Inflation: Quantity Theory of Money (QTM)

• It’s a classical theory of inflation.

• QTM links money supply to price level. MV=PY
• For this, we need to know what V is. V stands for velocity of circulation of money.

• Basic concept: the rate at which money circulates

• Definition: the number of times the average rupee note changes hands in a given time period
• Example: In 2007,
• Rs 500 billion in transactions
• money supply = Rs 100 billion
• The average rupee is used in five transactions in 2007
• So, velocity = 5
• In order for Rs 500 billion in transactions to occur when the money supply is only Rs 100b,
each rupee must be used, on average, in five transactions.
 Velocity
T
• This suggests the following definition: V=
M

where V = velocity, T = value of all transactions, M = money supply

Use nominal GDP as a proxy for total transactions. Then, P Y
V=
M
Where P = price of output (GDP deflator), Y = quantity of output (real GDP), P Y = value of output
(nominal GDP)

How do nominal GDP and total value of transactions differ?

Nominal GDP includes the value of purchases of final goods; total transactions also includes the value of
intermediate goods.

From DFS ch 16
 The Income Velocity of Money
The income velocity of money is the number of times the stock of money is turned over
per year in financing the annual flow of income
It is equal to the ratio of nominal GDP to the nominal money stock, or:
P Y Y
V = (1)
M M
P
It can also be interpreted as the ratio of nominal income to nominal money stock OR the ratio of real
income to real money balances.

From DFS ch 16
 The Income Velocity of Money vs Transaction Velocity of Money

The transactions velocity of money is the ratio of total transactions to money balances.
Total transactions far exceed GDP for two reasons:
• Many transactions involving the sale and purchase of assets do not contribute to GDP.
• A particular item in final output typically generates total spending on it that exceeds the contribution of
that item to GDP.
• E.g. A rupee’s worth of rice generates transactions as it leaves the farm, as it is sold by the miller, and so
forth.

Transactions velocity > Income velocity.

From DFS ch 16
 The Quantity Theory of Money

The quantity theory of money provides a simple way to think about the relation
between money, prices, and output:
M V = P  Y

It is an identity: it holds by definition of the variables.

The quantity equation links the price level and the level of output to the money stock.

The quantity equation became the classical quantity theory of money when it has assumptions that
V (velocity) and Y (output or income) are fixed. Real output was assumed fixed as the economy was
working at full employment. Both the assumptions are unrealistic.
If both V and Y are fixed, it follows that the price level is proportional to the money stock.

From DFS
The classical quantity theory = long run theory of inflation

V M
The price level is proportional to the money stock: P=
Y

If V is constant, changes in the money supply translate into proportional

changes in nominal GDP (PxY).
With the classical case (vertical) supply function, Y is fixed, and changes in
money translate into changes in the overall price level, P
 The quantity theory of money, cont.
• The growth rate of a product of two variables equals the sum of the
growth rates.
• The quantity equation in growth rates: M V P Y
+ = +
M V P Y

The quantity theory of money assumes

V
V is constant, so = 0.
V
The quantity theory of money, cont.
 (Greek letter “pi”) P
denotes the inflation rate:  =
P
The result from the M P Y
= +
preceding slide was: M P Y

Solve this result M Y

for  to get  = −
M Y
The quantity theory of money, cont.
M Y
 = −
M Y

• Normal economic growth requires a certain amount of money supply

growth to facilitate the growth in transactions.
• Money growth in excess of this amount leads to inflation.

Suppose real GDP is growing by 3% per year over the long run. Thus, production, income, and spending are all
growing by 3%. This means that the volume of transactions will be growing as well.

The central bank can achieve zero inflation (on average over the long run) simply by setting the growth rate of
the money supply at 3%, in which case exactly enough new money is being supplied to facilitate the growth in
transactions.
 The quantity theory of money, cont.
M Y
 = −
M Y
Y/Y depends on growth in the factors of production and on technological progress (all of which we
take as given, for now).
Hence, the Quantity Theory predicts a one-for-one relation between changes in the money growth rate
and changes in the inflation rate.

Note: the theory doesn’t predict that the inflation rate will equal the money growth rate. It *does* predict that
a change in the money growth rate will cause an equal change in the inflation rate.
Confronting the quantity theory with data
The quantity theory of money implies
1. countries with higher money growth rates should have higher inflation rates.
2. the long-run trend behavior of a country’s inflation should be similar to the
long-run trend in the country’s money growth rate.
Are the data consistent with these implications?
 International data on inflation and money growth
100 Turkey
Inflation rate
(percent,
Ecuador Indonesia Belarus
logarithmic scale)
10

Argentina
U.S.
0.1 Switzerland
Singapore
1 10 100
Money Supply Growth
(percent, logarithmic scale)

Each variable is measured as an annual average over the period 1996-2004. The strong positive correlation is
evidence for the Quantity Theory of Money. Source: International Financial Statistics.

Fig 4-2, p.89, Mankiw 8e

 U.S. inflation and money growth, Over the long run, the inflation and
1960-2007 money growth rates move together,
as the quantity theory predicts.
15%

12% M2 growth rate

9%

6%

3%
inflation
sources:
rate
CPI - BLS
Money supply - Board
0%
of Governors of the
Federal Reserve
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
obtained from
http://research.stlouisf
ed.org/fred2/
The quantity theory of money is intended to explain the long-run relation of inflation and money
growth, not the short-run relation. In the long run, inflation and money growth are positively related,
as the theory predicts.

(In the short run, however, inflation and money growth appear highly negatively correlated! One
possible reason is that the causality is reversed in the short run: when inflation rises – or is expected to
rise – the RBI cuts back on money growth.

If the economy slumps and inflation falls, the RBI increases money growth. We’ll discuss this when
covering short-run fluctuations.)
Seigniorage
• To spend more without raising taxes or selling bonds, the govt can print money.
• The “revenue” raised from printing money is called seigniorage (pronounced SEEN-your-idge).
• The inflation tax: Printing money to (artificially) raise revenue causes inflation. Inflation is like a tax on
people who hold money.

• In the U.S., seigniorage accounts for only about 3% of total government revenue. In Italy and Greece,
seigniorage has often been more than 10% of total revenue. In countries experiencing hyperinflation,
seigniorage is often the government’s main source of revenue, and the need to print money to finance
government expenditure is a primary cause of hyperinflation. E.g. Venezuela, Zimbabwe, Argentina
Inflation and interest rates The Fisher Effect

• Nominal interest rate, i The Fisher equation: i = r + 

not adjusted for inflation S = I determines r .
Hence, an increase in 
• Real interest rate, r causes an equal increase in i.
adjusted for inflation: This one-for-one relationship
r = i − is called the Fisher effect.
• Where r = real interest rate,  =
inflation rate, i= nominal interest
rate
 Inflation and nominal interest rates in the U.S., 1955-2007
percent
per year
15%
nominal
The inflation rate is the
percentage change in 12% interest rate
the (not seasonally
adjusted) CPI from 12
months earlier. 9%
The nominal interest
rate is the (not
seasonally adjusted) 3-
month Treasury bill rate 6%
in the secondary market.
Data obtained from
http://research.stlouisfe 3%
d.org/fred2/

inflation rate
0%

-3%
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Mankiw’s text, a replica of Fig 4-3, p.92
The data are consistent with the Fisher effect: inflation and the nominal interest rate are very highly
correlated. However, they are not perfectly correlated, which absolutely does not invalidate the Fisher
effect.

Over time, the saving and investment curves move around, causing the real interest rate to move,
which, in turn, causes the nominal interest rate to change for a given value of inflation.
 Inflation and nominal interest rates across countries
Nominal 100
Interest Rate Romania
The nominal
interest rate is
(percent, Zimbabwe
the rate on logarithmic scale)
short-term
government Brazil Bulgaria
debt. Inflation
and interest
rates are
measured as
10 Israel
annual
averages over
the period
1996-2004. Germany U.S.
The strong Switzerland
positive
relation is
evidence for
the Fisher
1
effect. 0.1 1 10 100 1000
Inflation Rate
(percent, logarithmic scale)

Fig 4-4, p.93, Mankiw text

 Central Bank: RBI

Reserve Bank of India is India’s central bank. Set up in 1934.

Sole monetary authority of the country: manages and regulates currency, money supply and interest
rates.

It acts as the lender of the last resort to the banking sector.

It regulates money markets, financial markets, and forex markets and all banks in the country.
 How does a central bank douse a crisis?
• In the Great Recession, Fed (US’ Federal reserve) aggressively cut interest rates
• Reduced to almost zero
• Continued even after official end of recession

From DFS ch 17
Why does a central bank reduce interest rates (repo rate in case of RBI)?

Because in a situation where aggregate demand (Y=GDP=C+I+G+NX) is down, private investments and
consumption must increase to raise Y. How would one do that? If interest rate is reduced, investors’
demand for bank credit will increase, when investments go up, production, employment, and incomes
will go up. Y will be up.

e.g., Great Recession (2007-08 in the US), Covid lockdown in India (2020-21)
When interest rate is down, money supply increases. (… Inflation rate goes up afterwards.)
Money Stock Determination
• The money supply consists mainly of currency and, deposits at banks → RBI does
not control the latter directly
• A key concept concerning money in India is the fractional reserve banking system: banks are
required to keep only a fraction of all deposits on hand or on reserve (not loaned out)

• High powered money (monetary base) consists of currency and banks’ deposits at
the RBI
• The part of the currency held by the public forms part of the money supply
• Currency in bank vaults and banks’ deposits at the RBI are used as reserves backing individual
and business deposits at banks
• RBI’s direct control over the monetary base is the main route through which it determines
the money supply
Money Stock Determination
• The RBI has direct control over high powered money (H)
• Money supply (M) is linked to H via the money multiplier, mm, which is the ratio of the
stock of money to the stock of high powered money → mm > 1
• Money supply consists of currency, CU, plus deposits:
• Assumption: only a uniform class of deposits M = CU + D

• High powered money consists of currency plus reserves that banks have at the central
bank:
H = CU + reserves

From DFS
Money Stock Determination

• Summarize the behavior of the public, the banks, and the RBI in the money supply
process by three variables:
• Currency-deposit ratio: cu  CU
D
• Reserve ratio (reserve deposit ratio) : re  reserves
D
• Stock of high powered money: H

From DFS
 Money Stock Determination
M= CU + D
cu= CU/D , re= reserves/D
M= ((CU/D)D)+D
M=(cu xD) +D = (cu+1)D
H= CU+ reserves
H= ((CU/D)D)+((reserves/D)D)=(cu.D)+(re.D)=(cu+re)D
• We can rewrite equations as
M = (cu + 1) D and H = (cu + re) D
• This allows us to express the money supply in terms of its
principal determinants, re, cu, and H:
1 + cu
M= H  mm  H
re + cu

1 + cu
where mm is the money multiplier, given by: mm 
re + cu
From DFS
 Money Stock Determination
• Some observations of the money multiplier:

1 + cu
mm 
re + cu

• The money multiplier is larger, the smaller the reserve ratio, re

• The money multiplier is larger, the smaller the currency-deposit ratio,
cu
• The smaller is cu, the smaller the proportion of H that is being used as
currency AND the larger the proportion that is available to be reserves

From DFS
The Currency Deposit Ratio

• The payment habits of the public determine how much currency is held relative to
deposits
─ The currency deposit ratio is affected by the cost and convenience of obtaining cash
─ Currency deposit ratio falls with shoe-leather costs
→ Ex. If there is a cash machine nearby, individuals will on average carry less cash with them
because the costs of running out are lower
─ The currency deposit ratio has a strong seasonal pattern (highest around Diwali/Eid/Christmas)

From DFS
The Reserve Ratio
• Bank reserves = deposits banks hold at the RBI and “vault cash” (notes and coins held
by banks)
• In the absence of regulation, banks would hold reserves to meet:
1. The demands of their customers for cash
2. Payments their customers make by cheques that are deposited in other banks

• In India, banks hold reserves at the RBI primarily because the RBI requires them to
(required reserves)
• In addition to required reserves, banks hold excess reserves to meet unexpected withdrawals
The Reserve Ratio

Banks have to keep reserves in the form of notes and coins because their customers have a right to
currency on demand. They keep accounts at the RBI mainly to make payments among themselves.

Thus, when I pay you with a cheque drawn on my bank account, which you deposit in your bank, my
bank makes the payment by transferring money from its account at the RBI to your bank’s account at
the RBI.

Banks can also use their deposits at the RBI to obtain cash, the RBI sends them the cash over in
armoured trucks on request.
 The Instruments of Monetary Control
• The central bank has three instruments for controlling money supply
1. Open market operations (repo, reverse repo)
• Buying and selling of government bonds and securities
• Central bank buying government securities or bonds in exchange for money increases money
stock (money supply). It is done to reduce the interest rates. Example of expansionary monetary
policy.
• Central bank’s selling g-secs or bonds in exchange for money paid by the purchasers of the g-
secs/ bonds, reduces the money stock (money supply). It is done to increase the interest rates.
Example of contractionary monetary policy.
2. Discount rate
• Interest rate the central bank charges commercial banks for borrowing money
• Central bank is often the lender of last resort for commercial banks
3. Required-reserve ratio (CRR, SLR)
• Portion of deposits commercial banks are required to keep on hand, and not loan out
4. Moralsuasion

From DFS
Loans and Discounts
A bank that runs short on reserves can borrow to make up the difference
Can borrow from the RBI or other banks

The cost of borrowing some high-powered money from the central bank to meet the temporary needs
for reserves is the discount rate (serves as a signal).

When the central bank increases the discount rate, banks and financial markets take this as a signal
that the central bank intends to reduce the money supply and increase market interest rates.

The cost of borrowing from other banks is the federal funds rate in the US, or the policy rate (repo rate)
in India.

From DFS
 The Reserve Ratio
• The RBI (or the Fed in the US) sets the required reserve ratio: the portion of each
deposit commercial banks must keep on hand
• Looking at the money multiplier, it is easy to see that the RBI can increase the
money supply by reducing the required reserve ratio (RRR):

1 + cu
M= H  mm  H
re + cu

• RRR is not a policy tool of choice as reserves pay no interest, and thus are an
interest free loan from banks to the RBI
• Changes in the RRR have undesirable effects on bank profits

From DFS
 Repo rate aka Policy rate (Monetary Policy
Agreement 2016)
The policy rate (repo rate) is the key lending rate of the central bank in a country. It is a monetary policy
instrument under the control of the Central Bank (RBI) - to regulate the availability, cost and use of money
and credit.

A change in the policy rate alters all other short term interest rates in the economy, thereby influencing the
level of economic growth and inflation. (A low interest rate regime is considered conducive to economic
growth while it generally fuels inflation).

In India, the fixed repo rate quoted for sovereign securities in the overnight segment of Liquidity Adjustment
Facility (LAF) is considered as the policy rate.
In most countries, policy rate is generally the repo rate, though the nomenclature varies from
country to country. For instance, in US, it is called the federal funds rate. Some countries use cash
reserve ratio (China) or bank rate (UK) as the main policy rates to influence credit growth.
 Repo rate aka Policy rate
Repo rate, or repurchase rate in the overnight LAF window, is the fixed rate at which RBI lends to banks
for a day to help them meet the short-term liquidity needs. RBI buying government bonds from banks
with an agreement to sell them back at a predetermined rate at a fixed rate.

From commercial banks’ perspective, “Repo" means an instrument for borrowing funds by selling
securities with an agreement to repurchase the securities on a mutually agreed future date at an agreed
price which includes interest for the funds borrowed.

Repo, or sale-and-repurchase agreement is a collateralized lending. A repo rate reduction injects more
liquidity or money supply into the system. An increase in the repo rate decreases money supply.

Repo rate changes transmit through the money market to alter the other interest rates in the financial
system, which in turn influence aggregate demand - a key determinant of inflation and growth. If the
RBI wants to make it more expensive for banks to borrow money, it increases the repo rate. Similarly, if
it wants to make it cheaper for banks to borrow money, it reduces the repo rate.
 Reverse Repo
Reverse repo operation is when RBI borrows money from banks in exchange for securities. The interest
rate paid by RBI in this case is called the reverse repo rate. Reverse repo operation therefore absorbs
the liquidity from the system.

From commercial banks’ perspective, “Reverse repo" means an instrument for lending funds by
purchasing securities with an agreement to resell the securities on a mutually agreed future date at an
agreed price which includes interest for the funds lent.

This is the general definition of Reverse Repo in India. The securities transacted here can be either
government securities or corporate securities or any other securities which the Central bank permits
for transaction.

Non-sovereign securities are used in many global markets for repo operations. Unlike them, Indian
repo market predominantly uses sovereign securities, though repo is allowed on corporate bonds and
debentures.
 Liquidity Adjustment Facility (LAF)

LAF is a facility extended by the RBI to the scheduled commercial banks (excluding Regional Rural Banks) and
primary dealers to avail of liquidity in case of requirement or park excess funds with the RBI in case of excess
liquidity on an overnight basis against the collateral of Government securities including State Government
securities. Basically, LAF enables liquidity management on a day-to-day basis.

LAF is a monetary policy tool which allows banks to borrow money through repurchase agreements or repos.
LAF is used to aid banks in adjusting the day-to-day mismatches in liquidity (frictional liquidity
deficit/surplus). Liquidity of a more durable nature is managed with other instruments like, CRR or Market
Stabilization Scheme (MSS).

The operations of LAF are conducted by way of repurchase agreements (repos and reverse repos) with RBI
being the counter-party to all the transactions.
 Base rate
The Base Rate is the minimum interest rate of a bank below which it cannot lend (it’s unviable to lend),
except in some cases allowed by the RBI. No bank is allowed to lend funds below this rate. This rate
is fixed to ensure transparency with respect to borrowing and lending in the credit market. The Base Rate
also helps the banks to cut down on their cost of lending so as to be able to extend affordable loans.

The base rate, introduced w.e.f. 1st July 2011 by the RBI, is the new benchmark rate for lending operations
of banks. Thus, all categories of domestic rupee loans should be priced only with reference to the Base
Rate, subject to the conditions mentioned in RBI circulars dated April 9, 2010.

Each bank arrives at its base rate separately. Banks are free to choose any methodology to arrive at the
base rate which is consistent, appropriate and transparent.
The interest on all categories of loans is determined with respect to the base rate except the following loans; (a) DRI advances ( that is Differential
rate of interest scheme whereby banks offer financial assistance at concessional rates) (b) loans to banks’ own employees (c) loans to banks’
depositors against their own deposits. Base rate is to be reviewed at least once in a quarter and has to be disclosed to the public.
 Cash Reserve Ratio (CRR)
CRR is the share of a bank’s total deposit that is mandated by the RBI to be maintained with the latter in the
form of liquid cash.

CRR is the fraction of the total Net Demand and Time Liabilities (NDTL) of a Scheduled Commercial Bank
held in India, that it has to maintain as cash deposit with the RBI. The requirement applies uniformly to all
banks in the country irrespective of an individual bank’s financial situation or size.
In contrast, certain countries e.g., China stipulates separate reserve requirements for ‘large’ and ‘small’
banks.

The CRR acts as one of the reference rates to determine the base rate. Apart from this, there are two
main objectives for existence of CRR:
• CRR ensures that a part of the bank’s deposit is with the Central Bank and is hence, safe.
• CRR helps in controlling inflation. To keep the liquidity in check, the RBI resorts to increasing and
decreasing the CRR.
CRR

When the RBI decides to increase the CRR, the amount of money that is available with the banks
reduces. This is the RBI’s way of controlling the excess supply of money.

As per the RBI Act 1934, all Scheduled Commercial Banks (that includes public and private sector banks,
foreign banks, regional rural banks and co-operative banks) are required to maintain a cash balance on
average with the RBI on a fortnightly basis to cater to the CRR requirement.

Non Bank Financial Corporations (NBFCs) are outside the purview of this reserve requirement. The Act
also authorizes RBI to stipulate an additional or incremental CRR, which, however, has not been put in
place by RBI.
 Statutory Liquidity Ratio (SLR)
The SLR is a prudential measure under which (as per the Banking Regulations Act 1949) all Scheduled
Commercial Banks in India must maintain within themselves an amount in one of the following forms as a
percentage of their total Demand and Time Liabilities (DTL) / Net DTL (NDTL);
[i] Cash, [ii] Gold; or [iii] Investments in un-encumbered instruments that include; (a) GoI Treasury-Bills. (b) Dated securities including those
issued by the GoI from time to time under the market borrowings programme and the Market Stabilization Scheme (MSS). (c) State
Development Loans (SDLs) issued by State Governments under their market borrowings programme. (d) Other instruments as notified by the
RBI.

In contrast to the CRR, under which banks have to maintain cash with the RBI, the SLR requires holding of
assets reserved in one of the above three categories within the banks themselves.

For this purpose, while gold held as a part of the SLR requirement is valued at a rate not exceeding the current market rate, valuation of
securities under category [iii] above is specified by the RBI from time to time. Specification of cash and gold as permissible forms are primarily
on the basis of these being safe and liquid.

SLR is also a tool for controlling liquidity in the domestic market via manipulating bank credit. A rise in SLR
locks up increasing portion of a bank’s assets in the above three categories and may squeeze out bank credit.
SLR vs CRR
Statutory Liquidity Ratio (SLR) Cash Reserve Ratio (CRR)
In case of SLR, banks are asked to have reserves of The CRR requires banks to have only cash reserves
liquid assets which include both cash and gold. with the RBI

The securities are kept with the banks themselves The cash reserve is maintained by the banks with the
which they need to maintain in the form of liquid Reserve Bank of India.
assets.

SLR is used to control the bank's leverage for credit The Central Bank controls the liquidity in the Banking
expansion. system with CRR.

Banks earn returns on money parked as SLR. Banks don't earn returns on money parked as CRR
 optional

In India, usually, commercial banks in India hold around 25% to 30% of their NDTL in the
form of government securities. Historically, banks’ SLR has been high as they need to bear
the burden of the government’s fiscal deficit.

The government borrows from the banks every year to bridge the fiscal deficit. A cut in SLR
indicates that RBI is confident of the government’s commitment to fiscal consolidation.

As the SLR is a statutory requirement and banks prefer to keep their SLR in the form of
income earning securities, government can easily sell its bonds to the banks. This means SLR
has facilitated government’s debt management programme.

Securities above the SLR limit will be eligible from accommodation (temporary loan) under
RBI’s repo. Understandably, all banks will be keeping government securities above the SLR
level so that it can avail immediate money from the RBI by submitting it under the Repo.
 Inflation

In the long run, inflation is always a monetary phenomenon. In the short run,
changes in velocity and output/ income affects the relationship between money
growth and inflation.
Costs of extremely high inflation are easy to see.
If prices rise rapidly enough, money stops being a useful medium of exchange.
Costs of low, expected inflation are difficult to see.
Unexpected inflation has distributional cost. E.g. Debtors benefit by repaying in
cheaper rupees and creditors suffer by being repaid in cheaper rupees.

From DFS ch 8
 The Costs of Inflation
• Perfectly anticipated inflation: Suppose an economy has been experiencing inflation
of 5% and the anticipated rate of inflation is also 5%, then all contracts will build in
the expected 5% inflation
• Nominal interest rates, long term labour contracts, and tax brackets account for the inflation in
the sense that they’d be all be raised at the rate of 5% per year.

• Perfectly anticipated inflation has no real costs, except for two qualifications:
• The costs of holding currency (notes and coins) rise along with the rate of inflation, and the
demand for currency decreases (shoe-leather costs)
• Menu costs of inflation

From DFS ch 8
Perfectly anticipated inflation

Shoe-leather costs:
The cost to the individual of holding currency is the interest foregone by not holding an interest-bearing asset.
When the inflation rate rises, nominal interest rate (i) rises, the interest lost by holding currency increases, and
therefore, the cost of holding currency increases.

Individuals have to make do with less currency, make more trips to the bank to get cash than they did before. The
costs of these trips to the bank is called “shoe-leather costs” of inflation.

Menu costs of inflation:

With inflation, people have to devote real resources to marking up prices and changing pay catalogues and vending
machines and cash registers. E.g. A restaurant will have to print new menus for price changes.

Another example: if Walmart chooses to increase prices, they must reprint all price labels (using capital and inputs)
and use more labor hours to replace the price tags. The costs to Walmart of the paper, ink, rental cost of printing
machines, and workers are part of menu costs.

Assumption: reasonably low inflation rates From DFS ch 8

 The Costs of Imperfectly Anticipated Inflation

• Imperfectly anticipated inflation: full adjustment to inflation does not describe

economies in the real world → imperfectly anticipated
• Most contracts are written in nominal terms
• If inflation is unexpectedly high, debtors repay loans in cheaper rupees
• If inflation is unexpectedly low, debtors repay loans in more valuable rupees (take a loss)
• The possibility of unexpected inflation introduces an element of risk, which might prevent some
from making some exchanges they otherwise would undertake
• Unanticipated inflation redistributes wealth and income
Returns on assets fixed in nominal terms (e.g., money, bonds, savings accounts, insurance contracts,
some pensions) follow different paths over time on account of inflation. Asset value redistribution

• Gains and losses from the redistributions of wealth among sectors and individuals that
take place as a result of unanticipated inflation cancels out over the economy as a whole.
From DFS ch 8
 If inflation unexpectedly rises during those five years:
• Inflation will devalue your future (real) payment to the bank.
• You (the borrower) will be better off, but the bank (the lender) will be worse off.
• Surprise inflation redistributes wealth from lenders to borrowers.

If both you and the bank fully expect the inflation to occur:
• The bank will require more in return for the loan.
• Inflation will not have any redistributive effects.

If unexpected deflation (sustained fall in price level) occurs:

• Deflation will increase your future (real) payment to the bank.
• You (the borrower) will be worse off, but the bank (the lender) will be better off.
• Surprise deflation redistributes wealth from borrowers to lenders.
From DFS ch 8
The real wage is a better measure of what a worker earns in terms of purchasing
power.
Money illusion causes workers to irrationally focus on their nominal wage instead of their real
wage.
They might then insist on real wages that are too high, given changes in the price level.

For your future wage negotiations:

If the price level increases more than your nominal wage, this is a real wage cut (w/p down).
If the price level increases less than your nominal wage, this is a real wage increase.
If the price level and nominal wage increase by the same amount, there is no change in the real
wage.
If the price level falls and there is no change to the nominal wage, this is a real wage increase.
Inflation and Indexation
• In countries where inflation rates are high and uncertain, long-term borrowing
using nominal debt becomes impossible: lenders are simply too uncertain about
the real value of the repayments they will receive.
• In such countries, governments issue indexed debt: a bond is indexed to the price level when
either the interest rate or the principal or both are adjusted for inflation
• The holder of the indexed bond will typically receive interest equal to the stated real interest
rate plus the actual inflation rate → risk reducing
• E.g. if the stated real interest rate is 3% and inflation rate is 18%, the holder of an indexed bond
receives 21% interest. That way, the bondholder is compensated for inflation.

• Some formal labor contracts include cost of living adjustment (COLA) provisions
• Link increases in money wages to increases in the price level
• Dearness Allowance in India
From DFS ch 8
Inflation and Indexation
• Suppose real material prices increase, and firms pass these cost increases on as
higher prices of final goods
• Consumer prices will increase
• Under a system of wage indexation, wages will also rise → this leads to further increases
in price, materials-cost, and wage.
→Indexation in this example feeds an inflation spiral

• Need to differentiate between supply and demand shocks to understand

the consequences of wage indexation
• In the case of a demand shock, there is a “pure” inflation disturbance and firms can
afford to pay the same real wages and will not be affected by indexation
• In the case of a supply shock, real wages (w/p) fall, and full indexation prevents this
from happening
→ Wage indexation complicates the adjustment of an economy to supply shocks
From DFS ch 8
Inflation and Indexation
• Many have argued that the government should adopt indexation on a broad scale,
including bonds and the tax system because:
─ Inflation would be easier to live with
─ Costs of unanticipated inflation would disappear

• Governments have been reluctant to index for three reasons:

1. Indexing makes it harder for the economy to adjust to demand and supply shocks whenever
changes in relative prices are needed
2. Indexing adds another layer of calculation to most contracts
3. Indexation will weaken the political will to fight inflation, lead to higher inflation, and perhaps
make the economy worse off

From DFS ch 8
 Hyperinflation
• Hyperinflation refers to period of massive price growth
• Prices grow so rapidly that the payment system is damaged to the point of shutdown
• Too much money has been printed → outward push of Aggregate Demand dominates all
else in our macroeconomic models
• In a hyperinflationary economy, inflation is so pervasive that it dominates daily economic
life

• Hyperinflation: very high rates of inflation → around 1,000 percent per annum
(Take Zimbabwe's case)
• Hyperinflation is mainly caused by excessive money supply growth in the
economy.

From DFS ch 22
 Hyperinflationary countries also have large budget deficits. (e.g. wartime spending generates large
national debt and destroys the tax capacity.)

Budget deficits cause rapid inflation as it causes the government to print money to finance the budget
deficit.

High inflation increases the measured deficit too. In two ways:

(a) Tanzi-Olivera effect: As inflation rate increases, real revenue raised from taxation falls because of
the lags in both calculation and payment/collection of taxes.

E.g. say people pay taxes on April 15 on the income they earned the previous year. Consider someone
who earned Rs 50000 last year and has a tax bill of Rs 10000 due on April 15. If prices have in the
meantime gone up by a factor of 10 (i.e. 10 times what it used to be), as is usual in hyperinflation, the
real value of the tax bill is only one-tenth of what it should be. The budget deficit is thus out of control.

From DFS ch 22, section 22.2

 High inflation increases the measured deficit too. In two ways:

(b) The measured budget deficit includes the interest payments on the national debt. Since the
nominal interest rate tends to rise when inflation increases, higher inflation generally increases the
nominal interest payments of the government and therefore, the measured budget deficit
increases.

Accordingly, high-inflation countries often calculate inflation-adjusted budget deficit.

inflation-adjusted budget deficit = total deficit – (inflation rate x national debt)

From DFS ch 22, section 22.2

 Stopping Hyperinflation
• All hyperinflations come to an end
• Dislocation of the economy becomes too great to bear, and the
government finds a way of reforming its budget process.
• Often a new money is introduced, and the tax system is reformed.
Discussion of
the cases of • Often exchange rate of a new currency is pegged to that of a foreign
Venezuela and currency to provide an anchor for prices and expectations.
Zimbabwe
• Frequently there are unsuccessful attempts at stabilization before the
final success.

• Often a coordinated attack on hyperinflation: heterodox

approach to stabilization
• Monetary, fiscal, and exchange rate policies combined with income
policies

From DFS ch 22, section 22.2

 Macroeconomics- 2

Short run fluctuations:

the Aggregate Demand and Aggregate Supply model

Learning objectives

We study how the economy goes through short-run business cycle fluctuations through
the use of the traditional Aggregate Demand-Aggregate Supply (AD-AS) model.
Introduction
• Let’s turn to short run fluctuations in the economy that
constitute the business cycle
• The AD-AS model is the basic macroeconomic tool for
studying output fluctuations and the determination of the
aggregate price level and the inflation rate
• Can be used to explain how the economy deviates from a path
of smooth growth over time, and to explore the consequences
of government policies intended to reduce unemployment
and output fluctuations and maintain stable prices.
AS and AD
Aggregate supply curve describes, for each given price level, the quantity of
output firms are willing to supply.

Upward sloping since firms are willing to supply more output at higher prices.

Aggregate demand curve shows the combinations of the price level and the
level of output at which the goods market and money market are
simultaneously in equilibrium.

Downward sloping since higher prices reduce the value of the money supply,
which reduces the demand for output.

Intersection of AS and AD curves determines the equilibrium level of output

and price level.
AD
Aggregate Demand
= total demand of final goods and services in an economy in a year
= total expenditure on final goods and services in an economy in a year
= C + I+ G+ NX
= GDP

AD curve slopes downward since higher prices reduce the value of the
money supply, which reduces the demand for output.

There is a negative relationship between quantity of aggregate demand

and the price level because of the following:
• Wealth effect
• Interest rate effect
• International trade effect
 The Wealth Effect

• Wealth = Value of the accumulated stock of assets (currency, stocks, bonds,

artwork, real estate, bank accounts) held by a person or household at a single
point in time
• Wealth effect: The change in the quantity of aggregate demand that results from
wealth changes due to price-level changes

If the aggregate price level rises:

• The purchasing power of wealth falls
• People cannot buy as much
• The quantity of aggregate demand falls
If the aggregate price level falls:
• The purchasing power of wealth rises
• People can buy more
• The quantity of aggregate demand rises

• The wealth effect is related to consumption (C) in the GDP or AD equation.

• Wealth and income are different (stock vs. flow). Wealth refers to the stock of assets held by a person
or household at a single point in time. These assets may include financial holdings and saving, but commonly also include the
family home. Income refers to money received by a person or household over some period of time. Income includes wages,
salaries, and cash assistance from the government.
The Interest Rate Effect

• Interest rate effect occurs when a change in the price level leads to a change in
interest rates and therefore in the quantity of aggregate demand. This occurs through
the loanable funds market. Changes in the price level affect saving. This directly impacts
the supply of loanable funds.
• There is an opportunity cost of borrowing. Higher interest rates make loans more
expensive and decrease economic activity in sectors that are interest rate-sensitive.

• As the aggregate price level rises:

The ability to save falls, lowering the supply of loanable funds.
The interest rate rises.
Purchases of goods on credit decline.
This is mainly a drop in investment (I) but some large-ticket consumer goods demand
as well.

• As the aggregate price level falls:

The ability to save rises, increasing the supply of loanable funds.
The interest rate falls.
Purchases of goods on credit increase.
This is mainly an increase in investment (I) but some large-ticket consumer goods
demand as well.
 The interest rate effect
• The loanable funds market is just another market
with supply and demand.
• The demand for loanable funds represents
investment spending.
• The supply of loanable funds represents
saving.
• The interest rate is the price of borrowing and
lending, so it is on the vertical axis.
• The quantity of loanable funds (measured by saving
or investment) is in the horizontal axis.

In this diagram:
• An increase in the price level has lowered the
amount of saving in the economy.
• The supply of loanable funds has declined.
• The interest rate rises as a result.

Increased interest rates dampen investment spending

because they dramatically increase the cost of
borrowing.
• Investment purchases will be postponed or
scrapped altogether.
 International Trade Effect
• International trade effect occurs when a change in the price level leads
to a change in the quantity of net exports demanded

• We are considering the domestic (Indian) market.

• Changes in the Indian price level mean the prices of Indian goods
change relative to the prices of goods from other nations. This will affect
both imports and exports.

• Suppose the Indian price level increases (assume all other countries’
price levels remain the same):
• The prices of India-made goods are now relatively more expensive. Exports will fall.
• The prices of foreign goods are now relatively cheaper. Imports will rise.
• Both effects mean that net exports will fall.

• The international trade effect is related to the NX in the GDP equation.

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Movements along the AD Curve versus Shifts
in the AD Curve

• Movements along the AD curve

• Start with a change in the price level
• Affect the quantity of aggregate demand through the three effects
• Wealth effect, interest rate effect, international trade effect

• Shifts in the AD curve

AS1
• Occur when something other than the AS2
P
price level changes

AD
2
AD
1

The ceteris paribus assumption holds throughout. When we draw the AD curve, we are assuming that the only things that are changing are
the price level and the quantity of aggregate demand.
Shifts in Aggregate Demand

• Anything that changes C, I, G, or NX (other than a change in the price

level) will cause the AD curve to shift.
• AD = C + I + G + NX
AD shifts due to shifts in each
• Consumption (C) of its components

• Investment (I)
• When people demand
• Government spending (G)
more goods and services
• Net exports (NX) at all price levels, AD shifts
to the right.
• When people demand
fewer goods and services
at all price levels, AD shifts
to the left.
 Shifts in Consumption

Examples:
• Changes in real wealth • The stock market rises
• Stock market rises or falls • Investors feel wealthier
• They buy more goods
• Widespread change in real estate values • Consumption rises
• AD rises
• General expectations about the future • Consumers worry about the
future (e.g., farmers during
• Changes in expected income
droughts)
• Change in consumer confidence • They increase saving
• They buy fewer goods
• Changes in taxes. • Consumption falls
• AD falls
• Taxes increase (e.g., salaried
workers)
• After-tax income falls
• People cannot afford to
purchase as much
• Consumption falls
• AD falls
Shifts in Investment, and in Government
Spending
• Shifts in Investment
• General expectations about the future [e.g., bearish equity market]
• Investor confidence
• Change in interest rates (caused by something other than a change in the
price level) [e.g., rise in interest rate to curb massive capital flight]
• Changes in the quantity of money in the economy [e.g., demonetization]
• Alters the interest rate
• Shifts in Government Spending
• Influenced by government policy
• These changes may be made in response to economic conditions.
• Government spending is the component of aggregate demand that economic
theory has the least to say about. It is influenced by government policy that
may or may not be driven by economic concerns. Sometimes, the government
creates policies to counteract current economic issues.
• E.g., NREGS spending, farm loan waiver
 Shifts in International Trade
• Change in income of individuals in other countries (e.g. recession abroad)
Foreign income:
• If foreign nations become wealthier:
• Demand for Indian goods increases
• NX increases
• AD increases
• If a foreign nation goes into recession:
• Demand for Indian goods decreases
• NX decreases
• AD falls

• Change in exchange rates (not caused by a change in the

domestic price level)
• If the value of the Indian Rupee rises:
• India can buy more imports
• Other countries can buy less Indian goods (decreasing exports)
• NX falls
• AD falls
• If the value of the Indian Rupee falls:
• India cannot afford as much imports
• Other countries can buy more Indian goods (increasing exports)
• NX rises
• AD increases
 The Function of the Firm

Basic function of the firm: Convert inputs (resources) into outputs (goods and services)
• Input prices determine the firm’s costs
• Output prices determine the firm’s revenues
 Aggregate Supply

• How do changes in the aggregate price level affect the supply

decisions of the firm, ceteris paribus?

• The answer depends on the time frame examined.

• Long run
• A period of time sufficient for all prices to adjust
• Short run
• The period of time in which some prices have not yet
adjusted
 Long-Run Aggregate Supply

• The long-run output of an economy depends on

inputs, technology, and institutions.
• It is not affected by the price level.

• In the long-run, the economy moves toward full-

employment output (Y*). The level of output
produced when an economy is at the natural rate of
unemployment (u*).

• Example: Assume two identical economies, A and B. A has

twice as much money as B. Long-run result: Same amount of
L, K, and technology in A and B, but goods are twice as
expensive in A.
• Implication: Different price level, same output
 The Long-Run Aggregate Supply Curve

The long-run AS is
vertical at Y*.
• As the price
level changes,
the long-run
quantity of
aggregate
supplied does
not change.
• It is always
at the full-
employme
nt level of
output.
 Shifts in Long-Run AS: examples
• Anything that alters full-employment
output (Y*) will shift the long-run AS curve.

• Examples of changes in inputs:

• More (or less) inputs
• Growth in labor force, early
retirement, Newly discovered
natural resources
• Better inputs
• Effects of human capital
investment
• Examples of changes in technology:
• Growth of the Internet, Growth in
telecommunications, Robotics
• Examples of institutional changes:
• Changes in tax rates affect the after-tax
return on investments
• Government research into new technologies
 Short-Run Aggregate Supply
• There are 3 reasons why there is
a positive relationship between
the price level and the quantity of
aggregate supply:

1. Sticky input prices but

flexible output prices
2. Menu costs
3. Money illusion

• Each of the three theories share a

common thread:
• When the price level deviates from
what society expects, this causes
real effects on output in the short
run.
Sticky input prices but flexible output prices

• Input prices tend to be sticky (not as flexible).

• Output prices are more flexible, easier to change. Not all prices adjust at the same rate.

• A change in the aggregate price level (output prices) affects firm revenues.
• Costs stay the same

Suppose the aggregate price level is increasing (but input prices are fixed for the period).
Higher output price increases profit potential for firm.
• Costs are not changing. Firm responds by producing more output.

• Suppose the aggregate price level is falling (but input prices are fixed for the period).
Lower output prices reduce profit potential for firm.
• Costs are not changing. Firm responds by producing less output.
 Menu Costs, and Money Illusion
• Menu costs are the costs of changing prices

• Suppose the price level rises (but that the firm doesn’t want to change its output price due to
menu costs):
• Buying from the firm is now relatively cheaper. Consumers will want to buy more. The quantity of
aggregate supply will rise to satisfy what consumers want. In the short run, the quantity of
aggregate supply rises.

• Money illusion occurs when people interpret nominal changes in wages or prices as real
changes

• Money illusion: If inflation is 10 percent and your wage goes up by just 5 percent, you may be tempted to view that as a
real raise, but it’s only a nominal raise. In real terms, your wage falls in this example because you won’t be able to buy
the same quantity of real goods and services since your wage rose by less than the price level.

• If the price level falls:

• Workers are very reluctant to accept nominal pay cuts, even if the pay cut is less than the level of
deflation (deflation is fall in price level).
• Firms see revenues fall (reduced output prices) with no change in costs. They reduce output. The
quantity of aggregate supply falls.
• Opposite happens when there’s an aggregate price rise.
Shifts in Short-Run Aggregate Supply
• Whenever the long-run AS curve shifts, it takes the short-run AS curve
with it.

• Factors that shift only the short-run AS curve

• Changes in input prices
• Changes in expectations of prices
• Supply shocks
• Surprise events that change a firm’s production costs
• It is important to note that the SRAS curve always shifts when there is a
shift in the LRAS curve. Anything that shifts the LRAS curve also shifts the
SRAS curve (in the same direction).

• But, SRAS can shift by itself, usually due to a change in the cost of
producing goods
• Most often, this means a change in input prices. Examples of input prices:
Wages, Gasoline, Electricity, Raw materials

• How do expected future price levels affect SRAS?

• If workers and firms expect higher prices tomorrow, they negotiate those
expectations into today’s contracts. Costs are higher, and the short-run AS shifts
left. However, it does not affect long-run production possibilities, so the long-run
AS does not change.
• Examples of supply shocks: drop in farm crops, jump in the petroleum price
• Supply shocks can be positive or negative.
 AS, AD, and equilibrium
• AS and AD intersect at point E in Fig. on
the right
• Equilibrium: AS = AD
• Equilibrium output is Y0 = observed
level of output in the economy at a
particular point in time
• Equilibrium price level is P0 = observed
price level in the economy at a
particular point in time

Material from DFS chapter 5 begins

AS, AD, and equilibrium
• Shifts in either the AS or AD
schedule result in a change in
the equilibrium level of prices
and output
• Increase in AD → increase in P and
Y
• Decrease in AD → decrease in P
and Y
• Increase in AS → decrease in P and
increase in Y
• Decrease in AS → increase in P and
decrease in Y

Figure on the right illustrates an

increase in AD resulting from an
increase in money supply
 AS, AD, and equilibrium
• The amount of the increase/decrease in
P and Y after a shift in either aggregate
supply or aggregate demand depends
on:
1. The slope of the AS curve
2. The slope of the AD curve
3. The extent of the shift of AS/AD

Figure 5-3 shows the result of an adverse AS

shock: AS → Y, P
Classical supply curve (long run)
• The classical supply curve is vertical, indicating that the same
amount of goods will be supplied, regardless of price
• Based upon the assumption that the labor market is in
equilibrium with full employment of the labor force
• The level of output corresponding to full employment of the
labor force = potential GDP, Y*

Keynesian AS Classical AS (long

(short run) run)
Keynesian supply curve (short run)
• The Keynesian supply curve is horizontal, indicating firms will
supply whatever amount of goods is demanded at the
existing price level [Figure 5-4 (a)]
• Since unemployment exists, firms can obtain any amount of
labor at the going wage rate
• Since average costs of production are assumed not to change
as output changes, firms are willing to supply as much as is
demanded at the existing price level
• Intellectual genesis of the Keynesian AS curve found in the
Great Depression, when firms seemed to increase production
without increasing P by putting idle K and N to work
• Additionally, prices are viewed as “sticky” (rigid) in the short
run
Short run price stickiness
In the short run, firms are reluctant to change prices and wages when
demand shifts.

Instead, at least for a little while, they increase or decrease output. As a

result, the AS curve is quite flat in the short run.

On a Keynesian AS curve, price level does not depend on output (GDP).

There is always some ongoing small increases in price level. This price
increase brings about an upward shift of the AS curve.

For the moment, we assume that we are in an economy with no expected

inflation.
AD Policy & the Keynesian Supply Curve

• Figure on the right shows the AD

schedule and the Keynesian supply
schedule
• Initial equilibrium is at point E (AS = AD)
• Suppose an aggregate demand policy
increases AD to AD’
The new equilibrium point, E’, corresponds to the
same price level, and a higher level of output
(employment is also likely to increase)
 AD Policy & the Classical Supply Curve
• In the classical case, AS schedule is
vertical at FE level of output
• The price level is not given, but depends
upon the interaction between AS and
AD
• If AD increases to AD’, spending
increases to E’ BUT firms can not obtain
the N required to meet the increased
demand
AD Policy & the Classical Supply Curve
• Firms hire more workers & wages and costs of
production rise → firms must charge higher
price
• Move up AS and AD curves to E’’ where AS =
AD’
• Prices increase and real money stock and
spending decrease
• Economy moves up AD until price and M/P
adjustments reduce total spending to a level
consistent with full employment
Supply-Side Economics
• Supply side economics focuses on Aggregate Supply as the main driver of
the economy
• Supply side policies are those that encourage growth in potential output
→ shift AS curve to right
• Such policy measures include:
• Reduction of tax rates (e.g. budgetary cuts in income taxes)
• Removing unnecessary and inefficient regulation (e.g. policies
improving ease of doing business)
• Maintaining efficient legal system, and judicial reforms
• Encouraging technological progress
• Politicians use the term ‘supply-side economics’ in reference to the idea
that cutting taxes will increase AS enough that tax collections will actually
increase, rather than fall. Supply-siders believe AS-boosting policies
promote growth in GDP and govt. revenues.
 Supply-Side Economics
• Cutting tax rates has an impact on both AS and AD
– AD shifts to AD’ due to increase in disposable
income
– Shift in AD is relatively large compared to that of
the AS
– AS shifts to AS’ as the incentive to work increases P
1
• In short run, post-tax-cut equilibrium moves from
E to E’: GDP increases (from y0 to y’), tax revenues
fall proportionately less than tax cut, fiscal deficit
rises (AD effect). (Y’- Y0) > (Y’’- Y0)
• In the long run, economy moves to E’’: GDP is
higher, but by a small amount (y0 to y’’), tax
collections fall as the fiscal deficit rises, and prices
rise permanently from P0 to P1 (AS effect).
• Supply-side policies are inflationary in the long Y
run, reduces tax revenues, and raise GDP at a ’
smaller clip. In the short run, it boosts GDP,
therefore, ‘supply-sider’ politicians are happy as
that short-term GDP growth increases their
electoral prospects.

DFS chapter 5, section 5.5

Supply Side Economics
• Supply side policies are useful, despite previous
example

• Only supply side policies can permanently increase

output

• Demand side policies are useful for short run results

• Many economists support cutting taxes for

the incentive effect, but with a simultaneous
reduction in government spending

• Tax collections fall, but the reduction in

government spending minimizes the impact on
the deficit
 IS-LM model

DFS ch 10 and 11
Introduction
• Why does output fluctuate around its potential level?
• In business cycle booms and recessions, output rises and falls relative
to the trend of potential output

• Model in this chapter assumes a mutual interaction between

output and spending: spending determines output and
income, but output and income also determine spending

• The Keynesian model develops the theory of AD

• Assume that prices do not change at all and that firms are willing to
sell any amount of output at the given level of prices → AS curve is
flat
• Key finding: increases in autonomous spending generate additional
increases in AD

DFS ch 10.
AD and Equilibrium Output
• AD is the total amount of goods demanded in the economy: (1)
AD = C + I + G + NX

• Output is at its equilibrium level when the quantity of output produced is

equal to the quantity demanded, or Y = C + I + G + NX (2)

• When AD is not equal to output there is unplanned inventory investment

or disinvestment: UI = Y - AD (3), where UI is unplanned additions to
inventory
• If UI > 0, firms cut back on production until output and AD are again in equilibrium
• Conversely, if output is below AD, inventories are drawn down until equilibrium is
restored.
The Consumption Function
• Consumption is the largest component of AD
• Consumption increases with income → the relationship between
consumption and income is described by the consumption function
• If C is consumption and Y is income, the consumption function is C = C + cY (4),
where C 0 and 0  c  1

• The intercept of equation (4) is the level of consumption when income

is zero → this is greater than zero since there is a subsistence level of
consumption

• The slope of equation (4) is known as the marginal propensity to consume

(MPC) → the increase in consumption per unit increase in income
The Consumption Function
Consumption and Savings
• Income is either spent or saved → a theory that explains consumption is
equivalently explaining the behavior of saving

• More formally, S  Y − C (5) → a budget constraint

• Combining (4) and (5) yields the savings function:
S  Y − C = Y − C − cY = −C + (1 − c)Y (6)

• Saving is an increasing function of the level of income because the marginal

propensity to save (MPS), s = 1-c, is positive
• Savings increases as income rises
• Ex. If MPS is 0.1, for every extra rupee of income, savings increases by Rs 0.10 OR consumers
save 10% of an extra rupee of income
Consumption, AD, and Autonomous Spending
• Now we incorporate the other components of AD: G, I, taxes, and foreign trade
(assume autonomous or independent of income)

• Consumption now depends on disposable income,

YD = Y − TA + TR (7) and
C = C + cYD = C + c(Y + TR − TA) (8)
YD: disposable
income, TA: tax, • AD then becomes: AD = C + I + G + NX
= C + c(Y − TA + TR ) + I + G + NX
TR: transfer
payments.

C-bar is autonomous
consumption
= C − c(TA − TR ) + I + G + NX  + cY
= A + cY (9)
where A is independent of the level of income, or autonomous
Equilibrium Income and Output
• Equilibrium occurs where Y=AD, which is
illustrated by the 45° line → point E
• The arrows show how the economy
reaches equilibrium
• At any level of output below Y0, firms’
inventories decline, and they increase
production
• At any level of output above Y0, firms’
inventories increase, and they decrease
production

IU: unplanned additions to inventories

The Formula for Equilibrium Output
• Can solve for the equilibrium level of output, Y0, algebraically:
• The equilibrium condition is Y = AD (10)
• Substituting (9) into (10) yields Y = A + cY (11)
• Solve for Y to find the equilibrium level of output:

Y − cY = A
Y (1 − c) = A
1 (12)
Y0 = A
(1 − c)
The Formula for Equilibrium Output
• Equation (12) shows the level of output as a function of the MPC and A

• Frequently we are interested in knowing how a change in some component of

autonomous spending would change output

• Relate changes in output to changes in autonomous spending through

1
Y = A (13)
(1 − c)
• Ex. If the MPC = 0.9, then 1/(1-c) = 10 → an increase in government spending by
Rs 1 billion results in an increase in output by Rs 10 billion

• Recipients of increased government spending increase their own spending, the

recipients of that spending increase their spending and so on
Saving and Investment
• In equilibrium, planned investment equals
saving in an economy with no government
or trade sector
• Vertical distance between the AD and
consumption schedules equal to planned
investment spending, I
• The vertical distance between the
consumption schedule and the 45° line
measures saving at each level of income
→ at Y0 the two vertical distances are equal and S
=I
Saving and Investment
• The equality between planned investment and saving can be seen directly from national
income accounting
• Income is either spent or saved: Y = C + S
• Without G or trade, Y =C+I
C+S =C+I
• Putting the two together:
S=I
AD = C + I + G + NX
• With government and foreign trade in the model:
Y = C + S + TA − TR
• Income is either spent, saved, or paid in taxes:
C + I + G + NX = C + S + TA − TR
• Complete aggregate demand is I = S + (TA − TR − G ) − NX
• Putting the two together: (14)
The Multiplier
By how much does a Re 1 increase in autonomous spending raise the equilibrium level of income? → The
answer is not Re 1

Out of an additional rupee in income, Rs c is consumed

Output increases to meet increased expenditure; change in output = (1+c)

Expansion in output and income results in further increases

The Multiplier
• If we write out the successive rounds of increased spending, starting with the
initial increase in autonomous demand, we have:

AD = A + cA + c 2A + c3A + ...

= A (1 + c + c2 + c3 + ...) (15)
• This is a geometric series, where c < 1, that simplifies to:
1
AD = A = Y0 (16)
(1 − c)
• Multiplier = amount by which equilibrium output changes
when autonomous aggregate demand increases by 1 unit

• The general definition of the multiplier is

Y 1 (17)
= =
A (1 − c)
Example of a budget multiplier
Definition: the increase in income resulting from a $1
increase in G.
In this model, the government
purchases multiplier equals Y 1
=
G 1 − MPC

Example: If MPC = 0.8, then

An increase in G
Y 1
= = 5 causes income to
G 1 − 0.8 increase 5 times
as much!
 Why is the multiplier >1 ?

• Initially, the increase in G causes an equal increase in Y: Y = G.

• But Y  C
 further Y
 further C
 further Y
• So, the final impact on income is much bigger than the initial G.
 Why is the multiplier >1? An example

Suppose the government spends an additional Rs 100 crores on buying military jets.
Then, the revenues of defense firms increase by Rs 100 crores, all of which becomes
income to somebody: some of it is paid to the workers and engineers and managers, the
rest is profit paid as dividends to shareholders. Hence, income rises Rs 100 crores (Y =
Rs 100 crores = G ).

The people whose income just rose by Rs 100 crores are also consumers,
and they will spend the fraction MPC of this extra income.
Suppose MPC = 0.8, so C rises by Rs 80 crores. Multiplier is 5 (=1/(1-c)).
• To be concrete, suppose the defense firm people buy Rs 80 crores worth of Maruti
Altos. Then, Maruti sees its revenues increase by Rs 80 crores, all of which
becomes income to somebody - either Maruti’s workers, or its shareholders (Y =
Rs 80 crores).
• And what do these folks do with this extra income? They spend the fraction MPC
(0.8) of it, causing C = Rs 64 crores (8/10 of Rs 80 crores). Suppose they spend
all Rs 64 crores on Parle-G biscuits. Then, Parle company experiences a revenue
increase of Rs 64 crores, which becomes income to someone or the other (Y = Rs
64 crores).
• So far, the total impact on income is Rs 100 crores+ Rs 80 crores + Rs 64 crores,
which is much bigger than the government’s initial increase in spending. But this
process continues, and the final impact on Y is Rs 500 crores (because the
multiplier is 5).
The Multiplier
Effect of an increase in autonomous spending
on the equilibrium level of output:
1. The initial equilibrium is at point E, with
income at Y0
2. If autonomous spending increases, the
AD curve shifts up by ∆𝐴ҧ , and income
increases to Y’
3. The new equilibrium is at E’ with income
at ∆𝑌0 = 𝑌0′ − 𝑌0
The Government Sector
• The government affects the level of equilibrium output in two
ways:
1. Government expenditures (component of AD)
2. Taxes and transfers

• Fiscal policy is the policy of the government with regards to G,

TR, and TA

• Assume G and TR are constant, and that there is a

proportional income tax (t)

• The consumption function becomes: C = C + c(Y + TR − tY )

= C + cTR + c(1 − t )Y (19)
The Government Sector
• Combining (19) with AD:
AD = C + I + G + NX
= C + cTR + c(1 − t )Y  + I + G + NX
= A + c(1 − t )Y (20)
• Using the equilibrium condition, Y=AD, and equation (19), the
equilibrium level of output is:
Y = A + c(1 − t )Y
Y − c(1 − t )Y = A
Y 1 − c(1 − t ) = A
A
Y0 = (21)
1 − c(1 − t )
• The presence of the government sector flattens the AD curve
and reduces the multiplier to 1
(1 − c(1 − t ))
IS-LM model: Introduction
• Money plays a central role in the determination of income and
employment
• Interest rates are a significant determinant of aggregate spending →
the central bank controls the money supply
• The stock of money, interest rates, and the central bank were
noticeably absent from the model developed

• The IS-LM model:

─ Builds an explicit framework of analysis within which to study the
interaction of goods markets and money market in a closed economy
IS-LM model
IS-LM model is the core of short-run macroeconomics
–Maintains the details of earlier model, but adds the interest rate as an additional determinant of
aggregate demand
–Includes the goods market and the money market, and their link through interest rates and income

The IS-LM model translates the General Theory of John M. Keynes into neoclassical terms (often called the
neoclassical synthesis ). It was proposed by John Hicks in 1937 in a paper called “Mr Keynes and the "Classics":
A Suggested Interpretation” and enhanced by Alvin Hansen (hence it is also called the Hicks-Hansen model).

The model examines the combined equilibrium of two markets :

The goods market, which is at equilibrium when investments equal savings, hence IS.
The money market, which is at equilibrium when the demand for liquidity equals money supply, hence
LM.
Examining the joint equilibrium in these two markets allows us to determine two variables : output Y and
the interest rate i.
The Goods Market and the IS Curve
• The IS curve shows combinations of interest rates
and levels of output such that planned spending equals income

• Derived in two steps:

1. Link between interest rates and investment
2. Link between investment demand and AD

• Investment is no longer treated as exogenous, but dependent

upon interest rates (endogenous)

• Investment demand is lower, the higher are interest rates

• Interest rates are the cost of borrowing money
• Increased interest rates raise the price to firms of borrowing for capital
equipment → reduce the quantity of investment demand
Investment and the Interest Rate
• The investment spending function can
be specified as:
I = I − bi
(1) where b > 0
• i = rate of interest
• b = the responsiveness of investment
spending to the interest rate
• I = autonomous investment spending
• Negative slope reflects assumption that
a reduction in i increases the quantity
of I

•The position of the I schedule is determined by:

–The slope, b
–Level of autonomous spending
The Interest Rate and AD: The IS Curve
• Need to modify the AD function of the last chapter to reflect the new planned
investment spending schedule:

AD = C + I + G + NX
= C + cT R + c(1 − t )Y  + ( I − bi ) + G + NX
= A + c(1 − t )Y − bi

• An increase in i reduces AD for a given level of income

• At any given level of i, can determine the equilibrium level of income and output
[as in Ch. 10]

• A change in i will change the equilibrium

The Interest Rate and AD: The IS Curve
AD = A + c(1 − t )Y − bi
• For a given interest rate, i1, the last term
in equation (2) is constant → can draw
the AD function with an intercept of
A − bi1
• Figure 11-5 shows the negative
relationship between i and Y →
Downward sloping IS curve

Derivation of the IS curve ->

The Interest Rate and AD: The IS Curve
• We can also derive the IS curve using the goods market equilibrium
condition:

Y = AD = A + c(1 − t )Y − bi 
Y − c(1 − t )Y = A − bi
Y (1 − c(1 − t )) = A − bi
Y = G ( A − bi )

1
where G = , the multiplier in presence of a proportional
(1 − c(1 − t ))
taxation system from session 7 (DFS ch 10)
The Slope of the IS Curve
• The steepness of the IS curve depends on:
• How sensitive investment spending is to changes in i
• The multiplier, G

• Suppose investment spending is very sensitive to i → the

slope, b, is large
• A given change in i produces a large change in AD (large shift)
• A large shift in AD produces a large change in Y
• A large change in Y resulting from a given change in i → IS curve is
relatively flat

• If investment spending is not very sensitive to i, the IS curve is

relatively steep
The Position (shift) of the IS Curve
• Figure 11-7 shows two different IS
curves → differ by levels of
autonomous spending
• The change in income as a result from a
change in autonomous spending is
∆𝑌 = 𝛼𝐺 ∆𝐴ҧ
The Money Market and the LM Curve
• The LM curve shows combinations of interest rates and levels
of output such that money demand equals money supply →
equilibrium in the money market

• The LM curve is derived in two steps:

1. Explain why money demand depends on interest rates and income
• Theory of real money balances, rather than nominal
2. Equate money demand with money supply, and find combinations of
income and interest rates that maintain equilibrium in the money
market
• (i, Y) pairs meeting this criteria are points on a given LM curve
Demand for Money
• The demand for money is a demand for real money balances
• People are concerned with how much their money can buy, rather
than the number of rupees in their pockets

• The demand for real balances depends on:

─ Real income: people hold money to pay for their purchases, which, in
turn, depend on income
─ Interest rate: the cost of holding money

• The demand for money is defined as: 𝐿 = 𝑘𝑌 − ℎ𝑖

The Liquidity Preference theory or the theory of money demand rests on three motives (transactions
motives, precautionary motive and speculative motives) behind holding or demanding money.
Demand for Money
𝐿 = 𝑘𝑌 − ℎ𝑖
• The parameters k and h reflect the
sensitivity of demand for real balances to
the level of Y and i.
• The demand function for real balances
implies that for a given level of income, the
quantity demanded is a decreasing function
of i.
• Figure 11-8 illustrates the inverse
relationship between money demand and i.
→ money demand curve
The Supply of Money, Money Market Equilibrium, and the
LM Curve
𝑀ഥ
• The nominal quantity of money supplied, M, controlled by central bank (real money supply is , where M and P
𝑃ത
are assumed fixed)

• Starting at Y1, the corresponding demand curve for real balances is L1 → shown in panel (a)
• Point E1 is the equilibrium point in the money market
The Supply of Money, Money Market Equilibrium, and the LM
Curve
• Point E1 is recorded in panel (b) as a point on the money market equilibrium schedule, or the LM curve
• (i1, Y1) pair is a point on LM curve
• If income increases to Y2, real money balances higher at every level of i → money demand shifts to L2
• The interest rate increases to i2 to maintain equilibrium in money market and the new equilibrium is
at point E2

Record E2 in panel (b) as another point on the LM curve

Pair (i2, Y2) is higher up the given LM curve
 The Supply of Money, Money Market
Equilibrium, and the LM Curve
• The LM schedule shows all combinations of interest rates and levels of
income such that the demand for real balances is equal to the supply
→ money market is in equilibrium

• LM curve is positively sloped because:

• An increase in the interest rate reduces the demand for real balances.
• To maintain the demand for real money balances equal to the fixed money supply, the
level of income has to rise.

• The LM curve can be obtained directly by combining the demand curve for real
balances and the fixed supply of real balances
 The Supply of Money, Money Market
Equilibrium, and the LM Curve
• For the money market to be in equilibrium, supply must equal
demand: M
= kY − hi
P
• Solving for i: 1 M
i =  kY − 
h P

• The steeper the LM curve:

• The greater the responsiveness of the demand for money to income,
as measured by k
• The lower the responsiveness of the demand for money to the
interest rate, h

• A given change in income has a larger effect on i, the larger is k and the smaller is h
The Position (shift) of the LM Curve
• Real money supply constant along the LM curve → a change in the real money
supply will shift the LM curve

• Figure 11-10 shows the effect of an increase in money supply

• Equilibrium occurs at point E1 with interest rate i1 → corresponding
point E1 on the LM curve
The Position (shift) of the LM Curve
• If real money balances increases, money supply curve shifts to the right
• To restore equilibrium at the income level Y1, the i must decrease too
• In panel (b), the LM curve shifts to the down and to the right
The IS-LM Equilibrium (the Goods and Money Market Equilibrium)
• The IS and LM schedules summarize the
conditions that have to be satisfied for
the goods and money markets to be in
equilibrium
• Assumptions (Keynesian short run):
– Price level is constant
– Firms willing to supply whatever amount of
output is demanded at that price level

• The equilibrium levels of income and

the interest rate change when either
the IS or the LM curve shifts.
Applications of the closed economy IS-LM model
Changes in the Equilibrium
• Figure 11-12 shows effects of an
increase in autonomous spending
• Shifts IS curve out by 𝛼𝐺 ∆𝐼 if
autonomous investment is the source
of increased spending
• The resulting change in Y is smaller than
the change in autonomous spending
due to slope of LM curve

If rise in autonomous spending (A-bar) is due to rise in autonomous investment (I-bar), IS curve shifts to the right. The
resulting change in Y is smaller than the change in autonomous spending due to slope of the LM curve.
Y0 – Y’ < horizontal distance between IS and IS’ . ∆𝑌0 < 𝛼𝐺 ∆𝐼 .
If LM curve is horizontal, Y0 – Y’ = horizontal distance between IS and IS’ . ∆𝑌0 = 𝛼𝐺 ∆𝐼 . Because interest rate would not
change when IS curve shifts. Why is ∆𝑌0 < 𝛼𝐺 ∆𝐼 ? I-bar up, A-bar up, Y up, L down, as M/P is fixed interest rate increases
𝑀ഥ
to ensure L = . i up, I down. Accordingly, equilibrium change in Y < the horizontal shift of the IS curve, 𝛼𝐺 ∆𝐼 .
𝑃ത