MacroEconomics

1. INTRODUCTION
Economic model:
Simplified models of a complex reality where irrelevant details are stripped away, which can be used
to show relationships between variables and explain economy’s behaviour

Endogenous and Exogenous variables:

Values of exogenous variables are determined outside the model (given).
Values of endogenous variables are determined in the model (depending on assumptions and given
data).

Economic model for Supply & Demand for Goods

Demand curve: Qd = D(P, Y)
Supply Curve: Qs=S(P, Ps)
Qd: Quantity of goods that buyers demand
Qs: Quantity that producers supply
P: Price of new goods
Y: Aggregate Income
Ps: Price of raw material
Endogenous variables: P, Qd, and Qs
Exogenous variables: Y, Ps

Effects of increase in income (Y): Demand curve shifts to the right due to higher purchasing power.
Equilibrium price and equilibrium quantity increases.
Effects of increase in raw material price (Ps): Supply curve shifts to the left – Producers have to
produce same quantity of goods at a higher cost.

Flexible and Sticky prices:

Flexible prices: Price of the goods adjust to equate supply and demand
Sticky prices: Price of the goods adjust sluggishly in response to changes in supply or demand (eg:
essential goods).
Market clearing: Assumption that prices are flexible
If prices are sticky, demand will not always equal supply. This explains:

 Unemployment (Excess supply of labor)

 Overproduction
In the long run, prices are ALWAYS flexible
In the short run, prices may be sticky. Hence economy works very differently in long run and short
run.
2. THE DATA OF MACROECONOMICS

Gross Domestic Product (GDP)

 Total expenditure on domestically-produced final goods and services.

 Total income earned by domestically-located factors of production.
Circular flow of money:

A Firm’s Value Added = value of its output minus value of intermediate goods used for
production
GDP = value of final goods produced
= sum of value added at all stages of production

Components of GGDP (Expendture)

1. Consumption (C)
Value of all goods and services bought by households. Includes:

 Durable goods (lasts a long time; eg: cars, home applicances)

 Non-durable goods (lasts a short time; eg: food, clothing)
 Services (work done for consumers; eg: dry cleaning, air travel)
2. Investment (I)
Spending on capital OR spending on goods bought for future use

 Business fixed investment (Spending on plant & equipment for production)

 Residential fixed investment (Spending on housing units)
 Inventory investment (Change in value of all firm’s inventories)
3. Government Spending (G)
All government spending on goods and services
4. Net Exports (NX)
Value of Total Exports (EX) minus Value of total imports (IM)
 Value of total output = aggregate expenditure
Y = C + I + G + NX

Gross National Product (GNP)

Total Income earned by the nation’s factors of production, independent of location
(whereas GDP is total income earned by domestically-located factors of production, regardless of
nationality)
Hence,
GNP – GDP = (factor payments from abroad) – (factor payments to abroad)

Nominal GDP: measures values using current prices.

Changes in Nominal GDP can be due to changes in prices OR changes in output produced.
Read GDP: measures values using prices of a base year.
Changes in real GPD can ONLY be due to changes in quantities of output produced.
Chain-weighted real GDP: base year is updated every year.

GDP deflator = 100 x ( Nominal_GDP / Real_GDP )

 Basket of goods used for GDP deflator changes every year

Inflation rate: percentage increase in overall level of prices.
Consumer Price Index (CPI) : A measure of overall level of prices published by Bureau of Labor
Statistics (BLS)
CPI (for any month) = 100 x ( Cost_of_basket_in_that_month / Cost_of_basket_in_base_period )

 Basket of goods used for CPI is fixed.

 CPI is a weighted average of prices; weight on each reflects the good’s relative importance in
the CPI basket.
 CPI overstates inflation (by 1% per year) due to
o Substitution bias (cannot reflect consumers’ ability to substitute towards goods whose
relative prices have fallen, due to use of fixed weights for CPI calculation)
o Introduction of new goods does not affect CPI
o Unmeasured changes in quality
3. NATIONAL INCOME: WHERE IT COMES AND WHERE IT GOES
MODEL FOR CLOSED ECONOMY WITH MARKET CLEARING

Factors of Production
Capital (K) – tools, machines, structures used in production
Labor (L) – efforts of workers in production
Production function: Y = F(K, L)
Where Y: output that can be produced from K units of capital and L units of labor.
Returns to scale
If all inputs are scaled by a factor z, ie., K2 = z * K1 and L2 = z * L1
If Y2 = z * Y1 ---- constant returns to scale
If Y2 > z * Y1 ---- increasing returns to scale
If Y2 < z * Y1 ---- decreasing returns to scale
Example:

Assumptions of the model:

 Technology is fixed
 Economy’s supplies of capital and labor are fixed at: K = K’, L = L’
Output determined by fixed factors and fixed state of technology: Y’ = F(K’, L’)
Demand for factors of production:

 Demand for Labor

o Firm hires each unit of labor if marginal cost (real wage, W) does not exceed
marginal benefit (Marginal Product of Labor, MPL: Extra output that can be
produced by an additional unit of labor)
o Each firm hires Labor up to the point where MPL = W / P
Marginal Product of Labor, MPL: Extra output that can be produced by an additional unit of labor
Marginal Product of Labor (MPL) and production function

MPL = the prod function’s slope:

The definition of the slope of a curve is the amount the curve rises when you move one unit to the
right. On this graph, moving one unit to the right simply means using one additional unit of labor.
The amount the curve rises is the amount by which output increases: the MPL.

Similarly, firms maximise profits by choosing K such that MPK = R / P , where R : Rent

Diminishing Marginal Returns

As a factor is increased, its marginal product falls
Diminishing returns to labor: (increase in L with fixed K => MPL decreases due to fewer machines
per worker and hence decreased productivity)
Diminishing returns to capital: (MPK decreases as K increases with fixed L)
Neoclassical theory of income distribution:
Y’ = MPL * L’ + MPK * K’
MPL * L’ : Labor Income
MPK * K’ : Capital Income

The Cobb-Douglas Production Function:

α = Capital’s share of total income
Capital Income: MPK * K = αY
Labor Income: MPL * L = (1- α) Y
Cobb-Douglas production function:

Y = AK αL1- α
A: Level of technology
Demand Side of the model:
C : Consumer demand for goods and services
I : Demand for investment goods
G : Government demand for goods and services
NX : net exports = 0 for a closed economy

Consumption, C
Disposable Income: Y – T
Consumption is a function of Y – T
C = C(Y-T)
Marginal Propensity to Consume (MPC): Increase in C caused by a one-unit increase in disposable
income. MPC is the slope of the consumption function.
Consumption function:

Investment, I
Investment is a function of real interest rate, r
I = I(r)
Real interest rate is the cost of borrowing or opportunity cost of using own funds for investmenting
If r increases, I decreases.
Investment function:
Government spending, G
G is government spending on goods and services
Assume govt spending and total taxes are exogenous
G = G’
Taxes:
T = T’

Aggregate demand:
Y’ = C(Y’-T’) + I(r) + G’
Aggregate supply:
Y’ = F(K’, L’)
The real interest rate (r) adjusts to equate demand with supply.

Model for loanable funds market:

Demand for funds: Investment
Supply of funds: Saving
Price of funds: Real Interest Rate
Private Saving: (Y – T) – C
Public Saving: T – G
National Saving: S = public_saving + private_saving = Y – C - G
If T > G,  Budget surplus = (T – G)
If T < G,  Budget deficit = (G – T), public saving is negative
If T = G,  Balanced Budget, public saving = 0
Supply curve is vertical because national saving (S) does not depend on real interest rate, r
5. The Open Economy
Open Economy- an economy in which there are economic activities between the domestic
community and outside.

In an open economy:

 spending need not equal output

 saving need not equal investment

C = Cd + C f

I = Id + If

G = Gd + Gf

Where superscripts,

d = spending on domestic goods

f = spending on foreign goods

EX = exports = foreign spending on domestic goods

IM = imports = C f + I f + Gf = spending on foreign goods

NX = net exports (a.k.a. the “trade balance”) = EX – IM

GDP = expenditure on domestically produced goods and services

Y = C + I + G + NX

NX = Y – (C + I + G)

NX = net exports

Y = Output

C + I + G = domestic spending

Trade surplus: output > spending and exports > imports

Size of the trade surplus = NX

Trade deficit: spending > output and imports > exports

Size of the trade deficit = –NX

International Capital Flows-

Net Capital Outflow(NCO)- if a country’s savers supply more funds than its firms wish to borrow for
investment, the excess of loan-able funds will flow abroad in the form of net capital outflow (the
purchase of foreign assets). Alternatively, if firms wish to borrow more than domestic savers wish to
lend, then the firms borrow the excess on international financial markets; in this case, there’s a net
inflow of loan-able funds, and S < I.

NCO = S – I

When S > I, country is a net lender

When S < I, country is a net borrower

NX = Y – (C + I + G)

NX = (Y – C – G) – I

=S–I

So, trade balance = net capital outflow

Thus, a country with trade deficit (NX<0) is a net borrower (S<I).

National saving: the supply of loan-able funds

Assumptions for Capital flows:

a. domestic & foreign bonds are perfect substitutes (same risk, maturity, etc.)

b. perfect capital mobility: no restrictions on international trade in assets

c. economy is small: cannot affect the world interest rate, denoted r*

a & b imply r = r* and c implies r* is exogenous

Investment: The demand for loan-able funds

Investment is still a downward-sloping function

of the interest rate, but the exogenous world

interest rate determines the country’s level of

investment.

In a small open economy

The exogenous world interest rate determines investment. The difference between saving and
investment determines net capital outflow and net exports.

Fiscal policy at home

Results:

ΔI = 0
ΔNX = ΔS < 0

In a small open economy, the fixed world interest rate pins down the value of investment, regardless
of fiscal policy changes. The analysis on this slide applies to ANYTHING that causes a decrease in
saving. Other examples: a shift in consumer preferences regarding the tradeoff between saving and
consumption, or a change in the tax laws that reduces the incentive to save.

Fiscal policy abroad

A fiscal expansion in other countries would reduce S* and raise r*. The higher world interest rate
reduces investment in our small open economy, and hence reduces the demand for loan-able funds.
The supply of loan-able funds (national saving) is unchanged, so there’s an increase in the amount of
funds flowing abroad.

Results:

ΔI < 0
ΔNX = -ΔI > 0
An increase in investment demand

ΔI > 0,

ΔS = 0,

net capital outflow and NX fall by the amount ΔI

In contrast to a closed economy, investment is not constrained by the fixed (domestic) supply of
loan-able funds. Hence, the increase in firm’s demand for loan-able funds can be satisfied by
borrowing abroad, which reduces net outflow of financial capital. And since net capital outflow = NX,
we see a fall in NX equal to the increase in investment.

Nominal exchange rate:

e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency

Real exchange rate:

ε = real exchange rate, the relative price of domestic goods in terms of foreign goods
e.g. Japanese Big Mac per U.S. Big Mac

ε = (e * P) / P*

Where, P and P* are the overall price levels of the domestic & foreign countries. Thus, they each
measure the price of a basket of goods.

The real exchange rate measures the amount of purchasing power in Japan that must be sacrificed
for each unit of purchasing power in the U.S. A good candidate for the basket of goods mentioned
here is the CPI basket. Perhaps a better candidate would be a basket including all goods & services
that comprise GDP. Then, the real exchange rate would measure how many units of foreign GDP
trade for one unit of domestic GDP.

ε  U.S. goods become more expensive relative to foreign goods

 EX, IM

 NX

Net Exports function:

The net exports function reflects this inverse relationship between NX and ε:

NX = NX(ε )
Determination of ε

Neither S nor I depend on ε, so the net capital outflow curve is vertical.

ε adjusts to equate NX with net capital outflow, S - I.

Supply and Demand in the Foreign exchange market

NX is actually the net demand for dollars: foreign demand for dollars to purchase our exports minus
our supply of dollars to purchase imports. Net capital outflow is the net supply of dollars: The
supply of dollars from U.S. residents investing abroad minus the demand for dollars from foreigners
buying U.S. assets.
Fiscal Policy at home

A fiscal expansion reduces national saving, net capital outflow, and the supply of dollars
in the foreign exchange market. Also, the real exchange rate to rise and NX to fall.

Fiscal policy abroad

An increase in r* reduces investment, increasing net capital outflow and the supply of dollars in the
foreign exchange market, causing the real exchange rate to fall and NX to rise.

Increase in investment demand

An increase in investment reduces net capital outflow and the supply of dollars in the foreign
exchange market, causing the real exchange rate to rise and NX to fall.

Trade policy to restrict imports

At any given value of ε, an import quota

 ↓IM ↑NX
 demand for dollars shifts right

Trade policy doesn’t affect S or I, so capital flows and the supply of dollars remain fixed.

Results:

Δε>0
(demand increase)

Δ NX = 0
(supply fixed)

Δ IM < 0
(policy)

Δ EX < 0
(rise in ε)

Purchasing Power Parity

  A doctrine that states that goods must sell at the same (currency-adjusted) price in all
countries.

 The nominal exchange rate adjusts to equalize the cost of a basket of goods across
countries.

Reasoning:

 arbitrage, the law of one price

e P = P*

e*P = cost of a basket of domestic goods in foreign currency

P = cost of a basket of domestic goods in domestic currency

P* = cost of a basket of foreign goods in foreign currency

P P* P
If e = P*/P, then ε  e    * 1
P *
P P
And NX is horizontal;

Under PPP, changes in (S – I ) have no impact on ε or e.

05. Economic Fluctuations

Business cycles consist of short-run fluctuations consisting of economic booms (rising

incomes and falling unemployment) and economic recessions (pay cuts and rising
unemployment). These business cycles are irregular and difficult to predict.

The key difference between short run and long run in economics is the behavior of prices. In
the short-run prices are sticky (unchanging) while in the long run prices are flexible.

Aggregate Demand

Aggregate demand (AD) is the relationship

between the quantity of output demanded
and the aggregate price level. In other
words, the aggregate demand curve tells
us the quantity of goods and services
people want to buy at any given level of prices.

The Aggregate Demand curve is downward

sloping

Shifts in the Aggregate Demand Curve

The Aggregate Demand curve shifts depend on the following factors,
- Income (Direct relationship)
- Tax (Indirect relationship)
- Interest Rates (Indirect relationship)
- Net Exports (Direct relationship)
Aggregate Supply

Aggregate Supply (AS) is the relationship

between the quantity of output supplied
and the aggregate price level. In other
words, the aggregate supply curve tells
us the quantity of goods and services
firms produce at any given level of prices.

The Aggregate Supply curves is upward sloping.

Shifts in the Aggregate Supply Curve

The Aggregate Supply curve shifts depend on the following factors,
- Cost of resources
- Government action (policies and regulations)
- Improvements in Productivity

Long Run and Short Run Aggregate Supply

In the long run, prices are flexible

and the aggregate supply curve is
vertical
(full employment).

In the short run the aggregate

supply curve is horizontal as the
prices are sticky.
Keynesian Aggregate Supply

The Keynesian AS curve assumes that prices and

wages are fixed in the short run. Over the
‘Keynesian range’ there is spare capacity in the
economy, the price level is stable, and real output
can expand as a result of increases in AD without
any inflationary pressure.

Shocks to Aggregate Demand

Shocks temporarily push the economy away from

full employment. A negative demand shock pushes
the AD curve to the left, depressing output and
employment in the short run.
Over time, prices fall and the economy moves down
its demand curve towards full time employment.

Shocks to Aggregate Supply

A supply shock alters prices by affecting the

production costs or through other factors such as
wage disputes, government regulations, etc.

A supply shock will cause an upward shift in the

Short-Run Aggregate Supply (SRAS) curve causing
output and employment to fall.

In the absence of further price shocks, prices will fall

over time and economy moves back toward full
employment.
The Central authority (such as Federal Reserve in US and RBI in India) is responsible for
stabilizing the economy in the event of supply or demand shocks through monetary policy
initiatives.
06. Aggregate Demand

Keynes’ theory of National Income

According to Keynes’ there can be different sources of national income such as government,
foreign trade, individuals, businesses, and trusts.
For determining the national income, the economy can be divided into four sectors –
business sector, household sector, government sector, and foreign sector.

Keynesian Cross
The Keynesian Cross is a simple closed economy model in which income is determined by
expenditure. It is the simplest interpretation of Keynes’ theory of national income and is a
building block for the more realistic IS-LM model.

The planned expenditure in an economy is a function of income (Y), level of planned

investment (Ȳ), and fiscal policy variables Ḡ(government purchases) and T (government
taxes),

E = C(Ȳ - T) + Ī + Ḡ

In the equilibrium condition (income is at equilibrium value), the planned expenditure should
equal the actual expenditure
Y=E

Fiscal Policy Multipliers (for inducing growth in the economy)

- Government Purchases
Increase in government purchases leads to a multiplier effect in the growth of the
economy (this multiplier is greater than 1)

Y = Change in Income
G = Change in government purchases
MPC = Marginal Propensity to Consume

- Tax
Decrease in taxes leads to a multiplier effect in the growth of the economy

Y = Change in Income
 G = Change in government taxes
MPC = Marginal Propensity to Consume

IS (Income-Savings) Curve

The IS curve is a graph of all combinations of output Y and interest rate r for which the
market is in equilibrium, i.e. actual expenditure (output) = planned expenditure.
It is denoted by the equation,
Y = C(Y - T) + I(r) + Ḡ

A fall in the interest rate motivates firms to

increase investment spending, which drives up
total planned spending (E).

To restore equilibrium in the goods market,

output (a.k.a. actual expenditure, Y) must
increase.

Loanable Funds Interpretation of IS Curve

An increase in income from Y1 to Y2 raises saving and thus lowers the interest rate that
equilibrates the supply and demand for loanable funds. The IS curve expresses this negative
relationship between income and the interest rate.
The Theory of Liquidity Preference

This is a theory put forward by John Maynard Keynes that states that the interest rate
adjusts to balance the supply and demand for money.

If the price level is fixed, a reduction in the money supply reduces the supply of real money
which leads to a rise in equilibrium interest rates.
Income, Money Demand, and the LM curve

The LM curve is the graph of all combinations of interest rates and output that equate the
supply and demand for real money balances.

The equation for LM curve is:

An increase in income raises money demand. Since the supply of real balances is fixed,
there is now excess demand in the money market at the initial interest rate.

The interest rate must rise to restore equilibrium in the money market.

The Short-Run Equilibrium

The short-run equilibrium is the combination of interest rate and output that simultaneously
satisfies the equilibrium conditions in the goods and money markets.

Y = C(Y - T) + I(r) + Ḡ
07. Aggregate Demand II
The IS-LM model, which stands for "investment-savings, liquidity-money," is a Keynesian
macroeconomic model that shows how the market for economic goods (IS) interacts with the
loan-able funds market (LM), or money market, and it is represented as a graph in which the
IS and LM curve intersect to show the short-run equilibrium between interest rates and
output. Y  C (Y T )  I (r )  G
The IS curve represents equilibrium in the goods market.
The LM curve represents money market equilibrium. M P  L (r ,Y )

The intersection determines the unique combination of Y and r that satisfies equilibrium in
both markets.

We can use the IS-LM model to

analyze the effects of

• fiscal policy: G
and/or T

• monetary policy: M

An increase in Govt. purchases

1. IS curve shifts by (1/1 – MPC)* ΔG causing
output and income to rise.
2. This raises money demand, causing the interest rate
to rise.
3. Which reduces investment so the final increase in Y is
smaller than (1/1 – MPC)* ΔG

A Tax Cut
1. The IS curve shifts by (-MPC/1 - MPC)* ΔT
2. r rises so the final increase in Y is smaller
than the direct effect of a tax cut

Monetary Policy: an increase in M

1. M > 0 shifts the LM curve down (or to the right)

2. Causing the interest rate to fall
3. Which increases investment, causing output & income to rise.

Shocks in the IS -LM model

IS shocks: exogenous changes in the demand for goods & services.
Examples:
 stock market boom or crash
 change in households’ wealth
 C
 change in business or consumer confidence or expectations
 I and/or C
LM shocks: exogenous changes in the demand for money.
Examples:
 a wave of credit card fraud increases demand for money.
 more ATMs or the Internet reduce money demand.
IS-LM and aggregate demand
 We have been using the IS-LM model to analyze the short run, when the price level
is assumed fixed.
 However, a change in P would shift LM and therefore affect Y.
 The aggregate demand curve captures this relationship between P and Y.

Monetary policy and the AD curve

Fiscal policy and the AD curve

IS-LM and AD-AS in the short run & long run

The force that moves the economy from the short run to the long run is the gradual
adjustment of prices.
A negative IS shock shifts IS and AD left, causing Y
to fall.
̅
In the new short-run equilibrium, Y < 𝑌

Over time, P gradually falls, which causes

• SRAS to move down.

• M/P to increase, which causes LM

to move down.

This process continues until economy reaches a

̅
long-run equilibrium with Y = 𝑌
08. The Open Economy Revisited: the Mundell-Fleming Model and
the Exchange-Rate Regime
The Mundell-Fleming model
 Key assumption:
Small open economy with perfect capital mobility.
r = r*
 Goods market equilibrium – the IS* curve:
Y  C (Y T )  I (r *)  G  NX (e )
Where,
e = nominal exchange rate = foreign currency per unit domestic currency
The IS* curve is drawn for a given value of r*.
Intuition for the slope: e   NX   Y The IS* curve: Goods market eq’m

The LM* curve

 is drawn for a given
value of r*.
 is vertical because:
given r*, there is
only one value of Y
that equates money demand with supply,
regardless of e.

M P  L(r *,Y )
The LM* curve: Money market eq’m

Equilibrium in the Mundell-Fleming model

In a system of floating exchange rates,

e is allowed to fluctuate in response to changing economic conditions.
In contrast, under fixed exchange rates,
the central bank trades domestic for foreign currency at a predetermined price.
Fiscal policy under floating exchange rates
At any given value of e,
a fiscal expansion increases Y,
shifting IS* to the right.
Results:

e > 0, Y = 0

Crowding out
 closed economy:
Fiscal policy crowds out investment by causing the interest rate to rise.
 small open economy:
Fiscal policy crowds out net exports by causing the exchange rate to appreciate.
Monetary policy under floating exchange rates
An increase in M shifts LM* right
because Y must rise to restore equilibrium in
the money market.
Results:

e < 0, Y > 0

Monetary policy affects output by affecting

the components of aggregate demand:
 closed economy: ↑M → ↓r → ↑I → ↑Y
 small open economy: ↑M → ↓ e → ↑NX → ↑Y

Expansionary monetary policy does not raise world agg. demand, it merely shifts demand
from foreign to domestic products. So, the increases in domestic income and employment
are at the expense of losses abroad.

Trade policy under floating exchange rates

At any given value of e,
a tariff or quota reduces imports, increases NX,
and shifts IS* to the right.
Results:

e > 0, Y = 0
Import restrictions cannot reduce a trade deficit.
Even though NX is unchanged, there is less trade:
 the trade restriction reduces imports.
 the exchange rate appreciation reduces exports.
Less trade means fewer “gains from trade.”
Import restrictions on specific products save jobs in the domestic industries that produce
those products, but destroy jobs in export-producing sectors.
Hence, import restrictions fail to increase total employment.
Also, import restrictions create “sectoral shifts,” which cause frictional unemployment.
Fixed exchange rates
 Under fixed exchange rates, the central bank stands ready to buy or sell the
domestic currency for foreign currency at a predetermined rate.
 In the Mundell-Fleming model, the central bank shifts the LM* curve as required to
keep e at its preannounced rate.
 This system fixes the nominal exchange rate. In the long run, when prices are
flexible, the real exchange rate can move even if the nominal rate is fixed.
Fiscal policy under fixed exchange rates
Under floating rates,
fiscal policy is ineffective
at changing output.
Under fixed rates,
fiscal policy is very effective at changing output.
Results:

e = 0, Y > 0

Monetary policy under fixed exchange rates

An increase in M would
shift LM* right and reduce e.
To prevent the fall in e, the central bank must
buy domestic currency, which reduces M and
shifts LM* back left.
Under floating rates, monetary policy is
very effective at changing output.
Under fixed rates, monetary policy cannot be used
to affect output.
Results:

e = 0, Y = 0
Trade policy under fixed exchange rates
A restriction on imports puts upward pressure on e.
To keep e from rising, the central bank must
sell domestic currency, which increases M
and shifts LM* right.
Results:

e = 0, Y > 0
Under floating rates, import restrictions
do not affect Y or NX.
Under fixed rates, import restrictions
increase Y and NX.
Floating vs. fixed exchange rates
Argument for floating rates:
 allows monetary policy to be used to pursue other goals (stable growth, low
inflation).
Arguments for fixed rates:
 avoids uncertainty and volatility, making international transactions easier.
 disciplines monetary policy to prevent excessive money growth &
hyperinflation.

The Impossible Trinity

A nation cannot have free capital flows,
independent monetary policy, and
a fixed exchange rate simultaneously.
A nation must choose one side of this
triangle and give up the opposite
corner.

Interest-rate differentials
Two reasons why r may differ from r*
 country risk: The risk that the country’s borrowers will default on their loan
repayments because of political or economic turmoil. Lenders require a higher
interest rate to compensate them for this risk.
  expected exchange rate changes: If a country’s exchange rate is expected to fall,
then its borrowers must pay a higher interest rate to compensate lenders for the
expected currency depreciation.
Expected change in exchange rates
 When a foreigner buys a domestic bond, they really earn more than just r, the
interest rate.
 They are holding a dollar asset. Foreigners gain if the dollar itself gains value
relative to the foreign currency.
e1  e
 The expected appreciation of the dollar:
e

Interest parity
 The total expected return for a foreigner isr 
ee1  e
e
 “Interest parity” says that the return on the home country’s bonds equal the foreign
ee1  e
interest rate:
r r *
e

Interest rates and exchange rates

 We can rewrite the interest parity equation to get a relationship that says the
exchange rate is determined by home and foreign interest rates, and the expected
future exchange rate:

ee1
e
1  r * r
 Home currency is stronger if:
 Home interest rate, r, rises
 Foreign interest rate, r*, falls
 Expected exchange rate increases
The short-run equilibrium
Let’s write the equation for exchange rates as
e = e(r,r*,ee)
Now let’s go back to our IS equation:
Y = C(Y-T) + I(r) +G + NX(e)
= C(Y-T) + I(r) +G + NX(e(r,r*,ee))
We have solved out for the exchange rate.
IS depends on the interest rate, r.
IS is shifted by changes in r* and ee
The LM curve is unchanged. For the open-economy, we can write an IS-LM model that is
similar to the closed economy:

Y  C (Y  T )  I (r )  G M P  L (r ,Y )
e
NX (e (r , r *, e ))
An increase in government purchases
1. IS curve shifts right
2. r rises and Y rises
3. e rises, from interest parity
4. NX must fall.
 The home country interest rate can rise.
We do not have to have r = r*
 There is crowding out – as G rises, NX falls.
 But it is not complete crowding out. NX does not fall as much as G rises.
 So, Y rises when G rises.
 Exogenous changes in demand can affect output.

Monetary policy: An increase in M

1. M > 0 shifts, the LM curve down

2. r goes down, Y goes up
3. e goes down
4. NX goes up

 A monetary expansion reduces the home interest rate, r, as in an open economy

 Investment demand and net exports are stimulated.
 In the open economy, a monetary expansion has an extra kick.
Summary:
 When we allow for expected changes in the value of the currency and use interest
parity, the model is like the closed economy IS-LM.
 The IS curve is flatter because a drop in the interest rate also causes e to fall, which
stimulates net exports.
 The expected exchange rate, ee, and the foreign interest rate, r*, can affect the IS
curve.
09. SOLOW MODEL
The Solow Growth Model or the Solow-Swan Model is a standard neo-classical model of
economic growth. It was independently developed by Prof. Robert M. Solow and Trevor
Swan. Robert M. Solow was awarded the Nobel Prize for it in 1987.

Key Points
- Solow’s model is a model for long run economic growth and helps in
understanding the factors that determine the economic growth for different countries.
- It attempts to explain long-run economic growth by looking at capital accumulation
(K), labour or population growth (L), and increases in productivity, commonly
referred to as technological progress or also as knowledge (A).
- A 'steady-state growth path' is reached when output, capital and labour are all
growing at the same rate, so output per worker and capital per worker are constant.
- The Solow model features the idea of catch-up growth when a poorer country is
catching up with a developed country, often via a higher marginal rate of return on
invested capital in faster-growing countries.
- The Solow–Swan model augmented with human capital predicts that the income
levels of poor countries will tend to catch up with or converge towards the income
levels of rich countries if the poor countries have similar savings rates for both
physical capital and human capital as a share of output, a process known as
conditional convergence.

Brief Explanation

According to Prof. Solow, for attaining

long run growth, let us assume that
capital and labour both increase but
capital increases at a faster rate than
labour so that the capital labour ratio is
high. As the capital labour ratio
increases, the output per worker declines
and as a result national income falls.

The savings of the community decline

and in turn investment and capital also
decrease. The process of decline
continues till the growth of capital becomes equal to the growth rate of labour. Consequently,
capital labour ratio and capital output ratio remain constant and this ratio is popularly known
as “Equilibrium Ratio”.

Prof. Solow has assumed technical coefficients of production to be variable, so that the
capital labour ratio may adjust itself to equilibrium ratio. If the capital labour ratio is larger
than equilibrium ratio, than that of the growth of capital and output capital would be lesser
than labour force. At some time, the two ratios would be equal to each other.
In other words, this is the steady growth, according to Prof. Solow as there is the steady
growth there is a tendency to the equilibrium path. It must be noted here that the capital-
labour ratio may be either higher or lower.

This model also exhibits the possibility of multiple equilibrium positions. The position of
unstable equilibrium will arise when the rate of growth is not equal to the capital labour ratio.
There are other two stable equilibrium points with high capital labour ratio and the other with
low capital labour ratio.