MONETARY ECONOMICSMonetary Macroeconomic

ModelingSetting the stage

CONTENT

Key indicators of Macroeconomic Performance

- Definition - Measurement - Stylized Facts Macroeconomic Policy Objectives - Stabilization - Long-run Growth Monetary Macroeconomic Framework

Key Indicators

Gross Domestic product (GDP): a measure of all currently produced final goods and services in a given period.

Unemployment: the number of unemployed persons expressed as a percentage of the labor force.

Inflation: a rise in the general level of price.

These are three key economic variables that policy makers try to influence….

GROSS DOMESTIC PRODUCT

Nominal VS Real

• Nominal: valued at current market price.

• Real: valued at constant price (i.e. relative to the base year)

• RGDP = NGDP/Price

Measurements

• Expenditure Approach: summation of all expenditures made on goods and services. This is represented by C + I + G + NX

• Production approach

• Income approach

GDP is NOT

• Measuring non-market productive activities

• Measuring the underground economy

• Measuring a welfare (However, it is used a measure of development).

GROSS DOMESTIC PRODUCT

Potential Output

• The level of output that would be reached if productive resources are fully utilized

Cyclical Variatio

n in Output

• This is referred as Business Cycle

• It is the deviation of actual output from the potential output.

BUSINESS CYCLEBusiness Cycle captures cyclical variations of actual output around potential output.

These cyclical variations are costly. Expansion is normally related to inflation while contraction is related to unemployment.

The worst scenario is when contraction is accompanied by inflation, termed as STAGFLATION.

Stabilization policies aim at dampening the magnitudes of cyclical variations

Growth policies aim at increasing the trend in output over long periods of time.

Measurement of Price Level

Consumer price index: the retail prices of a fixed market baskets of several thousand goods and services purchased by households

Producer price index: the wholesale prices of approximately 3000 items

GDP Deflator: the prices of all goods and services currently produced.

The rates of changes in these prices are measures of inflation

Measurement and Types of Unemployment

Unemployment: Unemployed persons as a percentage of the labor forces

Types of unemployment: - Frictional: in-between jobs - Structural: changes in economic structure - Cyclical: due to cyclical downturns What matters is cyclical unemployment Full employment: when unemployment

equals frictional + structural unemployment

Some Stylized Facts

Fluctuations are costly. But all economies have ridden through the cycles.

It seems that cyclical fluctuations are inevitable but they can be dampened.

Inflation-unemployment trade-offs Highly fluctuating cycles may dampen long-term

growth Issues: - How to dampen the cycles? - How to accelerate long-term growth? Requirement: - A need to understand theories of fluctuations and long-term growth.

Approaches to Analyzing Fluctuations – Closed Economy

Goods Market: Market for the production (supply) and the aggregate demand for those goods.

Money Market: Market for Money Demand and Money Supply.

Factor Markets: markets for the factor inputs in the production of goods and services.

OPEN-ECONOMY: markets that link the sales and purchases of goods and services between nations (Exports and Imports).

THE MODEL: IS-LM-AS

Goods Market(IS Function)

Factor Inputs Markets (AS

Function)

Money Market(LM Function)

The Model: IS-LM-ASGraphical Representation

SR AS

THE MODEL: IS-LM-ASMathematical Representation

IS Function Y = C(Y-T) + I(r) + G CY-T > 0; Ir < 0; Both G and T assumed

exogenous and NX = 0 LM Function M/P = L(Y, r); Ly > 0; Lr < 0 AS Function Y = f(P); fp > 0

These are basic functions with no elements of uncertainty and expectations

THE IS Curve

IS: a graph of all combinations of Y and r that result in goods market equilibrium.

Equilibrium in Goods Market Output (Y) = Aggregate Expenditure (E) Components of Aggregate Expenditure - Household Expenditure (C) - Firm Expenditure (I) - Government Expenditure (G) - International Sector (X – M) Y = C + I + G + (X-M)

IS Curve - Graph

IS FUNCTIONThe IS function is negatively sloped…

Justification: A fall in interest rate motivates investment and, thus, planned expenditure. To restore equilibrium, output (Y) must increase.

Slope: depends on marginal propensity to consume and Interest sensitivity of Investment.

Intercept: containing the factors that shift the curve.

Goods Market Equilibrium

Total Differentiation

Express dr as a function of the remaining expressions

𝑌=𝐶 (𝑌 −𝑇 )+ 𝐼 (𝑟 )+𝐺

𝑑𝑌=𝐶𝑌𝐷𝑑𝑌 −𝐶𝑌𝐷𝑑𝑇+ 𝐼𝑟 𝑑𝑟 +𝑑𝐺

𝑑𝑟=(1−𝐶𝑌𝐷)

𝐼𝑟𝑑𝑌 +

𝐶𝑌𝐷

𝐼 𝑟𝑑𝑇 − 1

𝐼𝑟𝑑𝐺

Slope

Intercept Term

The LM Curve

A graph of all combinations of Y and r that equate the supply and supply for real money balances

Assuming that the stock of money supply is a policy variable (i.e. influenced by monetary instruments), we state this equilibrium as:

𝑀𝑃

=𝐿(𝑌 ,𝑟 )

LM Curve - GRAPH

LM FUNCTIONLM Curve is positively sloped.

An increase in income raises money demand. With money supply fixed, interest rate must increase to restore equilibrium in the money market.

The SLOPE of the LM curve depends on the income and interest rate sensitivities of money demand.

Intercept: Changes in money appears in the intercept. It leads to shift in LM function.

Market Equilibrium

Total Differentiation

Express dr as a function of the remaining terms

𝑀𝑃

=𝐿(𝑌 ,𝑟 )

𝑃𝑑𝑀−𝑀𝑑𝑃𝑃2 =𝐿𝑌 𝑑𝑌+𝐿𝑟 𝑑𝑟

𝑑𝑟=−𝐿𝑌

𝐿𝑟

𝑑𝑌 + 1𝐿𝑌

𝑃𝑑𝑀−𝑀𝑑𝑃𝑃2

AS Function

Function Y = f(P)

Total Differentiation dY = fPdP

fP = 0 (Classical)

fP > 0 (Keynesian)

The foundation of AS function is the assumption of wage stickiness or imperfect information in the labor market.