Orthodox Orthodox Keynesianism:Keynesianism:IS-LM ModelIS-LM ModelIntermediate MacroeconomicsIntermediate Macroeconomics

ECON-305 Spring 2013ECON-305 Spring 2013Professor DaltonProfessor Dalton

Boise State UniversityBoise State University

PurposesPurposes

1.1. Review the IS-LM ModelReview the IS-LM Model

2.2. Consider effectiveness of monetary Consider effectiveness of monetary and fiscal policy in terms of modeland fiscal policy in terms of model

3.3. Discuss original Phillips Curve Discuss original Phillips Curve model and importance to orthodox model and importance to orthodox Keynesian analysisKeynesian analysis

4.4. Summarize central propositions of Summarize central propositions of orthodox Keynesianismorthodox Keynesianism

Recurrent ThemesRecurrent Themes Controversy over self-Controversy over self-

equilibrating properties of equilibrating properties of modern capitalist economiesmodern capitalist economies

Role and efficacy of activist Role and efficacy of activist government monetary and fiscal government monetary and fiscal policypolicy

Distinguishing BeliefsDistinguishing Beliefs

1.1. Economy is inherently unstableEconomy is inherently unstable Subject to erratic shocks originating Subject to erratic shocks originating

in business confidencein business confidence

2.2. Economy is weakly self-Economy is weakly self-equilibratingequilibrating Forces that return economy to full Forces that return economy to full

employment are slow and unrobustemployment are slow and unrobust

Distinguishing BeliefsDistinguishing Beliefs

3.3. Aggregate Demand determines Aggregate Demand determines aggregate output and aggregate output and employmentemployment government can intervene to assure government can intervene to assure

sufficient ADsufficient AD

4.4. Fiscal policy preferable to Fiscal policy preferable to monetary policymonetary policy More predictable, direct and fasterMore predictable, direct and faster

Development of IS-LMDevelopment of IS-LM

J.R. Hicks, “Mr. Keynes and the Classics: J.R. Hicks, “Mr. Keynes and the Classics: A Suggested Interpretation,” A Suggested Interpretation,” Econometrica Econometrica (April, 1937)(April, 1937)

F. Modigliani, “Liquidity Preference and F. Modigliani, “Liquidity Preference and the Theory of Interest and Money,” the Theory of Interest and Money,” Econometrica Econometrica (January, 1944)(January, 1944)

Popularized by A. Hansen and P. Popularized by A. Hansen and P. SamuelsonSamuelson

IS-LM ModelIS-LM Model

IS curve represents equilibrium in the IS curve represents equilibrium in the goods marketgoods market name derives from Investment = Saving name derives from Investment = Saving

equilibrium conditionequilibrium condition LM curve represents equilibrium in LM curve represents equilibrium in

the money marketthe money market name derives from Liquidity preference name derives from Liquidity preference

(M(Mdd) = Money Supply equilibrium ) = Money Supply equilibrium conditioncondition

IS Curve: The Goods IS Curve: The Goods MarketMarket

Closed economy, no Closed economy, no governmentgovernment

E = C + I; Y = C + SE = C + I; Y = C + S In equilibrium, E = YIn equilibrium, E = Y

C + I = C + SC + I = C + S

I = SI = S

IS Curve: The Goods IS Curve: The Goods MarketMarket

Expenditure ApproachExpenditure Approach C = CC = CAA + cY 0 < c < 1 + cY 0 < c < 1

I = II = IAA – ar – ar

A = CA = CAA + I + IAA

E = A + cY - arE = A + cY - ar

C

Y

C = CA + cY

CA

I

r

I = IA - ar

r0

I0

C = CA + cY

E = A + cY - ar

Y

E

CA

I0

E = Y

Ye

Equilibrium and Equilibrium and InventoriesInventories

Suppose actual income is Y0.

At Y0, E > Y0.

Inventories of firms are being depleted below desired levels – “unplanned inventory reductions.”

This sends signals to firms to expand production. Output and income rise toward Ye.

As Y increases, so does E.

Y

E

E = Y

E = A + cY -ar

YeY0

E Y0

Equilibrium and Equilibrium and InventoriesInventories

Y

E

E = Y

E = A + cY -ar

Ye

Suppose actual income is Y1.

At Y1, E < Y1.

Inventories of firms are rising above desired levels – “unplanned inventory accumulation.”

This sends signals to firms to reduce production. Output and income fall toward Ye.

As Y decreases, so does E.

Y1

E

Y1

Equilibrium and the Equilibrium and the MultiplierMultiplier

Y

E

E = Y

E0 = A + cY -ar

Ye

Begin at E0 and output is at equilibrium Ye.

Now suppose E increases to E1. Why?

At Ye, E1 > Ye.Unplanned inventory reductions will lead firms to increase output.As output increases so will expenditures. We end up at Ye’.

How much will Y change due to the change in E?

E1 = A + cY -ar

Ye’

Equilibrium and the Equilibrium and the MultiplierMultiplier

∆∆E = ∆YE = ∆Y

∆∆E = ∆A + c∆YE = ∆A + c∆Y

∆∆Y = ∆A + c∆YY = ∆A + c∆Y

∆∆Y - c∆Y = ∆AY - c∆Y = ∆A

∆∆Y (1 – c) = ∆AY (1 – c) = ∆A

∆∆Y = ∆A/(1 – c)Y = ∆A/(1 – c)

The multiplier equals (1/1 - c)The multiplier equals (1/1 - c)

Adding GovernmentAdding Government

Government can purchase goods Government can purchase goods (G), make transfer payments (TR), (G), make transfer payments (TR), and tax income (tY).and tax income (tY).

Households now consume out of Households now consume out of disposable income (Ydisposable income (Ydd), which ), which includes net transfers after taxes.includes net transfers after taxes.

Total expenditures (AD) now Total expenditures (AD) now includes government purchases (G).includes government purchases (G).

System with GovernmentSystem with Government

E = C + I + GE = C + I + G

C = CC = CAA + cY + cYdd

YYdd = Y + TR – tY = Y + TR – tY

T = TR – tYT = TR – tY

If government runs a deficit G > TIf government runs a deficit G > T

If government runs a surplus G < TIf government runs a surplus G < T

System with GovernmentSystem with Government

E = C + I + GE = C + I + G

C = CC = CAA + cTR + c(1-t)Y + cTR + c(1-t)Y

E = CE = CAA + cTR + c(1-t)Y + I + cTR + c(1-t)Y + IAA – ar + G – ar + G

Let ALet AG G = C= CAA + cTR + I + cTR + IAA + G + G

E = AE = AG G + c(1-t)Y - ar+ c(1-t)Y - ar

Introducing government shifts E Introducing government shifts E upup and and flattensflattens the E curve the E curve

Why?Why?

Sources and Changes in Sources and Changes in ExpendituresExpenditures

E = CE = CAA + cTR + c(1-t)Y + I + cTR + c(1-t)Y + IAA – ar + G – ar + G

CCAA

TRTR

IIAA

rr

GG

tt

cc

E E

EE

EE

EE

EE

EE

EE

What changes will change the slope of the E curve?

∆t or ∆c will change slopeWhat is the expenditure multiplier after introducing taxes?the new expenditure multiplier is [1\(1-c)(1-t)]

Deriving the IS Curve

r = r

I

rI = IA - ar

r 0

Y

E

E = Y

E = CE = CAA + cTR + c(1-t)Y + cTR + c(1-t)Y + G+ G

r 1

I 0I 1

Y1

r

Y0

Y0 Y

r

r0

r1

IS

Y1r

IS Curve The IS curve is

the locus of r & Y where goods market is in equilibrium

IS curve is steeper… the smaller is the

multiplier the more interest-

inelastic is investmentY0 Y

r

r0

r1

IS

Y1

IS Curve

IS curve shifts for changes in… CA

IA TR G t c

Y0 Y

r

r0

r1

IS

Y1

IS Curve

To the right of IS curve there is ES in goods market

To the left of IS curve there is ED in goods market

∆Y = ∆G * multiplier

Y0 Y

r

r0

r1

IS

Y1

LM Curve: The Money LM Curve: The Money MarketMarket

Money demandMoney demandTransactions demand ... f(Y)Transactions demand ... f(Y)Precautionary demand … g(Y)Precautionary demand … g(Y)Speculative demand … (r v. rSpeculative demand … (r v. ree))

The alternative to holding The alternative to holding money is holding securities money is holding securities (bonds)(bonds)

LM Curve: The Money LM Curve: The Money MarketMarket

Demand for financial wealthDemand for financial wealth

MMdd/P + B/P + Bdd = W = Wnn/P/P Stock of financial wealthStock of financial wealth

MMss/P + B/P + Bss = W = Wnn/P/P

where B = bondswhere B = bonds

WWn n = total financial wealth= total financial wealth

LM Curve: The Money LM Curve: The Money MarketMarket

In equilibrium,In equilibrium,

MMdd/P + B/P + Bdd = W = Wnn/P = M/P = Mss/P + B/P + Bss

MMdd/P + B/P + Bdd = M = Mss/P + B/P + Bss

oror

(M(Mdd/P - M/P - Mss/P) + (B/P) + (Bdd – B – Bss) = 0) = 0

when the money market is in equilibrium, so when the money market is in equilibrium, so tootoo, , is the bond market.is the bond market.

LM Curve: The Money LM Curve: The Money MarketMarket

MMdd/P = mY – br/P = mY – br

MMss/P is exogenously determined /P is exogenously determined (perfectly inelastic?)(perfectly inelastic?)

Md/P = mY0 - br

M/P

r

r0

Ms/P

An increase in Y increases Md/P and increases r An increase in Ms reduces r at a given Y An increase in re increases Md/P and increases r at

given Y An increase in P reduces both Ms/P and Md/P.

What happens to r at given Y? if ∆(Ms/P) > ∆(Md/P), then r rises if ∆(Ms/P) < ∆(Md/P), then r falls if ∆(Ms/P) = ∆(Md/P), then r stays the same

M/P

r

r0

r1

Ms/P

Md/P = mY0 - br

Md/P = mY1 - br

Ms2/P

r2

Md/P = mY1 - br

Why? Because the change in the money supply has to be “split” between three uses in demand (consumption, money balances, and securities).

Deriving the LM Curve

Y

r

r

M/P

r = r

Md/P = kY

Y0

MdT

Md/P (Y0)

Ms/P

r0

r0

Y1

MdT1

Md/P (Y1)

r1

r1

LM

LM Curve The LM curve is

the locus of r & Y where the money and bond markets are in equilibrium

LM curve is steeper… the greater the

income elasticity of Md

the smaller is the interest elasticity of Md

Y

r

Y0

r0

Y1

r1

LM

LM Curve

LM curve shifts for changes in… Ms

P re

Y

r

Y0

r0

Y1

r1

LM

LM Curve To the right of LM

curve there is ED in money market

To the left of LM curve there is ES in money market

∆Y because of ∆Ms depend on the interest elasticity of Md; ∆Y larger the more inelastic is Md

Y

r

Y0

r0

Y1

r1

LM

The Liquidity Trap At sufficiently low r

(expected when Y < YF), the Md/P becomes perfectly elastic because everyone expects r to rise. (Bond prices are so high that everyone expects bond prices to fall.)

In the liquidity trap the LM curve becomes horizontal over the relevant range of output.

In the liquidity trap, an increase in Ms has no affect on r.

So the relevant portion of the LM curve remains horizontal.

Y

r

Y0

rmin

LM

M/P

r

rmin

Ms0/P

Md/P

Ms1/P

LM

What did Keynes think of his liquidity trap

idea?

“There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest.”

- Keynes, General Theory, p. 207

The most striking examples of a complete breakdown of stability in the rate of interest, due to the liquidity function flattening out in one direction or the other, have occurred in very abnormal circumstances. In Russia and Central Europe after the war a currency crisis or flight from the currency was experienced, when no one could be induced to retain holdings either of money or of debts on any terms whatever, and even a high and rising rate of interest was unable to keep pace with the marginal efficiency of capital (especially of stocks of liquid goods) under the influence of the expectation of an ever greater fall in the value of money; whilst in the United States at certain dates in 1932 there was a crisis of the opposite kind—a financial crisis or crisis of liquidation, when scarcely anyone could be induced to part with holdings of money on any reasonable terms.

- Keynes, General Theory, p. 207

IS-LM Analytics

IS-LM Equilibrium

r*, Y* is the equilibrium combination of the interest rate and real output that brings about equilibrium in the goods and money (and bond) markets.

Suppose Y* < YF. Full employment can

be achieved by shifting either IS or LM, or both, to the right.

Y

r

Y*

r*

YF

LM

IS

IS’

LM’

IS”

LM”

IS-LM Equilibrium

IS will shift to the right if CA, IA, TR, G or c increase, or if t decreases.

LM will shift to the right if Ms increases or P or re decrease.

Y

r

Y*

r*

YF

LM

IS

IS’

LM’

IS-LM Equilibrium

Policy options are to increase G, reduce t, or increase Ms.

Fiscal policy options will shift IS to the right and increase r and Y.

Monetary policy will shift LM to the right and reduce r while increasing Y.

Y

r

Y*

r*

YF

LM

IS

IS’

LM’r’

r’’

Policy Effectiveness

Fiscal policy will be more effective… The flatter the LM curve (more interest elastic is Md). The steeper the IS curve (less interest elastic is I).

Y

r

Y*

r*

Yf

LMs

IS

IS’

Y

r

Y*

r*

Ys

LM

ISs

ISf

LMf

Ys

rf

rs

ISs’

ISf’

Yf

rsrf

Policy Effectiveness

Monetary policy will be more effective… The steeper the LM curve (less interest elastic is Md). The flatter the IS curve (more interest elastic is I).

Y

r

Y*

r*

Yf

LMs

IS

LMs’

Y

r

Y*

r*

Yf

LM

ISs

ISfrs

rs

rfrf

Ys Ys

LMf’

LMf

LM

Orthodox Keynesian View

Demand for money is interest elastic

Investment demand is interest inelastic

The LM curve is flat and the IS curve is steep

Fiscal Policy is more effective than monetary policy

Y

r

Y*

r*

YF

LM

ISIS’

r’

Policy Effectiveness During the 1950s several studies sought to

determine the interest elasticity of investment demand and the interest elasticity of money demand.

The early studies supported the Orthodox Keynesian view that investment demand was inelastic and monetary demand was elastic.

The empirics supported the notion that fiscal policy was more effective than monetary policy.

This empirical support, however, became increasingly questionable by the early 1960s.

The Crowding Out Argument

On theoretical grounds, the early 1960s saw a questioning of the effectiveness of “pure” fiscal policy (fiscal policy unaccompanied by accommodating changes in the money supply).

The argument: “Higher interest rates from expansionary fiscal policy crowd out private spending sensitive to the interest rate, limiting the effectiveness of fiscal policy.”

The Crowding Out The Crowding Out ArgumentArgument

r

S, I

SLF

DLF

DLF + (G–T)

r0

r1

I0I1

(G–T)

When government runs a deficit, and the interest rate rises, private demand for loanable funds to use for consumption and investment falls. The effects of fiscal policy are smaller than expected by the IS-LM model.

The Keynesian Response

The Keynesian response to the “crowding out argument” focuses on the wealth effects of bond-financed government expenditures Blinder and Solow, “Does Fiscal Policy

Matter?,” Journal of Public Economics (November 1973)

The Keynesian ResponseBegin in equilibrium r0, Y0 with

a balanced budget G0 = T.

Desire to increase Y, so increase G to G1.

The IS curve shifts to the right, increasing Y to Y1and providing T1 to finance part of the deficit.

Deficit equals G1-T1.

Government must issue additional bonds. The bonds represent additional private sector wealth which increases consumption and demand for money.

Y

r

r0

Y0

LM

ISIS’

T

Go

Y1

G1

G,T

T1

r1

G1 -T1

The Keynesian ResponseThe effect of higher

consumption is to shift the IS curve further to the right.

The effect of higher money demand is to shift the LM curve to the left.

If the consumption effect outweighs the money demand effect, income will continue to rise until Y2 and the deficit will be reduced to zero.

Y

r

r0

Y0

LM

ISIS’

T

Go

Y1

G1

G,T

r1

Y2

Debt Equivalence Theorem

Barro, “Are Government Bonds Net Wealth?” Journal of Political Economy (Nov./Dec. 1974).

The burden of government spending is the same whether it is financed by an increase in taxation or by bonds.

Borrowing reflects a future tax liability which if fully taken into account exactly offsets the value of the bonds in households wealth.

Government Bonds are not net wealth!

Is Debt Equivalent to Taxes?

Are households farsighted? Do households take into account future tax

liabilities that will fall on their heirs? Government has privileged access to

loanable funds so the interest rate at which government borrows is less than the interest rate at which future taxes are discounted.

Government bonds are net wealth

Underemployment Equilibrium

The General Case: Rigid Money Wages

Start in IS-LM quadrant.Initial equilibrium at r0, Y0.

If money wages are rigid, there is no guarantee that W, given P consistent with LM0, is consistent with labor market clearing.

The labor market can get stuck at less than full employment.

Y

LF

LM0

IS

r

Y = YY

Y

Y

L

L

Y= f(L)

Y0

SL

DL

(W/P)0

r0

W/P

L0

ESL

<

Underemployment Equilibrium

The General Case: Introduce Flexible Wages

The ESL cause W to fall, reducing prices of output.

In terms of IS-LM, as P falls, the real money supply (Ms/P) increases, causing the LM curve to shift to the right.

The LM shift to the right reduces r and increases I, increasing Y.

The increase in E moderates P decreases, so W fall > P fall; (W/P) fall.

Y

YF

LM0

IS

r

Y = YY

Y

Y

L

L

Y= f(L)

Y0

SL

DL

(W/P)0

r0

W/P

L0

ESL

LM1

r1

LF

(W/P)1

Underemployment Equilibrium

The General Case: Introduce Flexible Wages

This story is the “Keynes Effect” story.

But Keynes denied that the “Keynes Effect” would be sufficient to restore YF.

Why?

1. Liquidity trap (r wouldn’t fall)2. Interest-inelastic Investment (Investment wouldn’t increase enough)

Y

YF

LM0

IS

r

Y = YY

Y

Y

L

L

Y= f(L)

Y0

SL

DL

(W/P)0

r0

W/P

L0

ESL

LM1

r1

LF

(W/P)1

Unemployment & Liquidity Trap

Flexible Wages and Liquidity Trap

The ESL cause W to fall, reducing prices of output.

In terms of IS-LM, as P falls, the real money supply (Ms/P) increases, causing the LM curve to shift to the right.

The LM shift to the right, however, fails to reduce r because households and firms add the additional real money supply to their cash balances.

Y

YF

LM0

IS0

r

Y = YY

Y

Y

L

L

Y= f(L)

Y0

SL

DL

(W/P)0

r0

W/P

L0

ESLLM1

LF

Unemployment & Liquidity Trap

Flexible Wages and Liquidity Trap

Since r does not fall, investment does not increase, AD is unchanged.

Wages fall at the same rate as prices, so the real wage does not change and the ESL remains.

Full employment can be achieved by increasing G or reducing t, increasing expenditures, shifting the IS curve.

The increase in AD raises prices, reducing the real wage to clear the market.

Y

YF

LM0

IS0

r

Y = YY

Y

Y

L

L

Y= f(L)

Y0

SL

DL

(W/P)0

r0

W/P

L0

ESLLM1

LF

(W/P)1

IS1

Interest Inelastic Investment

Flexible Wages and Interest Inelastic Investment

The ESL cause W to fall, reducing prices of output.

In terms of IS-LM, as P falls, the real money supply (Ms/P) increases, causing the LM curve to shift to the right.The LM shift to the right reduces r and increases I, increasing Y.

But r can’t fell below zero, since r is the reward for parting with liquidity.

Persistent underemployment equilibrium.

Y

LM0

IS0

r

Y = YY

Y

Y

L

L

Y= f(L)

Y0

SL

DL

(W/P)0

r0

W/P

L0

ESL

LM1

LF

IS1

YF

(W/P)1

ESL

SummaryOrthodox

Keynesian IS-LM

Orthodox Keynesian IS-LM

1. Rigidity of nominal wages prevent adjustment to full employment.

2. If nominal wages are flexible, reductions in wages and prices fail to restore full employment unless the Keynes effect is operative.

3. If liquidity trap or interest-inelastic investment exists, the Keynes Effect is short-circuited and the economy, left to itself, fails to restore full employment.

Orthodox Keynesian IS-LM

Keynes failed to provide a general theory of unemployment; his argument rests on special cases (nominal wage

rigidity, liquidity trap, or severe interest-inelastic investment).

Wealth Effects: Real Balance and

Pigou Effects

“Classical” Economics Redux

Patinkin, Money, Interest and Prices (1956)

Unemployment is not an equilibrium, but a disequilibrium one which occurs even when W and P are flexible.

AD falls as W and P falls (balanced) and firms forced off DL curve from A to B.

But as P falls, real money balances increase, people feel wealthier, and CA and IA increase directly. Falling prices and higher real spending move the economy back to full employment.

Y

YF

r

Y = YY

Y

Y

L

L

Y= f(L)

Y0

SL

DL

W/P

L0

ESL

LF

(W/P)0 AB

“Classical” Economics Redux Start at full employment

(IS0, LM0, r0, YF, LF, (W/P)0).

Suppose some shock occurs (expected profitability falls) shifting IS to left, reducing Y.

Reduced AD cause a balanced fall in prices and wages.

Firms and workers are forced off DL and SL.

Falling prices cause a higher value of money balances, increasing wealth and shifting the IS curve back to the right through higher consumption and investment spending.

Full employment is restored.

YF

Y = YY

Y

Y

L

L

Y= f(L)

Y0

SL

DL

W/P

L0

ESL

LF

(W/P)0 AB

Y

IS0

r

r0

LM0

r1

IS1

Pigou Effect Patinkin’s argument concerning the “real balance

effect” indirectly revives the Pigou effect argument.

Pigou had argued that reduced prices increase wealth and increase AD, so that the Keynes Effect of a shifting LM curve was accompanied by a shifting IS curve to restore full employment, and that even if the Keynes Effect was inoperative, wealth effects restore equilibrium.

Harry Johnson: “The Pigou effect finally disposes of the Keynesian contention that underemployment equilibrium does not depend upon the assumption of wage rigidity. It does.”

Criticisms of Pigou Effect Falling prices might lead to expectations of

further declines in prices, postponing consumption and delaying return to full employment.

Falling prices might lead to firms delaying investment, believing recession will continue, and delay return to full employment.

How does Pigou effect change wealth? Currency (outside money), Bank credit (inside money), government bonds?

Empirical evidence for Pigou effect is weak.

The Neoclassical Synthesis

By mid-1960s, economists widely accepted the “neoclassical synthesis.”

Keynes was wrong in terms of theory. Keynesian economics was a special case of the more general classical theory (wage rigidity).

Keynes was right in terms of policy.Slow Keynes and Pigou effect adjustments mean that activist government policy is necessary.

Open EconomyIS-LM

Open Economy Late 1950s and early 1960s saw

increasingly liberalized (freer) trade and capital movements

IS/LM extended to cover open economies E = Y = C + I + G + (X-Im) Exports (X) and Imports (Im)

Mundell, “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates, Canadian Journal of Economics and Political Science (Nov. 1963)

Fleming, “Domestic Financial Policies under Fixed and under Floating Exchange Rates,” IMF Staff Papers (Nov. 1962)

Open Economy IS E = Y = C + I + G + (X-Im) Exports (X) and Imports (Im) X = h(YW, ePD/PF, z) Im = j(Y, ePD/PF, z )

where YW = world income, e = exchange rate,PD = domestic price level, PF = foreign price level, and z = vector of other determinants (tastes, quality, delivery dates, etc.)

Net exports (X-Im) rise as world income increases, domestic income falls, exchange rate falls, domestic price level falls or foreign price level rises.

Balance of Payments Balance of Payments - payments that flow

between a country and the rest of the world. It is determined by a country’s exports and imports of goods and services and the flow of financial capital and transfers. Current account records transfers of goods and

services. Capital account (broad) accounts for capital

transfers, trade of nonfinancial assets and financial assets and liabilities

Financial account v. capital account (narrow) X + Ki = Im + Ko or (X – Im) = Ko - Ki

(X – Im) + (Ki - Ko) = 0

Balance of Payments

Definitions

Balance of Payments Surplus : Payments made by a country are less than

payments received a the country Generally occurs when a trade surplus exists

Exports > ImportsBalance of Payments Deficit :

Payments made by a country are greater than the payments received by a country

Generally occurs when a trade deficit occurs Exports < Imports

Open Economy LM Fixed exchange rate regime

Central bank committed to buy and sell foreign exchange for domestic currency at a fixed rate

BP surplus leads to central bank buying foreign currency – increasing domestic Ms (LM shifts right)

BP deficit leads to central bank selling foreign currency – decreasing domestic Ms (LM shifts left)

Floating exchange rate regime Exchange rate adjusts to clear foreign exchange

market – balance payments always zero

BP Curve The locus of all r,Y

combinations that yield a balance of payments equilibrium.

Positively sloped Increases in Y that

worsen current account have to be accompanied by increases in r to improve the capital account

Points above BP curve are BP surplus, points below BP curve are BP deficit

BPr

Y

BP Curve Slope depends on

marginal propensity to import and interest elasticity of international capital flows

BP curve is flatter the smaller the marginal propensity to import and the more interest-elastic are capital flows

Limiting cases Complete capital immobility Perfect capital mobility

BP

BPmobile

BPimmobile

r

Y

BP Curve

The BP curve shifts to the right if net exports increase

Net exports increase ifworld incomeexchange ratedomestic prices

foreign prices

BP0

BP1

r

Y

Mundell-Fleming Model

LM curve typically steeper than BP curve (capital flows more interest elastic than the demand for money).

What is effect of monetary and fiscal policy under different exchange rate regimes?

BP0

LM0

r

Y

IS0

Mundell-Fleming Model

Fixed Exchange Rate Regime

Begin in equilibrium, r0,Y0Expansionary fiscal policy

shifts IS to rightMove from A to BBalance of payments surplusCentral bank must expand MS

to maintain fixed exchange rate

Long-run equilibrium occurs at C

BP0

LM0

r

Y

IS0

r0

Y0

IS1

A

B

C

LM1

r1

Y1

Mundell-Fleming Model

Fixed Exchange Rate Regime

In extreme case of perfect capital mobility, interest rates would not rise and fiscal policy becomes fully effective

BP0

LM0

r

Y

IS0

r0

Y0

IS1

A

B

C

LM1

Y1

Mundell-Fleming Model

Fixed Exchange Rate Regime

Begin in equilibrium, r0,Y0Expansionary monetary policy

shifts LM to rightMove from A to BBalance of payments deficitCentral bank must reduce MS to

maintain fixed exchange rateLong-run equilibrium occurs at

CMonetary policy is ineffective

regardless of capital mobility

BP0

LM0

r

Y

IS0

r0

Y0

A

B

C

LM1

Mundell-Fleming Model

Flexible Exchange Rate Regime

Begin in equilibrium, r0,Y0Expansionary fiscal policy shifts IS

to rightMove from A to BBalance of payments surplus

causes exchange rate to rise, shifting BP curve to left

IS curve also shifts to left as net exports decline

Long-run equilibrium occurs at CFiscal policy is less robust under

flexible exchange rates

BP0

LM0

r

Y

IS0

r0

Y0

IS1

A

B

C

BP1

IS2

r1

Y1

Mundell-Fleming Model

Flexible Exchange Rate Regime

In extreme case of perfect capital mobility, interest rates would not rise and fiscal policy becomes fully ineffective

BP0

LM0

r

Y

IS0

r0

Y0

IS1

A

B

C

Mundell-Fleming Model

Flexible Exchange Rate Regime

Begin in equilibrium, r0,Y0Expansionary monetary policy

shifts LM to rightMove from A to BBalance of payments deficit

causes exchange rate to fall, shifting BP to right

IS curve shifts to right as net exports rise

Long-run equilibrium occurs at CMonetary policy is more effective

than fiscal policy

BP0

LM0

r

Y

IS0

r0

Y0

A

B

C

LM1

r1

BP1

IS1

Y1

Mundell-Fleming Model

Flexible Exchange Rate Regime

In extreme case of perfect capital mobility, interest rates would not rise and monetary policy becomes fully effective

BP0

LM0

r

Y

IS0

r0

Y0

IS1

A

B

C

LM1

Y1

The Phillips Curve

Original Phillips Curve

Phillips, “The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957,” Economica (Nov. 1958) Fisher, “I Discovered the Phillips Curve,” Journal of

Political Economy, (March/April 1973) [1926] Phillips found an inverse relationship

between unemployment and the rate of change of money wages Data for 1948-1957 fit closely the earlier period

1861-1913

Original Phillips CurveOriginal Phillips Curve Phillips’ discovered Phillips’ discovered

relationship suggested a relationship suggested a long-run trade-off between long-run trade-off between money-wage inflation and money-wage inflation and unemploymentunemployment

Implied permanently low Implied permanently low levels of unemployment levels of unemployment could be achieved by could be achieved by tolerating permanently tolerating permanently high levels of inflationhigh levels of inflation

Provided explanation of Provided explanation of inflation missing in IS-LM inflation missing in IS-LM modelmodel

PC

dW

U

2%

2.5% 5.5%

Development of Phillips Development of Phillips CurveCurve

Empirical frontEmpirical front

Search for stable Search for stable relationship in other relationship in other countriescountries Samuelson and Samuelson and

Solow, “Analytical Solow, “Analytical Aspects of Anti-Aspects of Anti-Inflation Policy,” Inflation Policy,” AERAER (May 1960)(May 1960)

PC

dW

U

2%

2.5% 5.5%

Development of Phillips Development of Phillips CurveCurve

Theoretical frontTheoretical front

Development of Development of theoretical groundstheoretical grounds ““The Relationship The Relationship

Between Between Unemployment and Unemployment and the Rate of Change of the Rate of Change of Money Wage Rates in Money Wage Rates in the U.K. 1862-1957: A the U.K. 1862-1957: A Further Analysis,” Further Analysis,” EconomicaEconomica (Feb. (Feb. 1960)1960)

PC

dW

U

2%

2.5% 5.5%

Theoretical GroundingTheoretical Grounding

Lipsey argued:Lipsey argued: there exists a positive linear relationship there exists a positive linear relationship

between dW and ED for laborbetween dW and ED for labor there exists a negative non-linear there exists a negative non-linear

relationship between EDrelationship between EDLL and and unemployment rateunemployment rate

assumes the time it takes to move from assumes the time it takes to move from disequilibrium to equilibrium wage the disequilibrium to equilibrium wage the same regardless of size of EDsame regardless of size of EDLL

therefore lower initial W, the higher the dWtherefore lower initial W, the higher the dW

Theoretical GroundingTheoretical GroundingW SL

DL

WeW1

W2

a ab b

a b

dW2dW1

(DL – SL)/ DL

dW

L

EDL

ESL

e U

Linking to IS-LMLinking to IS-LM The level of output depends on The level of output depends on

the level of employment and the level of employment and prices set as mark-up over wage prices set as mark-up over wage costscosts

U = g(L); Y = f(L)U = g(L); Y = f(L) dP = dW – productivity growthdP = dW – productivity growth Begin at full employment and Begin at full employment and

zero inflation (A)zero inflation (A) Increase in AD shifts IS curve to Increase in AD shifts IS curve to

the right, price inflation of dPthe right, price inflation of dP11 occurs (B)occurs (B)

As prices increase real money As prices increase real money supply falls, shifting LM to left supply falls, shifting LM to left until full employment is restored until full employment is restored (C)(C)

LM0

IS

r

dP1

Y

dP

Y

IS1

LM1

YF

YF Y1

Y1

A

A

B

B

C

C

Orthodox Keynesianism

Central Propositions

First Proposition: Modern capitalism subject to periodic recessions caused by deficiency of aggregate demand. Recessions are undesirable departures from full employment.

Second Proposition: The economy can be in one of two situations – a demand-constrained Keynesian regime or a full-employment supply-constrained classical regime.

Third Proposition: Unemployment of labor is a major feature of a Keynesian regime and unemployment is involuntary.

Fourth Proposition: Deviations from full employment need to be corrected, can be corrected and therefore should be corrected.

Fifth Proposition: In modern capitalism, wages and prices are not perfectly flexible; changes in AD will have real effects on output and employment.

Sixth Proposition: Business cycles are asymmetrical fluctuations around trend long-run full-employment growth.

Seventh Proposition: Policy-makers face a non-linear tradeoff between inflation and unemployment.

Eighth Proposition: Some Keynesians favor the use of incomes policies (wage and price controls) to help guide the economy to full employment and price stability.

Ninth Proposition: Keynesian economics is an economics of the short-run; it does not apply to long-run growth and development (though it is recognized some policies can be more favorable to long run growth).

Algebraic Summary of Basic IS-LM

Model

Algebra of theBasic IS-LM Model

E = A + cY – ar Md/P = mY – brE = Y Md/P = M/P

Rearranging and solving for Y yields:

Y = A + M/P 1 – [c – (a/b)m] m + (b/a)(1-c)

As a → 0 and b →∞

Y = [A / (1-c )] + [(M/P) / ∞] = A / (1-c)

Y = A + cY – ar M/P = mY - brY – cY = A – ar let Z = M/PY (1-c) = A – ar mY – Z = brY = (A – ar)/(1-c) (mY - Z)/b = r

Substitute the value of r from the right-side into the left-side equationY = A – a[(mY - Z)/b] / (1-c)

Multiply both top and bottom by bY = (bA – amY + aZ) / b(1-c)

Multiply both sides by b(1-c)b(1-c)Y = bA – amY + aZ

Collect Yb(1-c)Y + amY = bA + aZ

Factor out YY [b(1-c) + am] = bA + aZ

Divide both sides by b(1-c) + amY = bA/[b(1-c) + am] + aZ/[b(1-c) + am]

Y = bA/[b(1-c) + am] + aZ/[b(1-c) + am]

Factor out b from 1st term on right and factor out a from 2nd term on right

Y = {bA/b[(1 – c) + (a/b)m]} + {aZ/a[(b/a)(1-c) + m]

CancelY = A/[(1 – c) + (a/b)m] + Z/[(b/a)(1-c) + m]

RearrangeY = A/[1 – (c – (a/b)m] + Z/[m + (b/a)(1-c)]

Replace Z with M/P

Y = A + M/P 1 – [c – (a/b)m] m + (b/a)(1-c)