0 A
a) r1 B

IS ( G0 , T0 )

Y0 Y1 Y
P

P0 A

b) P1 B

AD ( G0 , T0 , M 0 )

Y0 Y1 Y

• On the IS curve, the lower interest rates will increase demand for investment and
the equilibrium in the goods market is now given by a higher level of output at Y1
further down the IS schedule.

• On the AD curve, the lower interest rates have increased investment expenditure
which is part of Aggregate Demand, in Fig. (b). The new equilibrium is at B, with
higher income Y1 and a lower price level P1.

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• Hence, the aggregate demand schedule is downward sloping with respect to the
price level.

• The points A and B in Fig. (b) lie on the aggregate demand schedule AD, which is
drawn for a given nominal supply of money and a given fiscal policy stance.

3. Monetary policy and aggregate demand

r LM ( M 0 , P0 )

LM ( M 1 , P0 )

r0 A
a) r1 B

IS ( G0 , T0 )

Y0 Y1 Y
P

B
P0
A
b)

AD ( G0 , T0 , M 1 )
AD ( G0 , T0 , M 0 )

Y0 Y1 Y

• Consider now the case of an increase in the money supply (an expansionary
monetary policy) as depicted in above Figure.

• Beginning at point A in figure (a), the money market equilibrium schedule

LM(M0, P0) is drawn for a given quantity of money and price level P0. This
corresponds to point A in Fig. (b), with income level Y0 and price level P0.

• An expansionary monetary policy leads to a rightward shift of the LM schedule to

LM(M1, P0) resulting to a lower level of interest rate and a higher level of income
at point B.

• Lower interest rates will increase demand for investment. The equilibrium in the
goods market is now given by a higher level of output at Y1 further down the IS
schedule.

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• Thus, at initial equilibrium price P0, the aggregate demand will increase (mainly
due to increase in investment). This is shown as the shift to the right of the
aggregate demand schedule.

Note: the important distinction between an increase in the real money supply due to a
lower price level and an increase in the real money supply due to an increase in the
nominal quantity of money. In the former case, there is a movement along (down) a
given aggregate demand schedule, and in the latter case, the new equilibrium is on a
new aggregate demand schedule (AD1).

4. Expansionary Fiscal policy and aggregate demand

Consider an increase in government expenditure or a reduction in taxation which

increases aggregate demand.

• With an increase in government expenditure, the effect on aggregate demand is

direct.

• With a reduction in taxation, the effect is indirect. The lower taxes lead to higher
disposable income, which then increases aggregate demand by increasing
consumption.

• Both policies shifts the IS to the right

r LM ( M 0 , P0 )

r1 B
r0 A
a)

IS ( G1 , T0 )
IS ( G0 , T0 )

Y0 Y1 Y
P

P0 B
A
b)

AD ( G1 , T0 , M 0 )
AD ( G0 , T0 , M 0 )

Y0 Y1 Y

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 4

• Beginning at point A in figure (a) in the IS-LM framework. This corresponds to
point A in Fig. (b), with income level Y0 and price level P0.

• An expansionary fiscal policy shifts the IS schedule to IS1 resulting to a higher

level of interest rate and a higher level of income level at point B.

• Increasing government expenditure or a reduction in taxation increases total

desired expenditure, hence increase aggregate demand.

• This is equivalent to a rightward shift of the aggregate demand schedule at a fixed

price level of P0 (i.e. a move from A to B in Fig.(b)),

• The increase in demand, this time is caused by the increase in government

expenditure /private sector consumption expenditure (via the expenditure
multiplier), although demand for investment will have fallen as a result of the
higher interest rate.

The impact on AD curve: Comparison between Fiscal and Monetary policy

• In terms of the aggregate demand, there does not seem to be any difference
between monetary and fiscal expansions: both shift the AD schedule to the right.

• The difference is seen in the IS/LM diagrams where monetary expansions lower
interest rates and fiscal expansions raise interest rates.

• Moreover, there is a major difference in terms of the composition of aggregate

demand: investment is higher in the first case and lower in the second.

Exercise: What happen to IS or LM and AD curves when,

a. Central Bank raise/decrease reserve ratio

b. There are more robbers on the street

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 c. People lost confidence in using ‘plastic money’, e.g., nets, credit cards

d. Government reduce Tax

e. Government reduces tax rate

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5. Aggregate supply

• Whether or not higher demand results in higher output depends on what happens
to aggregate supply which is the capacity of economy to produce the outputs in
goods and services.

• In the previous analysis on the goods market, we assume that there are unlimited
capacity or unemployed resources in the economy. As a result, the output will rise
whenever there is excess demand.

• This assumption is clearly unrealistic in the median and the long run even though
it is true in the short run.

• There are two views on the shape of aggregate supply. They are the Classical view
and the Keynesian view.

The Classical view:

LAS
P

P0

AD

ܻത Y

• No economy can increase the supply of goods and services indefinitely as

resources required for production, such as labour and capital, are limited.

• This is a long-run constraint on output given by the availability of resources in the

economy.

• The long-run aggregate supply schedule (LAS) will be vertical.

• Any increase in aggregate demand will simply have the effect of raising the price
and demand management is futile!

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Keynesian view:

• If aggregate supply is vertical in the long run, this seems to suggest that all
resources (including labour) are fully employed.

• However, we know that there are always some workers who are unemployed, at
least temporarily.

• When there is unemployment, an increase in aggregate demand will cause output

to increase as those people who are unemployed will back to work.

• Therefore, the AS schedule will be upwards-slopping for levels of output where

there is unemployment.

AS
P

AD

ܻത Y

• Even when the economy is at its full employment, in the short run, it is possible to
increase output above the long-run equilibrium level.

• This is achieved through additional overtime work from employees, retired people
and people at home with children etc..

• However, when we reach the point of full employment, the short-run increase in
national output may cause price to increase which will reduces the money supply,
hence the national output.

• Therefore, the only feasible mechanism of adjustment is through price adjustment

in a full-employment situation.

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• In the Keynesian context, demand management will be effective as long as there
is unemployment in the economy. In particular, it will be an effective instrument
in alleviating unemployment.

• However, at full employment, the Keynesian supply will have the same
relationship with prices as the classical aggregate supply.

6. Combining AD and AS

LAS
P

SAS

P0 A

AD

ܻത

• We take both views of aggregate supply but distinguish between the short-run and
long-run aggregate supplies.

• The short-run Aggregate Supply that is upward slopping and the long-run
Aggregate Supply is vertical (classical) aggregate supply.

• The model implies that demand management could be effective in the short run.
That is, increasing Aggregate Demand increases both price and national income.

• However, in the long-run, demand management is not effective. Increases in

aggregate demand will only end up higher prices in the long run.

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7. AD - AS with Labor Market

LAS
P

SAS

P0 A

AD

ܻത

• Suppose there is an increase in aggregate demand, the AD curve will shift to right.
Prices will increase from P0 to P1.

• For the same level of nominal wages, a higher price level would imply that the
real wages that workers are getting are lower than before, that is:

w0 w0
<
P1 P0

• In the long-run, when wage negotiations open, workers will demand a

compensation for the increase in prices from P0 to P1. They will also want to be
compensated for the increase in price that will follow the increase in their nominal
wages. Hence, nominal wages will increase to ‫ݓ‬ଵ .

• As money wages rise, firms will be forced to reduce their supply and raise prices
even further in order to pass the increase in wage to consumer. SAS will shift to
the left, price increases to ܲଶ . At this price, the real wages is at the same level as
when the prices is ܲ଴ . That is,

w1 w0
=
P2 P0

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Exercise:
Analyze the impact of a fall in aggregate demand on the AD-AS model.

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8. Working of AD, AS framework—prices and wages are flexible

8.1. Fiscal Expansion

r LM ( M 0 , P2 )
LM ( M 0 , P1 )
LM ( M 0 , P0 )
C
r2 B
r1

r0
A

IS ( G1 , T0 )
IS ( G0 , T0 )
Y0 Y1 SAS ( w1 ) Y
P
SAS ( w0 )

C
P2
P1 B
P0
A

AD ( G1 , T0 , M 0 )
AD ( G0 , T0 , M 0 )
Y0 Y1 Y

• Starting from the long run equilibrium in which ܲ = ܲ଴ and ܻ = ܻ଴ ,

expansionary fiscal policy (e.g. government increases G or decreases T)
increases aggregate demand and shifts the IS curve to the right. The increase in
aggregate demand will increase output. It will also increase the interest rate which
will decrease demand for investment.

• The fiscal expansion and the consequent decrease in demand for investment will
shift the AD curve to the right. However, the distance between the two AD curves
will be smaller than the distance between the two IS curves.

• Following the rightward shift in the AD, price level increases to P1, which implies
1) Actual price level is higher than expected price level.
2) Real money supply decreases which will shift the LM curve to the left.
3) Real wage is also lower and workers are worse off at B than at A.

• In the short-run at B, output, price and interest rate are higher.

• In the long run, when wage negotiations open, workers will demand a
compensation for the increase in prices from P0 to P1. They will also want to be

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 compensated for the increase in price that will follow the increase in their nominal
w w
wages. That is, workers will negotiate for higher nominal wage until 0 = 1 .
P0 P2
• The increase in nominal wage will reduce the short-run aggregate supply as
producers pass the increase in cost to consumers. This will shift the SAS to the
left. Consequently, price level increases to P2.

• Higher price level will lower real money supply further which will shift the LM
curve further to the left until Y = Y0 . At C, the equilibrium interest rate is higher
and nominal wage is also higher.

8.2. Monetary Expansion

r LM ( M 1 , P2 ) LM ( M 0 , P0 )
LM ( M 1 , P1 )
LM ( M 1 , P0 )

r0 A= C
r1 B

IS ( G0 , T0 )

Y0 Y1 Y
P SAS ( w1 )
SAS ( w0 )

C
P2
P1 B
P0
A

AD ( G0 , T0 , M 1 )
AD ( G0 , T0 , M 0 )
Y0 Y1 Y

• Starting from the long run equilibrium in which ܲ = ܲ଴ and ܻ = ܻ଴ ,

expansionary monetary policy (e.g. Central Bank decreases reserve ratio)
increases money supply and shift the LM curve to the right. A higher money
supply will decrease equilibrium interest rate which will increase demand for
investment.

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• The money expansion and the consequent increase in demand for investment will
shift the AD curve to the right. This will increase price level to P1.

• A higher price level decreases real money supply. This will cause a leftward shift
of the LM curve to point B resulting to:

a. Actual price level is higher than expected price level.

b. Real wage is also lower and workers are worse off at B than at A.

• In the short-run at B, output, price and interest rate are higher.

• In the long run, when wage negotiations open, workers will demand a
compensation for the increase in prices from P0 to P1. They will also want to be
compensated for the increase in price that will follow the increase in their nominal
w w
wages. That is, workers will negotiate for higher nominal wage until 0 = 1 .
P0 P2
• The increase in nominal wage will reduce the short-run aggregate supply as
producers pass the increase in cost to consumers. This will shift the SAS to the
left. Consequently, price level increases to P2.

• Higher price level will lower real money supply further which will shift the LM
curve further to the left until Y = Y0 . At C, interest rate stays the same level but
nominal wage is higher.

Example
In an election year, the government increased its spending by borrowing from the
public. To prevent an increase in the interest rate, the government persuaded the
central bank to reduce the reserve ratio for commercial banks. The opposition accused
the government of sowing the seeds of recession while mortgaging the future
(reducing investment).

a) Discuss the opposition accusations in a closed economy with fixed prices and
fixed wages;
b) Discuss the opposition accusations in a closed economy with flexible prices and
flexible wages.

Answer:

a)

• The increase in government's spending financed by borrowing from the public

shifts the IS curve to the right. Hence, at any level of interest rate, equilibrium
can only be obtained at a higher level of output.

• Reducing reserve ratio increases the money supply which shifts the LM
downwards, leading to a lower equilibrium level of interest rates for a given level
of output.

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• In a closed economy with fixed prices and fixed wages, the impacts of both
policies will increase the equilibrium output. However, the equilibrium interest
rate will remain at the same level as before.

r
LM (M0,P0)

r0

IS (G0,T0)

Y0 Y

The opposition was wrong about recession and 'mortgaging the future' (the increase in
interest rates will reduce demand for investment).

b) A closed economy with flexible wages:

• The fiscal and monetary expansions increase aggregate demand which will
increase equilibrium output. This will shift the AD to the right and increase price
level from P0 to P1.

• Higher price level decreases real money supply. This will shift the LM slightly
back.

• In the short-run (point B) when wages are fixed, the impacts from both policies
will result in a higher price level and higher output. However, the level of interest
rate at B will be about the same as at A.

• At B, real wages are lower than before, as nominal wages are unchanged but
prices are higher.

• In the long-run, when wage negotiations open, workers will demand a

compensation for the increase in prices from P0 to P1. They will also want to be

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 15

 compensated for the increase in price that will follow the increase in their nominal
wages.

• As money wages rise, firms will be forced to reduce their supply and raise prices
even further in order to pass the increase in wage to consumer. SAS will shift to
the left and price increases.

• As higher price reduces real money supply, the LM will shift to the left to reflect
the fall in real money supply.

• In the long-run at point C, nominal wages will be higher even though real wages
will be the same as at A. Interest rate will be higher.

• The opposition was wrong about recession but right about 'mortgaging the future'
(the increase in interest rates will reduce demand for investment).

P
‫ܯܮ‬ሾ‫ܯ‬଴ , ܲ଴ ሿ

r0 A

‫ܵܫ‬ሾܶ଴ , ‫ܩ‬଴ ሿ

ܻത
LAS
P

ܵ‫ܵܣ‬ሾ‫ݓ‬଴ ሿ

P0 A

‫ܦܣ‬ሾܶ଴ , ‫ܩ‬଴ , ‫ܯ‬଴ ሿ

ܻ଴

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 16

Homework

1. Analyze the impact of a contractionary fiscal policy on an economy when prices

and wages are flexible.

2. Analyze the impact of a contractionary monetary policy on an economy when

prices and wages are flexible.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 17

 Macro 7 – 2: Inflation and the Phillips Curve

• Macroeconomic analysis started with the problem of unemployment, until

attention shifted to the problem of increasing prices during the boom years of the
1950s and 1960s.

• Inflation is the rise in the general level of prices of goods and services in a given
economy over a period of time.

• In the 1970s, however, another problem came to the attention of economists. As a

result of the oil price shocks, many industrialised economies experienced the
strange occurrence of increases in prices with concurrent unemployment, a
phenomenon known as stagflation.

1. The Philip Curve

• A first approach that was developed in response to these problems was the Phillips
Curve.

• The Phillips curve is a historical inverse relation between the rate of

unemployment and the rate of inflation in an economy.

• Stated simply, the lower the unemployment in an economy, the higher the rate of
change in wages paid to labor in that economy, in data from a number of
countries and historical periods.

∆w
U >U :
U <U :

U U

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• The Philip Curve shows an interesting empirical correlation between the rate of
change of nominal wages and the level of unemployment,

wt − wt −1
∆wt = = −ε (u − u )
wt −1

u >u
Note:
u<u

• ∆: Represents the rate of change:

1) If wages in period t are $150 now at time ‘t’ and $100 in the previous period, ‘t –
1’, then wages increased at a rate of 50%.

2) If wages in period t are $50 now at time ‘t’ and $100 in the previous period, ‘t –
1’, then wages increased at a rate of -50%.

• Let u —the level of unemployment for which wages remain unchanged—the

'natural rate’ of unemployment.

• When unemployment exceeds the 'natural rate', wages will fall. Conversely, wages
will increase whenever (u - u ) < 0.

Note: The above relationship shows that Philip Curve is not a theory of the
relationship between wages and unemployment. Rather, it is an empirically observed
regularity only.

• We can rewrite the above relation in the following way:

wt − wt −1
∆wt = = −ε (u − u ) ;
wt −1

wt − wt −1 = − wt −1ε (u − u ) ;

wt = wt −1 − wt −1ε (u − u )

wt = wt −1 [1 − ε (u − u )]

Note:
[ ( )]
u > u ⇒ 1− ε u − u <1
u < u ⇒ [1 − ε (u − u )] > 1

This can be interpreted as:

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 2

 • When wages are determined, labourers will want to keep their wages at least at
the current level.

• Whether they succeed depends on their bargaining power. Their bargaining

power depends on the level of unemployment (u − u ) .

[ ( )]
u > u ⇒ 1− ε u − u <1
u < u ⇒ [1 − ε (u − u )] > 1

• If the level of unemployment is high, their bargaining power is likely to be

low, since employers can easily find other, currently unemployed workers,
who will be willing to work for lower wages.
(u − u ) > 0 ⇒ wt < wt −1 ;(u − u ) < 0 ⇒ wt > wt −1

2. Theory of Inflation

• We now need a pricing theory to translate these empirical findings into a theory
of inflation.

• Recall from microeconomics that competitive firms will price at marginal cost,
i.e.,
w
P = MC =
MPL

• However, across an entire economy, not all markets are necessarily competitive:
some industries might price above marginal cost.

• Hence, instead of marginal productivity, we use 'average productivity'—‘a’.

• Similarly, we allow for some prices being above marginal cost by using an average
‘mark up’ ‘z’. Price is then determined as:

wt w
Pt = (1 + z ) and Pt −1 = (1 + z ) t −1
a a

As wt = wt −1 [1 − ε (u − u ) ] , then
w 1
Pt = (1 + z ) t = (1 + z ) wt −1 [1 − ε (u − u ) ] = Pt −1 [1 − ε (u − u )]
a a
Pt Pt P −P
= [1 − ε (u − u )]; − 1 = − ε (u − u ) and t t −1 = − ε (u − u )
Pt −1 Pt −1 Pt −1

∆P = − ε (u − u )

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 3

∆P = − ε (u − u ) produces the famous idea of a trade-off between inflation and
unemployment.

∆P U >U :
U <U :

U
U

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• This theoretical result has significant policy implication. The implication is
that a government can lower unemployment by increasing inflation.

• Indeed, the theory had been frequently practiced until the Augmented Philip Curve
was discovered by Friedman and Phelps.

• As unemployment and output are closely related, that is,

U > U ⇒ U − U > 0 ⇒ −ε (U > U ) < 0 ⇒

− ε (u − u ) = φ (Y − Y )
U < U ⇒ U − U < 0 ⇒ −ε (U > U ) > 0 ⇒

• We can then draw the Phillips Curve in inflation—output space, giving us

(almost) an aggregate supply function:

∆P

Y Y

• The above relation is a theory that relates inflation to output. It can be expressed as

∆P = − ε (u − u ) = φ (Y − Y )

• It seems to support the idea of an upward-slopping AS curve in the

output-price levels plane.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 5

 3. Theory of Inflation— the Augmented Philip Curve

• We have looked at wt = wt −1 [1 − ε (u − u ) ] . Friedman and Phelps argued that the

explanatory power of this equation is unsatisfactory. WHY?

w
• Workers worry about the real wage .
P

• If workers expect an increase in prices in the coming period, they know that their
real wages will fall.

• If an increase in price is expected, it will only be natural for them to ask for
nominal compensation for the expected price increase.

w0
• At time 0, the real wage is , and labourers expect prices to increase by ∆P,
P0
w
then, without adjustment, their real wage level would be lower than 0 . It equals
P0
w0
to
P0 (1 + ∆P)

• Labourers will then demand an increase in nominal wages such that the level of
real wages is at least unchanged. This implies that ∆w = ∆P such that

w1 w0 (1 + ∆w) w0
= =
P1 P0 (1 + ∆P) P0

• The current wage level should be that,

wt = wt −1 [1 + ∆P e − ε (u − u ) ]

where ∆P e represents the expected increase in price levels.

Exercise
Compare wage levels between the original Philip Curve and the augmented Philip
Curve when the rate of unemployment equals to the natural rate of unemployment.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 6

• Deriving the augmented Phillips Curve

wt w
Pt = (1 + z ) and Pt −1 = (1 + z ) t −1
a a
As wt = wt −1 [1 + ∆P − ε (u − u ) ] , then
e

w 1
Pt = (1 + z ) t = (1 + z ) wt −1 [1 + ∆P e − ε (u − u ) ]
a a
Pt = Pt −1 1 + ∆P − ε (u − u ) 
e

Pt
= 1 + ∆P e − ε (u − u )
Pt −1
Pt
= − 1 = ∆P e − ε (u − u )
Pt −1
∆P = ∆P e − ε (u − u )

• As − ε (u − u ) = φ (Y − Y ) , we thus have

∆P = ∆P e + φ (Y − Y )

• This suggests that there is a separate Phillips Curve for each level of expected
price increases. (The original trade-off between inflation and unemployment
reflected a zero expected price increase.)

∆P
LRPC (
P.C. ∆P2e > 0 )
(
P.C. ∆P1e > 0 )

(
P.C. ∆P e = 0 )

Y Y

• Assuming people are rational, and properly understand the way in which the
economy works, their expectations will be correct in the long run.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 7

• This means that the expected price increase will equal actual realized inflation in
the next period:
∆Pe = ∆P

• As ∆P = ∆P e + φ (Y − Y ) , this implies that in the long run Y = Y . That means in

the long-run supply is vertical. This yields a long-run Phillips curve which is
vertical.

Homework

2002 Zone A,B Q6/9

The findings represented by the Phillips curve support the Keynesian views on
aggregrate supply. True or false, explain.

2003 Zone A Q6/9

Without ‘rational expectations’, the classical view of economics will have to be
rejected. True or false, explain.

2003 Zone B Q6/9

We cannot deduce an upward slopping aggregate supply curve from the findings
revealed by the Phillips Curve. True or false, explain.

2004 Zone A Q6/9

‘The Phillips curve is merely a set of observations. Surely it cannot help in explaining
anything’. True or false, explain.

2004 Zone B Q6/9

‘The Phillips curve has brought near the opposing views of Keynesian and Classical
economists’. Comment on the statement.

2005 Zone A,B Q6/9

‘The phillip curve demonstrates that the Keynesian interpretation of aggregate supply
is the correct one’. Discuss.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 8

 Macro 8 – 1 : The open economy – the National Accounts

• An open economy is an economy in which its households, firms and the government
(domestic residents) can trade goods, services and financial assets with households, firms
and governments of other countries (foreign residents).

• The fundamental relationship between NNP and Y still holds in an open economy. That is,

ܰܰܲ ൌ ܻ

• However, when the economy is open, part of the national products are exported to foreign
markets (Export is denoted as X).

• On the use of income, part of national income is spent to import foreign goods (Import is
denoted as IM).

• Hence, the new national accounts identity is,

NNP = Y
C + I + G+ X = C + S + T + IM
C + I + G + (X – IM) = C + S + T

• We call the difference between export and import as Net Export (denoted as NX):

NX = X – IM

• The value of net export is shown in the economy’s Current Account (also denoted as
NX). The current account records all transactions in goods and services with foreign
economies.

• A Positive NX (X > IM ) represents a surplus in the current account (export is more than
import).

• A Negative NX (X < IM ) represents a deficit in the current account (import is more than
export).

• As NNP = Y, investment is now financed by private savings, pubilc savings and net
import which is equivalent to borrowings from forign economies. This is shown below,

NNP = Y
C + I + G+ X = C + S + T + IM
C + I + G + (X – IM) = C + S + T
I = S + (T – G) + (IM – X )

• Note that in a closed economy with government, increases in total savings, public and
private savings, will necessary increase private investments.

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 • In an open economy, an increase in public and private savings might not lead to an
increase in investment if there is a simultaneous fall in net import.

∆I = ∆S + ∆ (T − G ) + ∆ ( IM − X )

• Any change in investments will depend on the changes in these three sources of finance,
privat saving, public saving and net imports.

Exercise:
Determine the signs ( > 0 or < 0) for the following:

1. Government has a budget deficit.

2. Increase in government deficit (greater the government deficit).

3. Fall in government deficit.

4. There is private saving.

5. Current account is having deficit.

6. Increase in current account deficit (greater the current account deficit).

7. Fall in current account deficit.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 2

Example:
1. "A closed economy cannot be in equilibrium if private savings do not equal to investment.
For similar reasons, in an open economy, a budget deficit of the same size as the current
account deficit will make actual investment entirely dependent on private savings".
Comment on these statements.

In a closed economy with a government, the national accounts identity shows that,

NNP=Y
C + I + G = C + S + T;
I = S + (T – G)

It is not necessary that investments must equal to private savings in order for the economy to
be in equilibrium.

For the economy to be in equilibrium, actual investments must be equal to total savings,
private savings (S) and public savings (T – G).

In an open economy,
NNP = Y
C + I + G+ X = C + S + T + IM
C + I + G + (X – IM) = C + S + T

And, I = S + (T – G) + (IM – X )

If - (T – G) = (IM – X ).
then I = S + (T – G) +(IM – X )= S

That is, a budget deficit of the same size as the current account deficit, then actual investment
will be equal to private savings.

2. An increase in government deficit accompanied by an increase in net import of the same

size will leave actual domestic investment intact. True or false, explain.

In an open economy,
NNP = Y
C + I + G+ X = C + S + T + IM
C + I + G + (X – IM) = C + S + T

So, I = S + (T – G) + (IM – X )

Further, ∆I = ∆S + ∆ (T − G ) + ∆ ( IM − X )

Any change in private investments depends on the changes in three sources of finance, privat
saving, public saving and net imports.

As the government is having deficit, this implies that (T – G) < 0. An increase in government
deficit means ∆(T – G) < 0.

An increase in net import implies ∆ (IM – X) > 0.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 3

If the increase in government deficit is accompanied by an equal increase in net import, then
∆(T – G) + ∆(IM – X )= 0.

This implies ∆I = ∆S .

To leave actual domestic investment intact, i.e., ∆I = 0, it has to be that ∆ S = 0, i.e., there is
no change in private saving.

Thus, whether the investment will remain intact or not depends on private savings, i.e.,
∆I = ∆S .

Homework

1. In an open economy, when the government deficit equals private savings, there will not
be any domestic investment unless the current account is in deficit. True or false, explain.

2. As long as the deficit in the current account is equal to the size of the government deficit,
domestic investment will remain equal to the private savings. True or false, explain.

3. For a given level of savings, investment will fall further the greater is the deficit in the
current account. True or false, explain.

4. A fall in the government deficit which is equivalent to a fall in net exports will have no
effect on domestic investment. True or false? Explain.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 4

 Macro 8 - 2: Open Economy - Exchange Rate and Capital Mobility

1. Nominal Exchange Rate (Price of Foreign Currency)

- Nominal Exchange Rate is the amount of domestic currency required to pay for 1
unit of foreign currency. It is denoted as EDC/FC.

- In 2003, exchange rate for Singapore Dollar to US Dollar is E = 1.67. This means
that we need S$1.67 to buy US$ 1.

- When E increases, more units of domestic currency are required to buy one unit of
foreign currency. We say that domestic currency depreciates and foreign currency
appreciates.

- When E decreases, less units of domestic currency are required to buy one unit of
foreign currency. We say that domestic currency appreciates and foreign currency
depreciates.

2. Real Exchange Rate (ε, Price of Foreign Product in Real Term)

- Real exchange rate (ε) shows the rate of exchange between domestic and foreign
product. The following example shows its derivation.

- Suppose we want to buy a unit of domestic goods, we need S$P to buy one unit of
domestic good. Where P is the domestic price level.

- When we import goods from oversea market, we don’t pay Singapore dollar,
rather, we use US$ as the means of payment.

- How much S$ is required if we need to buy a unit of foreign product? The answer
comes in two parts.

- First, we have to convert our local currency into the foreign currency. Then, we
pay for the foreign product according to its price using foreign currency.

- If the foreign price level is P*, then we need P* units of foreign currency to buy
one unit of foreign product.

- In terms of domestic currency, this will cost us EP* if the nominal exchange rate
is E.

- If the domestic price level is P, then this amount of domestic currency would have
bought us:

EP *
ε= units of domestic product.
P

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 EP * 1.67 × 50
- For example: P* = 50, E = 1.67, P = 100 and = = 0.835 . This
P 100
means that it costs us 0.835 units of domestic product to buy one unit of foreign
product.

EP *
- gives us the rate of exchange between domestic and foreign product. It tells
P
us how many units of domestic product we need to exchange for 1 unit of foreign
product. This is called the real exchange rate.

- If the real exchange rate is above 1, that means the goods abroad is more
expensive than goods in domestic country. This might encourage foreign citizens
to consume domestic goods, hence, demand for export increases.

EP *
- If P increases: More units of domestic goods are required to exchange for one
unit of foreign goods. Domestic goods are more competitve.

EP *
- If P decreases: Less units of domestic goods are required to exchange for one
unit of foreign goods. Domestic goods are less competitve.

3. Impact of Real Exchange Rate on Demand for Export and Demand for
Import

- The demand for exports is a function of the real exchange rate. That is:

EP * EP *
X( ) = X0( )
P P

- When real exchange rate increases, it costs more units of domestic products to buy
one unit of foreign product. Compare to domestic products, foreign product is now
more expensive.

- Thus, export is increasing when the real exchange rate increases and decreasing
when the real exchange rate decreases.

- Demand for imports depends not only on the real exchange rate, but also on
income. Specifically,
EP * EP *
IM ( , Y ) = IM 0 ( ) + mY
P P

where ‘ 0 < m < 1’ is the Marginal Propensity to Import

- When real exchange rate increases, it costs more units of domestic products to buy
one unit of foreign product. Compared to domestic products, foreign product is

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 2

 now more expensive. An increase in the real exchange reduces the quantity which
we wish to import.

- Further, whenever income increases, demand for imports will increase.

Exercise:
Assuming that other things being equal, determine the impact of the following
changes on demand for export and demand for import.

Impact on Export Impact on Import

E increases
P increases
P* increases
Y increases

4. Equilibrium and Multiplier in Open Economy

- The aggregate demand, adjusted for the effects of imports and exports, can be
written as follows:

EP * EP * EP *
E(Y, r, ) = C(Y, T) + I(r)+ G + X( ) – IM( ,Y )
P P P
EP *  EP * 
= C0 + c1(Y – T0 ) + I0 - I1r + G0 + X 0 ( ) −  IM 0 ( ) + mY 
P  P 
EP * EP *
= C0 + c1(Y – T0 )+ I0 - I1r + G0 + X 0 ( ) − IM 0 ( ) − mY
P P
EP *
[
= C0 + c1Y – c1T0 + I0 - I1r + G0 + X 0 − IM 0 ( ] ) − mY
P
EP *
= { [
C0 - c1T0 + G0 + I0 - I1r+ X 0 − IM 0 (] ) } + ( c1 – m)Y
P
EP *
= A(r, G0, T0, ) + ( c1 – m)Y
P
- In equilibrium,
E 0 P0 *
E(Y, r0, )= Y0
P0
E 0 P0 * E P*
E(Y, r0, )= A(r0, G0, T0, 0 0 )+( c1 – m)Y = Y
P0 P0
E 0 P0 * 1
Y = A(r0, G0, T0, )
P0 1 − (c1 − m)

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 1
- Under a closed economy with Lump-sum tax, Y = A(G0 , T0, r0) .
1 − c1
- Note that the multiplier under an open economy is smaller than that of a closed
economy.

Exercises:
1) Derive the multiplier for an open economy with a proportional tax system.

2) Compare the slope of IS curves between a closed economy and an open

economy with a proportional tax system.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 4

5. Exchange Rate Regimes

- Nominal exchange rate can be fixed or flexible.

- Under a fixed exchange rate regime, countries maintain a constant exchange rate
or, equivalently, central parity between their currencies.

- In contrast, under a flexible exchange rate the relative price between two
currencies is free to fluctuate and there is no explicit commitment to maintain a
specific parity.

a) Flexible exchange rate

- When exchange rate regime is flexible, the central bank does not intervene in the
exchange rate movements. The nominal exchange rate will adjust to equate the
demand for foreign currency with the supply.

- An excess demand for foreign currency will cause the domestic currency to
Depreciate, and E will rise.

EP *
- Consequently, the real exchange rate ( ) will increase which will increase the
P
demand for exports and reduce the demand for imports.

- The adjustments in nominal exchange rate and current account will restore the
economy to a new equilibrium.

E
Sfc

E0

Dfc

Qfc

- An excess supply for foreign currency will cause the domestic currency to
Appreciate, and E will Fall.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 5

 EP *
- Consequently, the real exchange rate ( ) will decrease which will increase
P
demand for import and reduce demand for exports.

- The adjustments in nominal exchange rate and current account will restore the
economy to a new equilibrium.

E
Sfc

E0

Dfc

Qfc

b) Fixed exchange rate

- To fix the exchange rate, the central bank must stand ready to buy or sell domestic
currency/foreign currency at the stipulated exchange rate, E .

- Whenever demand for foreign currencies from the domestic economy exceeds
supply available, there will be an excess demand for foreign currency.

- If the central bank does not intervene, the exchange rate will increase.

- To fix the exchange rate, the central bank will sell foreign currency to eliminate
the excess demand.

- When the central bank sells foreign currency, its foreign currency reserves1 will
decrease.

- When the central bank sells foreign currency, it buys back domestic currency;
hence, the domestic money supply will decrease.

1
Governments in an open economy hold foreign currency as foreign currency reserve. The foreign
currency reserve allows the governments to purchase domestic currency which is considered as
liabilities of central banks. The operation helps to stabilize the domestic currency.

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 Domestic Central
Economy Bank

- Whenever demand for foreign currencies is less than supply, there will be an
excess supply of foreign currencies.

- If the central bank does not intervene, the exchange rate will fall.

- To fix the exchange rate, the central bank will buy back foreign currency to
eliminate the excess supply.

- When the central bank buys back foreign currency, its foreign currency reserves
will increase.

- When the central bank buys back foreign currency, it pays for it by domestic
currency; hence, money supply will increase.

Domestic Central
Economy Bank

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6. Capital Mobility

- In an open economy, trades with foreign firms and governments include trades in
goods and services.

- They also include trades in financial assets, such as stocks and bonds, if capital is
mobile between economies.

- In this course, we study two extreme cases of mobility. That is, capital is either
perfectly mobile or there is no capital mobility(zero capital mobility).

a) Zero capital mobility

- This happens when governments do not allow for any capital movements between
domestic and foreign economies.

- That is, domestic(foreign) citizens are not allowed to hold foreign(domestic)

financial assets.

- As a result, zero capital mobility excludes the demand and supply of foreign
currency generated by the capital account.

b) Perfect capital mobility

- It means capital movements between domestic and foreign economies is allowed.

Domestic(foreign) citizens can hold foreign(domestic) financial assets.

- With perfect capital mobility, investors must be indifferent in equilibrium between

holding assets denominated in any two currencies.

- This requirement means that risk-free interest rates (the interest rates on
government bonds) must be equalized across any pair of countries.

- If the rates of return for foreign assets(government bonds) are higher than the rate
of return for domestic asset (r* > r), domestic investor will hold foreign rather
than domestic assets.

- To do that, they need to convert domestic currency to foreign currencies and use
foreign currencies to purchase the foreign assets.

- This process is equivalent to domestic investors selling domestic currency to buy

(demand) foreign currencies and spend them in the foreign country.

- Demand for foreign currency will increase and there will be capital outflows.

- If the rate of return for domestic asset are higher than the foreign assets(r* < r),
foreign investor will hold domestic assets.

- To do that, they need to buy domestic currency using foreign currencies and spend
them in domestic market.

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- Supply of foreign currency will increase and there will be capital inflows.

- We can thus conclude that,

Capital Flows Investors’ Actions Impact on foreign currency market

r > r* Inflow Sell FC to buy DC Excess Supply of FC
r < r* Outflow Sell DC to buy FC Excess Demand for FC

7. The Balance of Payments

- The balance of payments keeps records of an open economy’s sources of foreign

currency, and the uses of foreign currency

- There are three accounts in the balance of payments. They are:

1) The current account

2) The capital account
3) Changes in government reserves

- A complete picture of BOP is shown below,

Foreign currency
Sources of Uses of
Current Account Export (X) Import (IM)
Capital Account Foreigners buying domestic assets Locals buying foreign assets
Reduction in reserves Increase in reserves
Reserves
(M supply decreases) (M supply increases)

- Apart from a statistical discrepancy, the current account, the capital account and
the foreign currency reserve sum to zero by construction. That is:

BOP = 0

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 9

Homework
1. What is nominal exchange rate? What is real exchange rate? What will happen to demand for
imports and demand for exports when elements inside real exchange rate (E, P*, P) change? What
will happen to demand for import and demand for export when national income, Y, increases?

2. When nominal exchange rate is fixed and there is no capital mobility, what will happen to
domestic money supply if current account is in surplus? What will happen to domestic money
supply if current account is in deficit?

3. When nominal exchange rate is flexible and there is no capital mobility, what will happen to
demand for import and demand for export when current account is in surplus? If current account is
in deficit?

4. When r > r* (domestic rate of returns is higher than the international rate of returns), what actions
will the central bank take when capital is perfectly mobile and nominal exchange rate is fixed?
When r < r*?

5. When r > r* (domestic rate of returns is higher than the international rate of returns), what will
happen to demand for import and demand for export when capital is perfectly mobile and nominal
exchange rate is flexible? When r < r*?

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 10

 Macro 8 - 3: Open Economy - General Equilibrium

• When an open economy is in equilibrium, its internal markets and external market
are both in equilibrium.

• Internal equilibrium refers to simultaneous equilibrium in the goods and money

markets. External equilibrium (balance-of-payments equilibrium) refers to
equilibrium in the foreign exchange market.

• Depending on regimes of exchange rate and if capital is perfectly mobile, the open
economy can be classified into four regime shown below,

No Capital Perfect Capital

Mobility Mobility
Fixed Exchange Rate 1 3
Flexible Exchange Rate 2 4

1. Open economy with No Capital Movements and with Fixed Exchange Rate

• External equilibrium requires the net export is zero when exchange rate is fixed and
there is no capital mobility. That is:

EP * EP *  EP * 
NX ( ,Y ) = X 0 ( ) −  IM 0 ( ) + mY 
P P  P 
EP * EP *
= X0( ) − IM 0 ( ) − mY
P P
EP *
= [ X 0 − IM 0 ] ( ) − mY
P
NX

EP *
[ X 0 − IM 0 ] ( )
P

Y0 Y

NX

• Thus, under an open economy without capital movement and with fixed exchange
rate regime, there is only one level of income under which current account will be
balanced. If Y0 is the equilibrium level of income, then:

1) When Y < Y0, NX > 0

2) When Y > Y0, NX < 0

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 1

 3) When Y = Y0, NX = 0

• Graphically, when the NX function intersects the horizontal axis, we have NX = 0.

Translating the NX function into the IS-LM framework, we have the following,

45’

E = C + I + G + (X – IM)

EP *
[ X 0 − IM 0 ] ( )
P

Y0
NX

EP*
NX ( ) =0
P

LM [M0,P0,]

r0 A

E0 P0*
IS [G0,T0, ]
P0

Y0

• The equilibrium level of income dictates the position of NX = 0 constrain in the

IS - LM framework. The vertical NX = 0 line is unaffected by interest rate, but its
position depends on the real exchange rate.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 2

1.1. Expansionary Fiscal Policy

 E P* 
NX  0 0  = 0
 P0 
r
LM ( M 1 , P0 )
LM ( M 0 , P0 )

r2 C
r1 B
r0 A

 E P* 
IS  G1 , T0 , 0 0 
 P0 
 E0 P0* 
IS  G0 , T0 , 
 P0 

Y0 Y1 Y

• The IS schedule shifts to the right. At point B, both interest rate and output are
higher.

• The higher interest rate has no effect on capital flows as capital is not mobile.
However, the increase in income increases demand for import which results in an
increase in demand for foreign currency. The current account is now in deficit.

• The deficit in current account creates upward pressure on the nominal exchange
rate. With a fixed exchange rate, official intervention is required to push up the value
of the domestic currency.

• To do this, the central bank sells foreign currency and buys back domestic currency.
Consequently, domestic money supply falls which shifts the LM curve to the left. In
equilibrium, output remains at the same level ( Y0 ).

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 3

1.2. Expansionary Monetary Policy

 E P* 
NX  0 0  = 0
 P0 
r LM ( M 0 , P0 )

LM ( M 1 , P0 )

r0 A
r1 B

 E P* 
IS  G0 , T0 , 0 0 
 P0 

Y0 Y1 Y

• The LM schedule shifts to the right. At point B, interest rate is lower but output is
higher.

• The lower interest rate has no effect on capital flows as capital is not mobile.
However, the increase in income increases demand for import which results in
increase in demand for foreign currency. The current account is now in deficit.

• The deficit in current account creates upward pressure on the nominal exchange
rate. With a fixed exchange rate, official intervention is required to push up the value
of the domestic currency.

• To do this, the central bank sells foreign currency and buys back domestic currency.
Consequently, domestic money supply falls which shifts the LM curve to the left. In
equilibrium, output remains at the same level ( Y0 ).

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 4

2. Open Economy with No Capital Mobility and with Flexible Exchange Rate

• External equilibrium requires the net export is zero when exchange rate is flexible
and there is no capital mobility.

• Under flexible exchange rates, the central bank does not intervene in the market for
foreign exchange. The exchange rate must adjust to clear the market so that the
demand for and supply of foreign exchange are in balance.

• The absence of intervention implies that there will be no NX = 0 constraint. Any

current account deficit must put upward pressure on exchange rate; any
current account surplus must put downward pressure on exchange rate.

• For instance, current account deficit causes an excess demand for foreign currency.
As a result, nominal exchange rate will increase. Consequently, a higher nominal
exchange rate will improve competitiveness and bring down current account deficit.

( X < IM
DFC > SFC
E rises
X increases and IM decreases)

• Current account surplus causes an excess supply of foreign currency. As a result,

nominal exchange rate will fall. Consequently, a lower nominal exchange rate will
lower current account surplus.

( X > IM
DFC < SFC
E falls
X decreases and IM increases)

• Since the central bank does not have the obligation to intervene, it can set the
monetary supply at will. There is no automatic link between the balance of
payments and the money supply.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 5

2.1. Expansionary Fiscal Policy

r
LM ( M 0 , P0 )

r2 C
r1 B
r0 A
 E P* 
IS  G1 , T0 , 1 0 
 P0 
 E P* 
IS  G1 , T0 , 0 0 
 P0 
 E P* 
IS  G0 , T0 , 0 0 
 P0 

Y0 Y1 Y2 Y

• The IS schedule shifts to the right. At point B, both interest rate and output are
higher.

• The higher interest rate has no effect on capital flows as capital is not mobile.
However, the increase in income increases demand for import which results in an
increase in demand for foreign currency. The current account is now in deficit.

• With a flexible exchange rate and the absence of central bank intervention, this
deficit will increase the nominal exchange rate and also the real exchange rate.

• The higher real exchange rate increases demand for exports and decreases demand
for imports. The IS curve shifts further to the right as net exports rises.

• At C, the level of income at which the balance of payments is in equilibrium is now

higher at Y2 .

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 6

2.2. Expansionary Monetary Policy

LM ( M 0 , P0 )

r LM ( M 1 , P0 )

r0 A C
r1 B

 E P* 
IS  G0 ,T0 , 1 0 
 P0 
 E P* 
IS  G0 , T0 , 0 0 
 P0 

Y0 Y1 Y2 Y

• At point B, interest rate is lower but output is higher.

• The lower interest rate has no effect on capital flows as capital is not mobile.
However, the increase in income increases demand for import which results in
increase in demand for foreign currency. The current account is now in deficit.

• With a flexible exchange rate and the absence of central bank intervention, this
deficit will increase the nominal exchange rate and also the real exchange rate.

• The higher real exchange rate increases demand for exports and decreases demand
for imports. The IS curve shifts to the right as net exports rises.

• At C, the level of income at which the balance of payments is in equilibrium is now

higher at Y2 and the equilibrium interest rate is more or less at the same level as
before.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 7

3. Open Economy with Perfect Capital Movement (Perfect Capital Mobility)

• With perfect capital mobility, investors must be indifferent in equilibrium between

holding assets denominated in any two currencies. This requirement means that
risk-free interest rates (the interest rates on government bonds) must be equalized
across any pair of countries.

• If interest rates were not the same then there would be large capital flows towards
the country with the high interest rate and away from the country with the low
interest rate.

• For an open economy, these investment flows would dominate the demand for its
currency stemming from trade, hence the market for foreign exchange can only be in
equilibrium when international investors are indifferent, having no incentive to
reallocate their portfolios from one country to another.

• The actions taken by domestic and foreign investors are shown below,

Capital Flows Investors’ Actions Impact on foreign currency market

r > r* Inflow Sell FC to buy DC Excess Supply of FC
r < r* Outflow Sell DC to buy FC Excess Demand for FC

• Only when r = r*, the balance-of-payments will be in equilibrium. On IS-LM

framework, equilibrium in an open economy with capital mobility thus imposes a
horizontal line as the equilibrium condition. That is, when r = r*, BOP = 0.

LM ( M 0 , P0 )
r

r0 = r * BOP = 0
A

 E P* 
IS  G0 , T0 , 0 0 
 P0 

Y0 Y

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 8

3.1. Fixed Exchange Rate

3.1.1. Fiscal expansion

r
LM ( M 0 , P0 )

LM ( M 1 , P0 )

B
r1
A
r0 = r * BOP = 0
C

 E P* 
IS  G1,T0 , 0 0 
 P0 
 E P* 
IS  G0 , T0 , 0 0 
 P0 

Y0 Y1 Y2 Y

• The IS schedule shifts to the right. At point B, both interest rate and output are
higher.

• The higher interest rate will cause an inflow of capital. Supply of foreign currency
will be greater than demand which creates downward pressure on the nominal
exchange rate.

• With a fixed exchange rate, official intervention is required to push down the value
of the domestic currency.

• To do this, the central bank buys foreign currency and sells domestic currency.
Consequently, domestic money supply rises which shifts the LM curve to the right.

• The process continues until r0 = r * .

• At the new equilibrium, the income is higher than before. Fiscal expansion is
effective.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 9

3.1.2. Monetary expansion

r
LM ( M 0 , P0 )

LM ( M 1 , P0 )

A
r0 = r * BOP = 0
r1 B

 E P* 
IS  G0 , T0 , 0 0 
 P0 

Y0 Y1 Y

• The LM schedule shifts to the right. At point B, the interest rate is lower and the
output is higher.

• The lower interest rate causes a capital outflow while the increase in output leads to
a current account deficit. Demand of foreign currency will be greater than supply.
Thus at B, there is a large payment deficit. This creates upward pressure on the
nominal exchange rate.

• With a fixed exchange rate, official intervention is required to push up the value of the
domestic currency.

• To do this, the central bank sells foreign currency and buys back domestic currency. As a
result, domestic money supply is decreased which shifts the LM curve to the left.

• The process continues until r0 = r * and the initial equilibrium at A is restored. Monetary
expansion is ineffective.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 10

 3.2. Flexible exchange rate
3.2.1. Fiscal expansion

r
LM ( M 0 , P0 )

B
r1
A
r0 = r * BOP = 0

 E P* 
IS  G1,T0 , 0 0 
 P0 
 E P* 
IS  G0 , T0 , 0 0 
 P0 

Y0 Y1 Y

• The IS schedule shifts to the right. At point B, both interest rate and output are
higher.

• The higher interest rate will cause an inflow of capital. Supply of foreign currency
will be greater than demand. This creates downward pressure on the nominal
exchange rate.

• As nominal exchange rate is flexible, an excess supply of foreign currency thus

decreases nominal exchange rate. A lower nominal exchange rate discourages
export and encourages import. Demand for domestic goods thus declines and the IS
shifts back. The process continues until r0 = r * .

• Fiscal expansion is ineffective as it does not change equilibrium output.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 11

3.2.1. Monetary expansion

r
LM ( M 0 , P0 )

LM ( M 1 , P0 )

A
r0 = r *
B
BOP = 0
r1 C

 E P* 
IS  G0 ,T0 , 1 0 
 P0 
 E P* 
IS  G0 , T0 , 0 0 
 P0 

Y0 Y1 Y2 Y

• The LM schedule shifts to the right. At point B, the interest rate is lower and the
output is higher.

• The lower interest rate causes a capital outflow while the increase in output leads to
a current account deficit. Demand of foreign currency will be greater than supply.
Thus at B, there is a large payment deficit. This creates upward pressure on the
nominal exchange rate.

• As nominal exchange rate is flexible, an excess demand for foreign currency thus
increases nominal exchange rate. A higher nominal exchange rate encourages export
and reduces demand for import. Demand for domestic goods will increase and the IS
will shift up and to the right.

• The income will increase further and the process continues until r0 = r * . The
monetary expansion is effective.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 12

 Homework
1. A reduction in the reserve ratio requirement will cause a recession in an open economy with perfect capital
mobility and a flexible exchange rate policy. True or false, explain.

2. An open economy is in equilibrium with a flexible exchange rate. How will the purchase of extra shares in a
foreign country (due to a change in preferences) affect the economy?

3. A decrease in the international interest rate will bring about an increase in output in an open economy with
perfect capital mobility and a fixed exchange rate regime. True or false? Explain your answer.

4. An increase in the marginal propensity to import would have no effect on domestic investment in an open
economy without capital mobility and a fixed exchange rate regime. True or false? Explain your answer.

5. The economy is in recession so the government wishes to induce more activities suggested that the
government should increase its own spending and that it should finance this activity by borrowing from the
public. Critics argue that it is always better to use an expansionary monetary policy, rather than an
expansionary fiscal policy regardless of how the latter is being financed.
a) Show the effects of an expansionary fiscal policy financed by borrowing from the public in
(i) closed economy;
(ii) an open economy with no capital mobility with a fixed exchange rate;
(iii) an open economy with no capital mobility and flexible exchange rate;
(iv) an open economy when there is perfect capital mobility fixed exchange rate and
(v) an open economy when there is perfect capital with a flexible exchange rate.
b) Show the effects of a monetary expansion in all the above cases;

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 13

 Macro 8 - 4: Open Economy – Examples

1. A government with a very large deficit proposes to finance it by a one off borrowing from the
central bank to be followed by a cut in government spending to achieve a balanced budget.
a) Analyse the effects of the policy on a closed economy with fixed and flexible wages and
prices;
b) Analyse the effects of the policy on an open economy without capital mobility and a fixed
exchange rate policy;
c) Analyse the effects of the policy on an open economy with perfect capital mobility and with a
fixed exchange rate policy;
d) How will your answer to (c) change had there been a flexible exchange rate policy?

Suggested answers:
There are two components of government policy, they are:

1) A cut in government spending which is a contractionary fiscal policy. The consequence of this
policy will shift the IS to the left.
2) A one off borrowing from the central bank which increases money supply. This is an expansionary
monetary policy. The consequence of this policy will shift the LM to the right.

The resulting impacts on IS – LM model are shown below,

a) Closed economy with fixed wage and prices

r
LM (M0,P0)

r0

IS (G0,T0)

Y0 Y

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 1


In equilibrium, output will be more or less at the same level as before but equilibrium interest
rate will be lower.

b) Closed econ with Flexible wages and prices

LM (M0,P0)

r0

IS (G0,T0)

SAS(w0)

P0

AD (G0,T0,M0)

Y0

Case 1:

If the increase in money supply completely offset by the fall in government spending, the economy
will mover straight from A to B.

There will be no change in income. However, the equilibrium interest rate will be lower.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 2

 LM (M0,P0)

r0

IS (G0,T0)

SAS(w0)

P0

AD (G0,T0,M0)

Y0

Case 2:

If the effect of increase in money supply is greater than that of fall in Government spending, the
LM will shift further to right.

There will be a higher level of aggregate demand, thus, the AD will shift to right and price will rise
from P0 to P1.

Higher price will shift the LM slightly back, since higher price reduces real money supply.

In the short-run equilibrium when wage is fixed, the economy will end at point B with a higher
prices, higher level of output and interest rate. At B, real wages are lower than before.

In the long-run, when wage negotiations opens, workers will demand a compensation for the
decrease in real wage. They will also want to be compensated for the increase in price that will
follow the increase in their nominal wages.

Nominal wages will increase in the long run. Increases in wages will force employers to increase
price further, SAS will shift to left. LM will also shift to left since higher price reduces real money
supply.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 3


Thus, the economy will move to point C with a higher level of nominal wages but same level of
real wages as at point A. equilibrium interest rate is lower.

c) Open economy with no capital mobility and fixed exchange rate

EP*
NX ( ) =0
P

LM [M0,P0,]

r0

E0 P0*
IS [G0,T0, ]
P0

Y0

Case 1:

If the increase in money supply completely offset by the fall in government spending, the economy
will mover straight from A to B.

There will be no change in national income but the equilibrium interest rate will be lower.

Case 2:

EP*
NX ( )=0
P

LM [M0,P0,]

r0

E0 P0*
IS [G0,T0, ]
P0

Y0

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 4


If the effect of increase in money supply is greater than that of fall in government spending, the
LM will shift further to right and this will bring a rise in national income/output.

Increase in output/income will increase demand for import which will result in an excess demand
for foreign currency.

Under fixed exchange rate without capital mobility, central bank will sell foreign currency and buy
back domestic currency. Consequently, money supply will decrease.

The LM will shift to left and economy will back to its initial equilibrium with lower equilibrium
interest rate.

d) Open economy with perfect capital mobility

Starting with initial equilibrium where r* = r, the composite of policies shift the IS to left and the
LM to right. Consequently, domestic rate of return falls.

There will be an increase in demand for foreign assets. This will lead to an increase in demand for
foreign currency accompanied by an outflow of capital.

Under Fixed Exchange Rate, government will reduce the excess demand in foreign currency by
selling foreign currency. When it does so, its foreign currency reserve decreases.

When government sells foreign currency, it buys back domestic currency. Hence money supply
decreases. The LM will shift to left.

LM [M0,P0,]

r* = r BOP = 0

E0 P0*
IS [G0,T0, ]
P0

Y0

In equilibrium, there will be lower level of income.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 5

 e) Under Flexible Exchange Rate

LM [M0,P0,]

r* = r BOP = 0

E0 P0*
IS [G0,T0, ]
P0

Y0

Starting with initial equilibrium where r* = r, the composite of policies shift the IS to left and the
LM to right. Consequently, domestic rate of return falls.

There will be an increase in demand for foreign assets. This will lead to an increase in demand for
foreign currency accompanied by an outflow of capital.

Excess demand in foreign currency will cause local currency to depreciate. The nominal exchange
rate E will increase.

Increasing in E will increase demand for export and IS will shift to right.

In equilibrium, there will be higher level of national income.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 6

2. In order to alleviate poverty, the government decides to increase its programme of income support
for the poor. Critics of the government argue that such a policy will have no real effect (Y will not
change) and will cost the economy its future (r will be higher implying lower future demand for
investment). Instead, they argue, the government should cut taxes. Analyse the effects of the
government policy and consider the view of its critics:
a) in a closed economy with fixed wages and prices;
b) in a closed economy with flexible wages and prices;
c) In an open economy without capital mobility and a fixed exchange rate policy;
d) in an open economy with perfect capital mobility and a fixed exchange rate;
e) in an open economy with perfect capital mobility and a flexible exchange

Suggested answer:

We need to consider two different policies, i.e., an increase in income support and a tax cut.

To simplify the problem, we assuming a lump-sum tax system. Further, there are two groups of
people in the economy, the rich and the poor. The poor does not pay tax and only the rich people
pay tax.

Let YR be the income earned by the rich. The rich people’s consumption function is:

C R = C0R + c1RYdR = C0R + c1R (YR − T ) = C0R + c1RYR − c1RT

Assuming the poor people earns income of Yp. Their consumption function is:

C P = C0P + c1pYdp

The poor people receive income support from the government. Let a proportion of α of tax paid by
the rich be the amount of transfer given to the poor, the poor’s consumption function will be:

C P = C0P + c1p (YP + aT ) = C0P + c1pYp + ac1pT

Consumption function for the whole economy is the sum of both the poor’s consumption and the
rich’s consumption. It is:

C = C P + C R = C0R + c1RYR − c1RT + C0P + c1pYp + ac1pT

= C0 + c1pYp + c1RYR + T (ac1p − c1R )

Increasing income transfer to the poor increases ‘α’ which is the proportion of tax revenue

dC
transferred to the poor. The impact on consumption is positive as = Tc1p > 0 and the IS will
dα
shift to right.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 7


If a tax cut policy is chosen, the outcome is ambiguous. Whether consumption will increase or not

depends on whether ac1p − c1R > or < 0

If ac1p − c1R < 0 , then the outcome is similar to that of income transfer. Otherwise, the outcome
is a reduction of consumption and the IS will shift to left.

We present an anwer that assumes ac1p − c1R < 0 . That is, there will be a positive impact on the
aggregate demand following both policies. The IS shifts to right for both policies.

a) Closed economy with fixed wage and prices:

r
LM (M0,P0)

r0

IS (G0,T0)

Y0 Y

Either increasing income support or the tax cut will increase output. The equilibrium income and
interest rate will be higher.

If ac1p − c1R > 0 , the effect will similar to a contractionary fiscal policy. In equilibrium, there
will be a lower interest rate and income. A lower interest rate will promote demand for investment.

b) Closed economy with flexible prices and wages and prices

Both the IS and the AD shift to right and prices rise from P0 to P1.

Higher prices will shift the LM slightly back as higher prices reduce real money supply.

In the short-run equilibrium when wage is fixed, the economy will end at point B with a higher
prices, higher output and interest rate.

At B, real wages are lower than before.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 8


In the long-run, when wage negotiations open, workers will demand a compensation for the
increase in prices from P0 to P1. They will also want to be compensated for the increase in prices
that will follow by the increase in their nominal wages.

In the long run, nominal wages will increase. The increases in nominal wages will force employers
to increase prices further, the SAS will shift to left. The LM also shifts to left since higher prices
reduce real money supply.

LM (M0,P0)

r0

IS (G0,T0)

Y0

SAS(w0)

P0

AD (G0,T0,M0)

Y0

In the long run, the economy end at point C with a higher level of nominal wages but the same
level of real wages. Interest rate will be higher as well.

Higher interest rate will reduce demand for investment.

If ac1p − c1R > 0 , the effect will similar to a contractionary fiscal policy.

In equilibrium, there will be a lower interest rate and the same level of income. A lower interest
rate will promote investment.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 9

 c) Open economy without capital mobility and a fixed exchange rate.

EP*
NX ( )=0
P

LM [M0,P0,]

r0

E0 P0*
IS [G0,T0, ]
P0

Y0

The IS curve shifts to right, income will increases.

The increase in income will increase demand for imports. This will cause an excess demand for
foreign currency.

Under fixed exchange rate without capital mobility, the central bank must intervene and will sell
foreign currency and buy back domestic currency. Consequently, domestic money supply will
decrease.

The LM will shift to left and economy will be back to equilibrium with the same level of income
but a higher interest rate.

If ac1p − c1R > 0 , the effect is similar to a contractionary fiscal policy which shifts the IS to left.
The equilibrium interest rate will be lower.

d) Open economy with perfect capital mobility

Starting with initial equilibrium where r* = r, the effect of increasing income support as well as tax

cut when ac1p − c1R < 0 is similar to an expansionary fiscal policy.

The IS shifts to right, and domestic rate of return increases. Consequently, domestic interest rate of
return is higher than the international rate of return, i.e., r > r*. There will be inflow of capital and
foreign currency to domestic economy.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 10

Under Fixed Exchange Rate regime

LM [M0,P0,]

r* = r BOP = 0

E0 P0*
IS [G0,T0, ]
P0

Y0

The IS schedule will shift up and to right. The economy moves to point B. Both interest rate
and output will increase.

The higher interest rate will cause an inflow of capital which will lead exchange rate to
appreciate.

The central bank must intervene and will buy foreign currency using domestic currency. The
supply of domestic currency increases. Consequently, the LM schedule shifts down and to
right. The process continues until r = r*. At the new equilibrium, the income is higher than
before.

Under Flexible Exchange Rate regime

LM [M0,P0,]

r* = r BOP = 0

E0 P0*
IS [G0,T0, ]
P0

Y0

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 11


The IS schedule shifts up and to right. The economy moves to point B. Both interest rate and
output increase.

The higher interest rate will cause an inflow of capital which will lead domestic currency to
appreciate.

The appreciation of domestic currency will discourage export and encourage import. Demand for
domestic goods will decline and the IS will shift back. The process continues until r = r*. .

Fiscal expansion does not change equilibrium output.

Supposed that ac1p − c1R > 0 , the effect is similar to a contactionary fiscal policy and the IS
shifts to left. Consequently, income decreases and the rate of domestic return will be lower than
that of international. There will follow by a capital outflow from the domestic country.

3. Impact of P* Changes

A lower foreign price decreases the real exchange rate making foreign products more competitive.
Consequently, net export will be balanced at a lower level of income.

In addition, a fall in the trading partner’s prices encourages higher import which further decreases
net export. The net impact of the two will be a fall in aggregate demand and the IS will shift to left.

EP *
[ X 0 − IM 0 ] ( )
P

Y0

NX
EP*
NX ( )=0
P

LM [M0,P0,]

r0

E0 P0*
IS [G0,T0, ]
P0

Y0

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In the case of zero capital mobility, this will shift the vertical NX = 0 line to left.

The decrease in demand for export and the increase in import will also shift the IS to left.
Consequently, equilibrium output and interest rate will be lower.

There are two impacts on the foreign currency market when the economy moves from A to B.

First, due to the fall in foreign price, there will be an increase in demand for imported goods as
well as foreign currency which creates a situation of excess demand for foreign currency.

However, as income falls, due to fall in demand for domestic products, demand for imports falls
too.

As we move from A to B, the excess demand for foreign currency reduces to zero.

Exercise:
Analyse the impact of P* increase on the economy with a fixed exchange rate and no capital mobility.

EP*
NX ( )=0
P

LM [M0,P0,]

r0

E0 P0*
IS [G0,T0, ]
P0

Y0

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Example:
Consider an open economy when a major trading partner experiences a recession which result in a
falling prices. Analyze the implications for the home economy when,
a) there is no capital mobility and exchange rate is fixed.
b) there is perfect capital mobility and exchange rate is fixed.
c) there is perfect capital mobility and exchange rate is flexible.

Suggested answers:

When a major trading partner experiences a recession, its aggregate demand falls which will
decrease its price level making the real exchange rate of the domestic economy lower.

A lower real exchange rate will decrease demand for export and increase demand for import.
Together, the net export will decrease.

a) When there is no capital mobility and exchange rate is fixed

The equilibrium condition in an open econ with no capital mobility and fixed exchange rate is
when  = 0. Specifically,

EP * EP *  EP *  EP *
NX ( ,Y ) = X 0 ( ) −  IM 0 ( ) + mY  = [ X 0 − IM 0 ] ( ) − mY = 0
P P  P  P

Graphically, this is shown below.

EP *
[ X 0 − IM 0 ] ( )
P

Y0

NX

When foreign trading partner is in economic recession, P* falls. Lower foreign prices decrease the
real exchange rate making foreign product more competitive.

Consequently, net export will be balanced at a lower level of income.

In addition, a fall in the trading partner’s general prices encourages higher import while
discouraging export. It will result in a lower aggregate demand for domestic economy.

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 In terms of the IS-LM framework, both the vetical NX = 0 constraint and the IS will shift to left.

EP*
NX ( ) =0
P

LM [M0,P0,]

r0

E0 P0*
IS [G0,T0, ]
P0

Y0

Consequently, both equilibrium income and interest rate will be lower.

There are two impacts on the foreign currency market when the economy moves from A to B.

First, due to the fall in foreign price, there will be an increase in demand for imported goods as
well as foreign currency which creates a situation of excess demand for foreign currency.

However, as income falls, due to fall in demand for domestic products, demand for imports falls
too.

As we move from A to B, the excess demand for foreign currency reduces to zero.

Under Perfect capital Mobility

Lower foreign prices will increase demand for import and reduces demand for export.

The IS will shift to left resulting to a lower domestic rate of return. There will be an increase in
demand for foreign assets.

This will lead to an increase in demand for foreign currency accompany by an outflow of capital.

b) Under Fixed Exchange Rate,

Government will reduce the excess demand in foreign currency by selling foreign currency which
will decrease its foreign currency reserve.

When government sells foreign currency, it buys back domestic currency. Hence money supply
decreases. LM will shift to left until r = r*.

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 LM [M0,P0,]

r* = r BOP = 0

E0 P0*
IS [G0,T0, ]
P0

Y0

In equilibrium, there will be lower level of income.

c) Under Flexible Exchange Rate

LM [M0,P0,]

r* = r BOP = 0

E0 P0*
IS [G0,T0, ]
P0

Y0

Excess demand in foreign currency will cause the local currency to depreciate by increasing
nominal exchange rate.

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Increasing in nominal exchange rate will increase demand for export and the IS will shift to right
until r = r*.

In equilibrium, national income will remain at the same level.

4. When Marginal Propensity to Import Changes

When domestic agents (households, firms and government) shift their preference/tastes from local
products to foreign products, demand for import will increase.

This could due to reasons such as a loss of confidence in the safety of domestically produced
goods.

The shift of preference to foreign products increases the marginal propensity to import, ‘m’.

In contrast, a fall in MPI triggered by a ‘Buy Local’ campaign from government. If the campain is
successful, we should expect the marginal propensity to import to decrease.

The impact of an increase in the marginal propensity to import on the NX function is shown below,

EP *
NX = [ X 0 − IM 0 ] ( ) − mY = 0
P

EP *
[ X 0 − IM 0 ] ( P
)

Y0

NX
EP*
NX ( )=0
P

LM [M0,P0,]

r0

E0 P0*
IS [G0,T0, ]
P0

Y0

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For the given level of output, there will be a higher demand for import. Consequently, export will
be balanced at lower level of income.

There will be two impacts on IS-LM framework. First, the vertical NX = 0 line will shift to left.
Further, the IS will shift to left with steeper slope (why?).

The impacts on currency exchange rate is affected by two forces.

First, due to the raise of preference to imported goods, there will be an increase in demand for
foreign currency which creates excess demand for foreign currency.

However, as income falls, due to fall in demand for domestic products, demand for imports falls
too.

As we move from A to B, the excess demand for foreign currency reduces to zero.

EP*
NX ( )=0
P

LM [M0,P0,]

r0

E0 P0*
IS [G0,T0, ]
P0

Y0

Normally, it takes longer for income to fall than for the excess demand in the foreign currency
market to be formed.

Hence, some of the adjustment may come through the central bank's intervention by selling foreign
currency and reducing real balances, where LM shifts to left.

This may mean a new equilibrium at a higher interest rate than at B.

Therefore, the NX = 0 and the IS shift in such a way that a new equilibrium is not immediately
formed.

At B, there is excess demand for imports and hence foreign currency.

As this is a fixed exchange rate regime, the central bank will sell extra foreign currency and cause
a fall in the supply of money. LM will shift to left until equilibrium is restored at point C.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 18

Exercise:
Analyse the impact of a decrease in the Marginal Propensity to Import on the economy with fixed
exchange rate and no capital mobility.

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Example:
The public in an economy have lost confidence in the safety of the domestic production of a certain
product.
a) What effect might this have on the economy's multiplier?
b) Analyse the consequences of such a loss of confidence on an open economy without capital
mobility with a fixed exchange rate.
c) Would the outcome be similar if this had been an open economy with perfect capital mobility and
a fixed exchange rate?
d) Critics of government policy argue that only by removing all barriers to the adjustment of the
exchange rate will the problem be resolved. Discuss this argument.

When the public loses confidence in the safety of domestic production, they will want to consume less
domestic goods and substitute them by imported goods. There will be a fall in demand for domestic
goods and a rise in the demand for imported goods.

a) There are two possible ways that “lost confidence” could affect the aggregate demad. They are:
1) a fall in the autonomous component of consumption (and an equivalent rise in the autonomous
component of demand for imports)
2) a fall in the marginal propensity to consume (and an increase in the marginal propensity to
import).

If the change is in the marginal propensities rather than the autonomous component of aggregate
demand, the multiplier will become smaller. This is shown below,

EP *  EP *  EP *
E(Y, r, ) = C(Y, T) + I(r) + G + X   – IM ( ,Y )
P  P  P
EP *  EP * 
= C0 + c1(Y – T0 )+ I0 - I1r + G0 + X0( ) -  IM 0 ( ) + mY 
P  P 
EP * EP *
= C0 + c1(Y – T0 )+ I0 - I1r + G0 + X0( ) − IM 0 ( ) − mY
P P
EP *
= C0 + c1Y – c1T0 + I0 - I1r + G0 + [ X 0 − IM 0 ] ( ) − mY
P
EP *
= [C0 - c1T0 + G0 + I0 - I1r+ [ X 0 − IM 0 ] ( ) ] + ( c1 – m)Y
P
EP *
= A(r, G0, T0, ) + (c1 – m)Y
P
E0 P0 *
In equilibrium, E(Y, r0, )= Y
P0

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 E 0 P0 *
A(r0, G0, T0, )+( c1 – m)Y = Y
P0
E0 P0 * 1
Y = A(r0, G0, T0, )
P0 1 − (c1 − m)

A fall in marginal propensity to consume accompanying by a rise in marginal propensity to import will
make the multiplier smaller. This is shown below,
1 1
= ; Let ∆c1 , ∆m > 0
1 − (c1 − m) 1 − c1 + m
1 1 1
= =
1 − [(c1 − ∆c1 ) − (m + ∆m)] 1 − [c1 − ∆c1 − m − ∆m] 1 − c1 + m + ∆c1 + ∆m
1 1
>
1 − c1 + m 1 − c1 + m + ∆c1 + ∆m

If the change is in the autonomous component of aggregate demand, the multiplier will remaind
the same but the autonomious component of demand will be smaller.

b) Open economy without capital mobility and a fixed exchange rate

Assuming that the lost in confidence of local product results in a decrease in the autonomous
component to consumption and increases marginal propensity to import, the IS will shift to left and
becomes steeper.

In addition, there will be an impact on the on the NX function is shown below,

EP *
NX = [ X 0 − IM 0 ] ( ) − mY = 0
P

EP *
[ X 0 − IM 0 ] ( )
P

Y0

NX

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Starting at A, both IS and NX = 0 shift to left leading to a new equilibrium at B. In equilibrium,
both income and interest rate are lower.

The impacts on currency exchange rate is affected by two forces.

First, due to the raise of preference to imported goods, there will be an increase in demand for
foreign currency which creates excess demand for foreign currency.

However, as income falls, due to fall in demand for domestic products, demand for imports falls
too.

As we move from A to B, the excess demand for foreign currency reduces to zero.

EP*
NX ( )=0
P

LM [M0,P0,]

r0

E0 P0*
IS [G0,T0, ]
P0

Y0

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Normally, it takes longer for income to fall than for the excess demand in the foreign currency
market to be formed.

Hence, some of the adjustment may come through the central bank's intervention by selling foreign
currency and reducing real balances, where LM shifts to left.

This may mean a new equilibrium at a higher interest rate than at B.

Therefore, the NX = 0 and the IS shift in such a way that a new equilibrium is not immediately
formed.

EP*
NX ( )=0
P

LM [M0,P0,]

r0

E0 P0*
IS [G0,T0, ]
P0

Y0

At B, there is excess demand for imports and hence foreign currency.

As this is a fixed exchange rate regime, the central bank will sell extra foreign currency and cause
a fall in the supply of money. LM will shift to left until equilibrium is restored at point C.

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c) Open economy with perfect capital mobility and a fixed exchange rate:

We start at A where r = r*. The fall in demand for domestic product and the increases of
preference to imported goods will shift the IS to left resulting to dometic rate of returns being
lower than the international rate of returns (r1 < r*).

There will be an excess demand for foreign assets accompanied by an excess demand of foreign
currency and an outflow of capital.

Under Fixed Exchange Rate,

LM [M0,P0,]

r* = r BOP = 0

E0 P0*
IS [G0,T0, ]
P0

Y0

Government will meet this excess demand in FC by selling FC, hence decreases its FC Reserve.

When government sells FC, it buys back DC, hence money supply decreases. LM shifts to left.

In equilibrium, there will be lower level of national income.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 24

Under Flexible Exchange Rate

LM [M0,P0,]

r* = r BOP = 0

E0 P0*
IS [G0,T0, ]
P0

Y0

Excess demand in FC will cause local currency to depreciate by increasing nominal exchange rate
(E).

Increasing in E will increase demand for export, IS shifts to right.

In equilibrium, national income will remain at the same level as before.

Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 25

 Macro 9: Paradox of thrift

‘The paradox of thrift’ is a debate about the virtues of saving and spending. If there is
a ‘Paradox of thrift’ effect, increase in saving will cause a subsequent fall in
equilibrium income and, hence, saving.

So long as subsequent equilibrium income does not fall, there is no ‘Paradox of thrift’
effect.

Why an increase in private saving will affect subsequent income? When agents in an
economy decide to save more, they will inevitably consume less. Hence, an increase
in saving decreases private consumption. Consequently, it will reduce aggregate
demand.

Base on the IS-LM framework, the initial impact of the increase in private saving and
the fall in private consumption will shift the IS curve to the left.

Depending on the regimes of economy, the fall in aggregate demand might lead to a
fall in subsequent equilibrium income, and hence, subsequent level of saving.

1. Closed economy when wages and prices are flexible

• An increase in the private saving will cause a fall in demand for consumption.
Consequently, the IS shifts to the left resulting to a lower level of income.

• The fall in demand for consumption also implies that there will be a lower level of
aggregate demand, thus, the AD shifts to the left and price falls from P0 to P1.

• The lower price level increase real money supply which shifts the LM slightly to
the right due to a higher real money supply.

• In the short-run when wage is fixed at point B, price level, output and interest rate
are all lower. However, real wages are higher than before.

• In the long-run, when wage negotiations open, producers will demand for a fall in
nominal wages as workers’ real wage was higher at B than at A.

• The fall in nominal wage will increase the aggregate supply, this will shift the
SAS to the right and price level decreases further which will shift the LM further
to the right.

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 r LM ( M 0 , P0 )
LM ( M 0 , P1 )
LM ( M 0 , P2 )
A
r0

r1 B
r2
C

IS ( G0 , T0 )
IS ( G0 , T0 )
Y1 Y0 SAS ( w0 ) Y
P
SAS ( w1 )

A
P0
P1 B
P2
C

AD ( G0 , T0 , M 0 )
AD ( G0 , T0 , M 0 )

Y1 Y0 Y

• The long-run equilibrium will be at point C where the level of income is the same
as before. The interest rate is lower implying a subsequent higher level of demand
for investment.

• There is no Paradox of Thrift effect as the new equilibrium level of income stays
at the same level as at point A.

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2. Open economy without capital mobility and with a fixed exchange rate

 E P* 
NX  0 0  = 0
 P0 
LM ( M 0 , P0 )
r

LM ( M 1 , P0 )

r0 A

r1 B

r2 C

 E P* 
 E P*  IS  G0 , T0 ,
0 0

IS  G0 ,T0 , 0 0   P0 
 P0 
Y1 Y0 Y

• An increase in the private saving will cause a fall in demand for consumption.
Consequently, the IS shifts to the left resulting to a lower level of income.

• The fall in income results in a decrease in the demand for import which will lead
to an excess supply of foreign currency.

• Under fixed exchange rate without capital mobility, central bank intervention is
required to ease the excess supply of foreign currency. To do that, the central bank
buys back the excess foreign currency and sells domestic currency. The operation
increases domestic money supply.

• The LM thus shifts to the right and the income will be back to its initial level with
a lower level of interest rate.

• There is no Paradox of Thrift effect as the subsequent equilibrium level of income

stays at the same level as before.

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Exercise:
Is there a paradox of thrift in an open economy with zero perfect capital mobility and
the exchange rate is flexible?

•C down
IS shifts to left .

•Y decreases, DIM decreases.

LM ( M 0 , P0 )
r
•DFC < SFC
E0 P0*
•E decreases
P0 falls.

•X decreases and IM
r0 A increases.
r1
B •IS shifts to left .
r2
C  EP 
0 0
*
IS  G0 , T0 , 
 P0 
 E P* 
 E1P0*  IS  G0 , T0 , 0 0 
IS  G0 , T0 ,  P0 
 P0  

Y2 Y1 Y0 Y

Yes as Y decreases at the subsequent equilibrium.

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3. Open economy with perfect capital mobility and a fixed exchange rate

LM ( M 1 , P0 )
LM ( M 0 , P0 )
r

r0 = r * BOP = 0
C A
r1 B

 E0 P0* 
 E0 P0*  IS  G0 , T0 , 
IS  G0 , T0 ,   P0 
 P 0 
Y2 Y1 Y0 Y

• An increase in the private saving will cause a fall in demand for consumption.
Consequently, the IS shifts to the left resulting to a lower level of income and
interest rate.

• As the domestic rate of returns is now lower than the international rate of returns,
there will be an outflow of capital leading to an excess demand for foreign
currency.

• Under a fixed exchange rate regime, central bank intervention is required to ease
the excess demand for foreign currency. To do that the central bank sells foreign
currency and buys back domestic currency. Consequently, domestic money supply
decreases. The LM shifts to the left.

• In the subsequent equilibrium, the domestic rate of returns will be back to the
same level as the international rate of returns. Income will fall further to Y2. There
is a Paradox of Thrift effect. The initial increase in saving will lead to a
subsequent fall in saving since income is lower now.

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Exercise:
Is there a paradox of thrift in an open economy with perfect capital mobility and the
exchange rate is flexible?

•C down
IS shifts to left .

•r decreases, r < r*, capital

LM ( M 0 , P0 ) outflows.
r

•DFC > SFC -> E increases.

E0 P0*
• P0 increases.

r0 = r * BOP = 0 •X increases and IM

A =C
decreases.
r1 B
•IS shifts to right.

 E P* 
 E P*  IS  G0 , T0 ,
0 0

IS  G0 , T0 , 0 0   P0 
 P0 
Y1 Y0 Y

No, as Y remains at the same level as before.

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