Economics II - Macroeconomics

M

P

Y = transactional component of demand higher the income, higher the purchases



performed (I consume more);

r = speculative component of demand when r goes up, you are more willing to buy more

 

Md goes down.

Second linking Function between the goods market and the financial market.

 dom

The money demand ( ) depends on income and interest rate!

M

Why is the LM curve upward sloping?

When Y goes up, money demand Md goes up. d

When the income (Y)↑, money demand ( ) ↑ and so the equilibrium in the financial

M

market is broken:

d S

>

M M .

This means that there is a shortage of money in the market, to fill which individuals sell

S d

bonds (B), the supply of bonds increases ( bonds’ price (PB) ↓ and finally the

> ¿

B B ,

interest rate (r) ↑. Thus, the positive relation between income (Y) and money demand (

dom ) extends to income (Y) and interest rate (r).

M What moves the IS curve?

Dynamics of the Model: which are the variables that are

The IS curve “shits” following changes in the Goods market:

able to move the curve?

Changes in Consumption (C) driven by modifications in its components ( )

 ć ,c , T́

0 1

Changes in Public Expenditure ( )

 Ǵ

Y = ZZ = c + c (Y - T) + I + G

0 1

Changes on I don’t make the IS curve shift they make the equilibrium move along the



curve. =f (Y )

remember I , r

We do not consider variations of I ) because their determinants (Y e r)

¿

endogenous

are variables.

Expansionary c , c

shocks , ↑ ↓

If or then the IS curve moves upwards

 T́

Ǵ

0 1

(different policies) make IS curve shift rightward.



Contractionary f c , c

shocks , ↓ ↑

I or then the IS curve moves

 T́

Ǵ

0 1

downwards make IS curve shift leftwards.



What moves the LM curve?

Ms = Md, Md endogenous

is completely 

a change makes the equilibrium

move along the curve.

H*mm = f(Y,r)

mm affected by decisions of individuals or



commercial banks not policy makers

 

what changes is a monetary shock.

H only

can be modified by the central bank



monetary policy.



The LM curve “shits” following changes in the Money market, so changes in the Money

M S

Supply ( ):

↑

S expansionary

If the LM curve moves down r decreases policy;

 

M ↓

S

If the LM curve moves up for the same level of income, I’m going to have higher r



M

contractionary policy.



How Equilibrium Income and Interest Rate Change

Expansionary shock/ policy LM goes up



´

c c

, , ↑ or ↓

We have said that if then the IS curve shifts upwards.

Ǵ T́

0 1

Direct effect : makes income increase and r increase:

´

c

IS side (1) (Goods market): if ↑ then consumption (C)↑, aggregate demand (ZZ)↑

• 0

and so also the income (Y)↑

d s

LM side (2) =f (Y )

: if (Y)↑ ↑ > , shortage of money in the system,

M ; r

• M

individuals sell bonds (B), the supply of bonds increases exceeding the demand for them (

s d , bonds’ price (PB)↓, then the interest rate (r)↑

¿

B ↑> B (mitigation mechanism)

Indirect effect mitigate the intensity (it has a lower power



because the force of the shock loses its value when it changes from one market to the other):

IS side (3) =f (Y )

I ,r

: if (r)↑ (do you remember that ?) so investments (I)↓, demand

• (ZZ)↓ and so does the income (Y)↓

d s

LM side (4) : if (Y)↓ ↓ < , excess of money in the system, individuals buy

• M M d S

bonds (B), the demand for bonds increases by exceeding the supply of them ( ,

¿

B ↑>B

bonds’ price (PB)↑, so the interest rate (r)↓

Final effect: Y higher, r higher

Shock on the Money market side?

Expansionary Ms

shock increase in curve shifts downwards.

 

Direct effect S d

LM side (1) : if ↑ > , excess of money in the system, individuals buy bonds

• M M d S

(B), the demand for bonds increases by exceeding the supply of them ( , bonds’

¿

B ↑>B

prices (PB)↑, so the interest rate (r)↓

IS side (2) =f (Y ) ↑

I ,r

: if (r)↓ (do you remember that ?) so investments (I) , the

• ↑ ↑

aggregate demand (ZZ) and finally also the income (Y)

mitigation mechanism

Indirect effect: (we go back to the money market):

d S

LM side (3) : if (Y)↑ ↑ > lack of money in the system, individuals sell bonds

• M M , S d

(B), the supply of bonds increases, exceeding the demand for bonds ( , the price

¿

B ↑>B

↑

of bonds (PB)↓, so the interest rate (r)

IS side (4) =f (Y )

I ,r

: if (r)↑ (do you remember that ?) so investments (I)↓, demand

• (DA)↓ and also the income (Y)↓

Final effect: higher Y, lower r

Particular case: the Liquidity trap

Equilibrium is 0 Describes the situation in which nominal interest rates have reached

 

their minimum level, which corresponds to zero, making expansionary monetary policy

ineffective (at least as regards its "conventional" component).

Expansionary policy doesn’t make the equilibrium change:

S d

LM side : if ↑ > , excess of money in the system,

M M

individuals buy bonds (B), the demand for bonds increases by

d S

exceeding the supply of them ( , bonds’ prices

¿

B ↑>B

(PB)↑, so the interest rate (r) would decrease, but, being

already at its minimum level, it does not move and the

effect of such a policy is null.

Contractionary monetary policy

LM side S d

: if ↓ , lack of liquidity in the system,

 ¿

M M

individuals sell bonds (B), and the supply of bonds

S d

increases, exceeding the demand for bonds ( , the price of bonds (PB)↓, so the

¿

B ↑>B

↑

interest rate (r)

IS side (2)

 =f (Y )

I ,r

: if (r)↑ (do you remember that ?) so investments (I)↓, demand

(DA)↓ and also the income (Y)↓

12/10/2022 – Lecture 5/6

The Players in the Economic System

Economic policy maker Decide which is the environment in which the other will play

 

The Decision-makers

Governments and Central banks influence the behavior of commercial banks,



individuals and businesses.

Government

- is responsible for conducting the fiscal policies,

Central banks

- with their decisions (monetary policies) affect directly the money

market.

Who plays in the system?

individuals

But also, are important in determining the outcome of the economic system (I

firms

can decide to keep more money in my pocket), that can decide to invest more or

Commercial banks

less, employ more people or not… and which decide how much

money to store and how much money reintroduce in the economic system.

How does a policymaker perform his activities?

Always act according to a target efficient policies are the ones for which the target is



clearly determined.

But to achieve my target I need tools – the variables under their direct control -, to make the

economic system converge to what I want.

Fiscal Policy :

- Government: Responsible.

- Tools to carry out fiscal policy: Public expenditure (G), Taxation (T) (and not

consumption or investing, which are decisions taken by individuals or firms)

- Policies:

Expansionary st

(to increase the income and production) to fulfill 1 target ZZ↑ Y↑

 

Contractionary (reduce production and the income) reducing public expenditure

  nd

and increase taxation to reduce public debt and keep it under control to fulfill 2

 

target ZZ↓ Y↓

- Targets:

Promoting economic growth busting production and income (Y↑),

 

Control budget balance and manage the public debt level.



- Reference curve: the IS curve

Expansionary Fiscal Policy: How does it work

Expansionary

An fiscal policy maneuver generates an income-increasing effect (Y↑) to



make income increase (or at least not make it decrease).

How does it influence the economic environment?

To achieve this, the Government must increase Public spending (G↑) or decrease Taxes

(T↓). This may be necessary to spur economic growth and/or help it counter a recession or

the effects of a negative external shock.

Direct effect :

IS side (1)

- : If �↑ aggregate demand (ZZ)↑ and so

also the income (Y)↑

LM side (2)

- : if (Y)↑ ��↑ > ��, shortage of money

in the r system, individuals sell bonds (B), the supply of

bonds increases, exceeding the demand for them (��↑

> ��), bonds’ price (PB)↓, then the interest rate

(r)↑

Indirect effect

:

IS side (3)

- : if (r)↑ (do you remember that � = �(�, �)?)

investments (I)↓, demand (ZZ)↓ and so does the

income (Y)↓

LM side (4) Ms,

- : if (Y)↓ ��↓ < excess of money in

the system individuals buy bonds (B), the demand for bonds increases by exceeding the

supply of them (��↑ > �s), bonds’ price (PB)↑, so the interest rate (r)↓

Final effects r Y.

: increase in , increase in

Contractionary Fiscal Policy reduce its public debt.



Contractionary

A fiscal policy maneuver generates a diminishing effect on income (Y↓).

How? ).

To achieve this, the Government must reduce Public spending (G↓) or raise Taxes (T↑

This may be necessary to keep under control the budget balance and reduce the debt of the

State.

Direct effect

IS side (1)

- : If �↑ then the disposable income (�d)↓, consumption (C)↓, aggregate

demand (ZZ)↓ and so does the income Y↓

LM side (2)

- : if (Y)↓ ��↓ < ��, excess of money in the system, individuals buy bonds

(B), the demand for bonds increases by exceeding the supply of them (��↑ > �s), bonds’

price (PB)↑, so the interest rate (r)↓

Indirect effect

IS side (3)

- : if (r)↓ (do you remember that � = �(�, �)?) so investments (I)↑, the aggregate

demand (ZZ)↑ and finally also the income (Y)↑

LM side (4)

- : if (Y)↑ �d↑ > Ms, lack of money in the system, individuals sell bonds (B),

the supply of bonds increases, exceeding the demand for bonds