MACROECONOMIC MODELS

1. Introduction
By utilizing the models we can analyze what happens when the government increases
consumption, when the central bank increases the target interest rate and when domestically
produced goods do well in foreign markets. We can also understand important observations
of the economy, such as cyclical fluctuations in growth, correlation between unemployment
and inflation and the relationship between interest rates and foreign exchange rates.
Macroeconomics is not an exact science such as physics. No one knows exactly how the
macroeconomic variables are related. Instead, there exist a number of models that try to
explain various observations and relationships between macroeconomic variables.
Unfortunately, not all of these models consistent - one model may predict that unemployment
will fall if the central bank lowers the target interest rate while another may claim that such a
change will not affect unemployment.
This type of problem is something you have to get used to and accept. Economics is not a
subject where you can perform an experiment to find out what is really “true”. Observed
phenomena may have different explanations in different models and different models will
lead to different predictions of macroeconomic variables. If you conclude that “An increase
in x will lead to an increase in y” you really should not think of this as a property of the real
world but rather as the property of a particular model.
One model that is very popular in virtually all basic courses in macroeconomics all over
the world is the so-called neo-classical synthesis. As the name suggests, this is a combination
or a synthesis of two models, namely the classical model and the Keynesian model. In short,
the neo-classical synthesis claims that the Keynesian model is correct in the short term while
the classical model is correct in the long run. The rest of this book builds up the neo-classical
synthesis. Note that there are actually many minor variations of the neoclassical synthesis. I
try to present the most common version.
2. Common assumptions
All models require a number of assumptions to be able to say anything of interest.
2.1. Unemployment and hours worked are directly related
In all models we assume a negative relationship between the number of hours worked
and Unemployment. If the number of hours worked increases, the unemployment will fall
and vice versa. This assumption will be true if the workforce is constant and individuals in
the labor force either work full time or not at all.
In reality, this relationship need not hold. We may see an increase in the labor force (for
example from immigration) that is larger than the increase in employment which would lead
to an increase in both hours worked and unemployment but we disregard this possibility.
2.2. The central bank has complete control over money supply
Remember that the money supply is equal to the money multiplier times the monetary
base. We will assume that the money multiplier is constant and since the monetary base is
completely under the control of the central bank, the central bank will control the money

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supply.
2.3. Monetary policy = change in money supply
The central bank actually has other monetary policy instrument apart from being able to
determine the money supply. The most important one is the target interest rate for the
overnight market. In this book we will not consider the possibility of changing the target
interest rate. However, we know that there is a negative relationship between the target rate
and the money supply. Therefore, if you want to investigate the effect of an increase in the
target interest rate, you may just as well investigate a decrease in the money supply.
2.4. There is just one interest rate
Including different interest rates with different maturities would complicate the models
but it would not buy you very much. Since interest rates with different maturities are highly
correlated, they typically move in the same direction and the direction of a variable is
typically what we are interested in. If you like, think of “the interest rate” as the one-year
interest rate on government securities.
2.5. Exchange rate
In all models we will assume that the exchange rate is flexible.
Furthermore, we assume that the exchange rate is determined by the ratio of the domestic
price level to the foreign price level. If, for example, domestic prices increase by 10% while
foreign prices are constant, the domestic currency will depreciate by 10% against the foreign
currency.
With this assumption, exports and imports may be assumed to be independent of the domestic
price level. If domestic prices increase by 10% while the currency loose 10%, the price of
domestically produced goods abroad will be unchanged.

2.6. Capital Flows

The domestic interest rate increase against the foreign interest rates, capital would flow
into our country which would drive down the domestic interest rate again.
Most reasonable models in which the domestic interest rate is affected by foreign interest
rates are more complicated. To understand such models, you must first understand the models
where this complication does not arise. Also, the predictions from models where the domestic
interest rate is not affected by foreign interest rates are fairly similar to the more realistic
models wchich allows for capital flows.
3. The macroeconomic variables
In this section we have summarizes all the macroeconomic variables we will consider in
this book. The first column indicates the symbol we use for the variable while column 2
shows the name of the variable.
Variable Variable Name Variable Variable Name
Y Real GDP NT Net tax (real)

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 P Price level X Exports (real)
P.Y Nominal GDP Im Imports (real)
U Unemployment NX Net exports (real)
L Hours worked SH Household savings (real)
K Amount of capital SG Government savings (real)
W Nominal wage SR Rest of the world savings (real)
W/P Real wage π Inflation
M Money supply (nominal) πe expected inflation
R Nominal interest rate πw Wage inflation
r Real interest rate πM Growth in money supply
C Private consumption (real) E Exchange rate
I Investments (real) πE Depreciation in exchange
G Government expenditure (real)
Two of the variables are stock variables: K and M. Prices cannot be characterized as a
stock or flow variable. P, W, R, r and E apply at a given point in time while π, π e, πw and πE
apply over a period of time. π, πw and πE are changes in P, W and E during the previous time
period while πe is the expected change in P during the next time period. All the other variables
are flow variables measured in some unit per unit of time (for example, L is the number of
hours worked per year or per any other unit of time).
3.1. Supply and demand
In microeconomics, we are careful to distinguish between the demand, the supply and the
observed quantity. The first two are hypothetical concepts which indicate the desired
quantities from households and firms under various conditions. The observed quantity is the
quantity that consumers actually end up buying from the firms.
The main difference is that demand and supply are functions - they depend on other
variables – while observed quantities are variables. These functions are usually illustrated in a
chart where we illustrate how demand and supply depend on other variables.
In macroeconomics, we also consider the demand and the supply of many of the
variables. So far, each variable has represented an observed quantity. For example, L has been
the symbol for the actual number of hours worked, a variable that we can measure. However,
we have not made any distinction between the demand and the supply of labor which we need
to do from now on. The variables for which we will consider the supply and the demand are:
Y, L, K M, C, I, G, X and Im.
In order to separate the supply and the demand from the observed quantity, we use
subscript S for supply and subscript D for demand. For example, L is still the observed
amount of work (a variable) while LS and LD represent the supply of labour and the demand

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for labour.
4. Macroeconomic models- an overview:
Macroeconomics is not an exact science such as physics. No one knows exactly how the
Macro-economic variables are related. Instead, there exist several models that try to
explain various observations and relationships between macroeconomic variables.
Unfortunately, not all these models consistent - one model may predict that unemployment
will fall if the central bank lowers the target interest rate while another may claim that such a
change will not affect unemployment.
This type of problem is something you must get used to and accept. Economics is not a
subject where you can perform an experiment to find out what is really “true”. Observed
phenomena may have different explanations in different models and different models will
lead to different predictions of macroeconomic variables. If you conclude that “An increase
in x will lead to an increase in y” you really should not think of this as a property of the real
world but rather as the property of a particular model.

4.1 Growth theory:

The classical growth theory: The production function will not provide us with a theory or
explanation of growth. It is only a convenient tool which helps us breaking down growth into
its components. However, there are many growth theories that try to go a step further. The
oldest of these theories is the so-called classical growth theory which is primarily associated
with Thomas Robert Malthus.
The classical growth theory should not be confused with the classical model that we will
look at in the next chapter. Also, the classical growth theory, which was developed in the late
1700s, has little or no relevance today. We present it so that you can better understand more
modern growth theories.
In short, the classical growth theory may be described as follows:
1. Due to technological development, the amount of capital increases and the marginal
product of labor rises.
2. GDP per capita rises. With higher living standards, the population will increase.
3. As population increases, the labor productivity will fall (more individuals but the same
amount of capital).
4. GDP per capita will fall again. When GDP per capita has fallen to a level just high
enough to keep the population from starving, the increase in population will cease.
Destruction of capital, for example, through a war, works in the opposite way. The
marginal product of labor falls, GDP per capita falls and the population decreases. This will
again lead to an increase in the marginal product of labor and GDP per capita return to the
"survival rate".
The main point of the model is that population growth will always eliminate the positive
effects of technological development and GDP per capita will always return to the survival
level. This very "dismal" growth theory was prominent in the early 1800s, and economics to

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this day is sometimes called the "dismal science".
Today we know that the predictions of the model where incorrect. During the rest of the
1800s Europe experienced a growth in GDP per capita. Although the population growth was
high, it was not nearly sufficient to eliminate the positive effects of technological
development.

4.2 The neo-classical growth model:

The main purpose of another important growth model, the neo-classical growth model, is
to explain how it is possible to have a permanent growth in GDP per capita. The model was
developed by Robert Solow in the 1960s and it is sometimes called the Solow growth model
or the exogenous growth model.
The neo-classical growth model should not be confused with the neoclassical synthesis,
which we will study in chapter 10. "Neo" means "new" - the neo-classical growth theory is a
"new version" of the classical growth model.
The crucial difference between the classical and neo-classical growth model is that
population is endogenous in the former and exogenous in the latter. In the classical model,
population will increase or decrease depending on whether GDP per capita is higher than or
lower than the survival level. In the neo-classical model population growth is not affected by
GDP per capita (however, the population growth will affect the growth in GDP per capita).
In the neo-classical model, it is the technological progress only that affects the GDP per
capita in the long run. We will have a permanent increase in GDP per capita when there is a
technological development that increases productivity of labour. Permanent growth in GDP
then requires continuous technological progress.
It is not possible for the government, except temporarily, to affect the growth rate in the
neo-classical growth model. The government might be able to affect GDP per capita (and
thus is the growth rate) but the growth rate always returns to the level determined by the
technological progress. The same is true for savings. An increase in savings may have a
temporary effect on GDP but it will have no effect in the long run.

4.3 Endogenous growth theory:

Endogenous growth theory or new growth theory was developed in the 1980s by Paul
Romer and others. In the neo-classical model, technological progress is an exogenous
variable. The neo-classical growth model makes no attempt to explain how, when and why
technological progress takes place.
The main objective of the endogenous growth theory is to make the technological
progress an endogenous variable to be explained within the model, hence the name
endogenous growth theory.
There are many different explanations for technological progress. Most of them,
however, have a lot of common characteristics:

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 • They are based on constant return to scale for capital. Thus, MPK is not a decreasing
function of K in these models.
• They consider technological development as a public good.
• They focus more on human capital.
• It is possible for the government to affect the growth rate. Higher savings also leads to
higher growth, not just higher GDP per capita.
• They predict convergence of GDP per capita between countries in the long run. This is
a consequence of the public good property of the technological developments.
Separation of growth and fluctuation
It is often useful to separate the evolution of a variable that grows over time into a trend
and fluctuations around the trend. The graphs below show such a separation for real GDP.

Fig: Growth and the fluctuation around the trend.

The left diagram shows a stylized graph of real GDP over time. It demonstrates the two
important characteristics in real GDP. GDP fluctuates over time and GDP grows over time -
at least over a longer period of time. The left graph is the sum of the middle graph and the
right graph.
The middle graph shows the trend in GDP. The trend represents the second characteristic
of GDP - the fact that GDP grows over time. The right graph shows the fluctuations around
the trend (cycles) of GDP. These fluctuations around the trend represent the first property of
GDP.
In macroeconomics it is common to study trends and cycles separately. The purpose of
growth theory is to investigate the trend while most of macroeconomics apart from growth
theory is about the cycles. The trend is about the very long run perspective of the economy
while cycles are about the short and medium run. The rest of this is all about cycles and not at
all about trends. Therefore, when you think of GDP in the remaining chapters, you should
think of GDP as in the right-hand graph: GDP has cycles but no trend. Basically, we will
study GDP where the trend has been removed.

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 4.4 The classical model:
The Classical Model was popular before the Great Depression. It says that the economy
is very free-flowing, and prices and wages freely adjust to the ups and downs of demand over
time. In other words, when times are good, wages and prices quickly go up, and when times
are bad, wages and prices freely adjust downward.
The major assumption of this model is that the economy is always at full employment,
meaning that everyone who wants to work is working, and all resources are being fully used
to their capacity. The thinking goes something like this: if competition is allowed to work, the
economy will automatically gravitate toward full employment, or what economists
call potential output - just like the expressway at an average speed of 55 miles per hour.
Remember what happened when traffic slowed down because there were too many cars?
After a few minutes, everything went back to normal. Classical economists believe that the
economy is self-correcting, which means that when a recession occurs, it needs no help from
anyone. So that's the Classical Model.

4.5 Keynesian cross model:

The Keynesian model has as its origin the writings of John Maynard Keynes in the
1930s, particularly the book “The general theory of Employment, Interest, and Money”.
The similarities between the Keynesian model and the classical model are definitely
greater than the differences. Let’s point out the three most important differences directly:

Say's Law does not apply in the Keynesian model.

The quantity theory of money does not apply in the Keynesian model.
The nominal wage level W is an exogenous variable in the Keynesian model.

Remember that W being exogenous means that it is pre-determined outside the model. It
does not necessarily mean that it is constant over time – even though this is a common
assumption. However, the nominal wage must be known at any point in time in this model.
To simplify our description of the Keynesian model, we will begin by assuming that W is
constant.

The Keynesian model is slightly more complicated than the classic model, and it is
developed in four stages by analyzing four separate models. Each model has, however, a
value in itself. The models we will consider and the major characteristics of each are:

Cross model: W, P and R are constant (and exogenous).

IS-LM model: W, P is constant, and R is endogenous.
AS-AD model: W is constant, P and R are endogenous.

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 The full Keynesian model: W is exogenous (but not constant), P and R are endogenous.
Once we have developed the full Keynesian model, we will combine it with the classic
model which will lead to the neoclassical synthesis. The final section covers the Mundell-
Fleming model – an extension of the neoclassical synthesis to an open economy where we
also analyse the exchange rate.

4.6 IS-LM-model:
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 loanable funds market (LM) or money market. 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.

BREAKING DOWN 'IS-LM Model':

British economist John Hicks first introduced the IS-LM model in 1937, just one year
after fellow British economist John Maynard Keynes published "The General Theory of
Employment, Interest, and Money." Hicks's model served as a formalized graphical
representation of Keynes's theories, though it is used mainly as a heuristic device today.
The three critical exogenous variables in the IS-LM model are liquidity, investment and
consumption. According to the theory, liquidity is determined by the size and velocity of the
money supply. The levels of investing and consumption are determined by the marginal
decisions of individual actors.
The IS-LM graph examines the relationship between real output, or GDP, and nominal
interest rates. The entire economy is boiled down to just two markets, output and money, and
their respective supply and demand characteristics push the economy towards
an equilibrium point. This is sometimes referred to as "the Keynesian Cross."
Characteristics of the IS-LM Graph
In the IS-LM graph, the IS curve slopes downward and to the right. This assumes the
level of investment and consumption is negatively correlated with the interest rate but
positively correlated with gross output. By contrast, the LM curve slopes upward, suggesting
the quantity of money demanded is positively correlated with the interest rate and with
increases in total spending, or income.
Gross domestic product (GDP), or (Y), is placed on the horizontal axis, increasing as it
stretches to the right. The nominal interest rate, or (i or R), makes up the vertical axis.
Multiple scenarios or points in time may be represented by adding additional IS and LM
curves. In some versions of the graph, curves display limited convexity or concavity.
Limitations of the IS-LM Model
Many economists, including many Keynesians, object to the IS-LM model for its
simplistic and unrealistic assumptions about the macroeconomy. In fact, Hicks later admitted

8
model's flaws were fatal, and it was probably best used as "a classroom gadget, to be
superseded, later on, by something better." Subsequent revisions have taken place for so-
called "new" or "optimized" IS-LM frameworks.
The model is a limited policy tool, as it cannot explain how tax or spending policies
should be formulated with any specificity. This significantly limits its functional appeal. It
has very little to say about inflation, rational expectations or international markets, although
later models do attempt to incorporate these ideas. The model also ignores the formation of
capital and labor productivity.

4.7 The AS-AD-model:

Aggregate Supply is the total amount of goods and services in the economy available at
all possible price levels. Aggregate Demand is the amount of goods and services in the
economy that will be purchased at all possible price levels. In an economy, as the prices of
most goods and services change, the price level changes and individuals and businesses
change how much they buy. The aggregate supply curve on a graph illustrates the relationship
between prices and output supplied whereas the aggregate demand curve shows relationship
between price and real GDP demanded.

When aggregate supply (AS) curve and aggregate demand (AD) curves are put together,
it shows the AS/AD equilibrium in the economy. The intersection of the AS and AD1curves
indicated an equilibrium price level of P1 and an equilibrium real GDP of Q1. Any shift in
aggregate supply or aggregate demand has an impact on the real GDP and the price level. [1]
Short-run macroeconomic equilibrium occurs when the quantity of GDP demanded
equals the quantity supplied, which is where the AD and short-term AS (SAS) curves
intersect. The price level adjusts to achieve equilibrium. Short-run equilibrium does not
necessarily take place at full employment. Long-run macroeconomic equilibrium occurs

9
when real GDP equals potential GDP so that the economy is on the long term AS curve
(LAS) as shown in Fig 2.

The AS/AD framework illustrates the reaction of an economy to an increase in aggregate

demand:
In the short run, the AD curve shifts to the right and the equilibrium moves along the
initial SAS curve. Real GDP increases and the price level rises.
The money wage rate rises to reflect the higher prices, and the SAS curve shifts leftward,
decreasing real GDP and further raising the price level.
In the long run, the SAS curve shifts leftward enough so that real GDP returns to
potential GDP. Further adjustments cease. Real GDP is at potential GDP, and the price level
is permanently higher than before the increase in aggregate demand.
The AD/AS model also explains how the economy responds to a decrease in aggregate
supply:
The SAS curve shifts leftward, real GDP decreases and the price level rises. A period of
time with combined recession and inflation is known as stagflation. [2]
Factors that Affect AS and AD
There are multiple activities that can cause shifts in the AS and AD curves. The
following are factors that can shake the aggregate supply:
The increase in nominal wages shifts AS to the left because costs of production increases,
which lowers profits.
The increase in prices of other inputs into manufacturing of products also shifts AS to the
left because production costs increase. For example, the rise in the price of oil or electricity
would increase costs for producers and lower their profits (so they produce less).
The usage of technology can shift the AS to the right because it increases the
productivity; as a result, firms can produce more output with the same amount of resources
(increases in efficiency). An example is computers. [3]
Similarly, there are factors that can cause changes in the AD curve as well such as:

10
 When there is an increase in the country’s exchange rates, the net exports decrease, and
aggregate expenditure also takes a dip resulting in shifting the AD curve to the left.
An increase in the income of the citizens will encourage them to spend more; eventually
causing a rightward shift.
Foreign income also has a significant impact on the aggregate demand. When foreign
income increases, exports will increase causing the curve to shift to the right as a result of
increased aggregate demand. [4]
The AD-AS framework divides the economy into two parts – the ‘demand side’ and the
‘supply side’ – and examines their interaction using accounting identities, equilibrium
conditions and behavioral and institutional equations. The ‘demand side’ typically examines
factors relating to the demand for goods and the demand and supply of assets. The ‘supply
side’ typically examines factors relating to output and pricing decisions of producers, and
factor markets. The framework ensures that neither demand nor supply side factors are
overlooked in the analysis and that macroeconomic outcomes depend on the interaction
between the different markets. [5]
This model scores highly in terms of simplicity. In terms of flexibility, it is comparable to
IS-LM. It can straightforwardly be extended to deal with stochastic shocks and open-
economy issues. However, where this model does fail badly is in terms of accuracy. Again the
basic assumption concerning monetary policy is that the authorities fix the value of the
money stock. This leads to the unattractive feature that the ‘equilibrium’ is one in which the
price level has converged on a constant value.
There are other problems as well with the AD-AS model than the assumption of a fixed
money stock. Colander (1995) pointed out that the model contains two contradictory accounts
of aggregate supply. In deriving the aggregate demand curve a fixed price multiplier theory is
assumed while in deriving the aggregate supply curve the underlying assumption is one in
which supply expands to the point at which marginal cost equals marginal revenue. [6]
Effect of Monetary Policy
In the case of contractionary monetary policy, the money supply in the economy is
decreased which further leads to a decrease in the nominal output, also known as the Gross
Domestic Product (GDP). Additionally, the declined money supply in the market also leads to
reduced spending by the consumers which thus shifts the aggregate demand curve to the
right.
In the case of expansionary monetary policy, the central bank increases the money supply
in the market by purchasing government bonds, and this pumps money into the market, and
also decreases the interest rate as banks have more cash to loan to firms. Thus, firms begin to
invest in order to increase output i.e. increased GDP. This leads to increase in employment.
Additionally, as there is more money in the market, the consumer spending increases as well.
All this activity shifts the aggregate demand curve to the left. [7]

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 Effect of Fiscal Policy

In pursuing expansionary fiscal policy, the government either increases spending, or

reduces taxes or does a combination of both. As mentioned above, increase in the government
spending shifts the AD curve to the right. Reduced taxes mean the consumer has more
dispensable income at hand, and so can purchase more. This as well shifts the AD curve to
the right. Plus, a combination of both increased government spending and reduced taxes also
works in shifting the AD curve to the right. The extent of the shift in the AD curve due to
government spending depends on the size of the spending multiplier, while the shift in the
AD curve in response to tax cuts depends on the size of the tax multiplier.
The government uses a contractionary fiscal policy when there is a demand-pull
inflation. It also facilitates in paying off unwanted debt. In the case of contractionary fiscal
policy, the government either decreases spending, or raises taxes, or does a combination of
the two. Less money rotation in the market leads to decline in the output which means
reduced GDP. The consumer spending also takes a dip as there is lesser money available for
expenses. Contractionary fiscal policy shifts the AD curve to the left. If the tax revenues
exceed government spending, then this type of policy leads to a budget surplus. [8]

The complete Keynesian model:

Wage inflation:
In this section, we will continue to develop the Keynesian model removing the
assumption of fixed nominal wages. We define wage inflation nw as the percentage average
increase in wages. Wages and wage inflation are still exogenous, i.e. they are not determined
within the model. One justification for this assumption is that wages often are determined by
agreements which often last for several years.

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 We do not need a new model to deal with inflation. Non-constant wages can be handled
within all three Keynesian models as long as they are exogenous. The reason we chose to let
wages be constant in the previous Keynesian models were entirely pedagogical - these
models are easier to understand when wages are constant.
Price Inflation
The main reason for allowing for non-constant wages in the model is that we then can
allow for persistent inflation/deflation. With constant wages, we cannot have persistent
inflation as real wages would go to zero.
Neutral inflation is defined as a situation where wage inflation is equal to inflation (in
prices). With neutral inflation, the real wages are constant. The Keynesian model does not
require neutral inflation and real wages may vary over time. However, we cannot have an
inflation which is always greater than or always smaller than wage inflation as real wages
again would go to zero or infinity (again, remember that growth has been removed so we
expect no upward trend in real wages). However, a few adjustments must be made in the
models when we have inflation.
Adjustments to the Keynesian models when wages are no longer constant
Real interest rates, nominal interest rate and expected inflation
When we have inflation, we cannot, of course, assume that expected inflation is zero.
Therefore, real interest rate will no longer be equal to the nominal interest rate and we must
use R = r + ne. In this chapter, expected inflation ne is exogenous (although not necessarily
constant. In more advanced Keynesian models you will find various assumptions on how
expectations are formed.
Aggregate demand with inflation
In previous versions of the Keynesian model, none of the components of aggregate
demand depended on P. In the IS-LM and in the AS-AD models, investments depended on
the nominal interest rate R. We argued that investment actually depends on the real interest
rate r, but since R = r when if = 0, we could make it a function of R.
When if no longer is zero and the real interest rate r = R - if, we should
write I(r) or I(R - if). We should also write YD(Y, r) or YD(Y, R - if). Since inflation
expectations are exogenous (given), it is still the case that YD depends negatively on R. Note
that if there is an equal increase in expected inflation and in nominal interest rate, real interest
rate is unaffected and so is investments and aggregate demand.
The IS curve with inflation
We can draw the IS curve for a given value of if. As previously explained, the IS curve is
not affected by changes in P. However, it will shift upwards when 7f increases.

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 Fig: The IS curve and expected inflation.
If if increases, R must increase by the same amount to keep r and YD unaltered.
The money market with inflation
Let us begin with the money market diagram in 12.3.6 and introduce inflation. Since
the MD depends positively on P, the MD curve to "glide" out towards the right when
inflation is positive and toward the left when we have deflation.

Fig: The money market with inflation and constant money supply.
If money supply is constant, nominal interest rate will continuously increase when we
have inflation and continuously decrease when we have deflation.
An interesting special case is when money supply increases by the same rate as P. In
this case, the money supply curve will also glide outwards or inwards (depending on whether
we have inflation or deflation) at exactly the same rate as the money demand. The nominal
interest rate will then be constant.

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 Fig: The money market with inflation and rising money supply.
If we let %M denote the growth rate in money supply, we can conclude the following.
For a given Y, R will increase if n > nM (prices increase faster than the money supply)
and R will fall if nM > n. R is unchanged if n = nM.
For example, when n > nM, the MD curve glides out to the right faster than MS curve
which is why R increases.

The LM curve with inflation

Earlier, we found that the LM curve will shift upwards when P increases
(assuming MS is constant). This is still true, but we can also add that the LM
curve glides upwards if n > nM (as R increases) and the LM curve glides downwards
if nM > n.
The previous result is a special case of this result. If P increases, then n > 0 and if MS is
constant then nM = 0 and the LM curve glides upwards. Earlier, we only considered cases
when P jumped (from say 100 to 120). This translates into having inflation for a short period,
an LM curve that glides upwards and when P reaches 120, inflation cease and the LM curve
will stop moving.
The neo-classical synthesis:
The neoclassical synthesis was a post-World War II academic movement
in economics that worked towards absorbing the macroeconomic thought of John Maynard
Keynes into neoclassical economics. The resultant macroeconomic theories and models are
termed Neo-Keynesian economics. Mainstream economics is largely dominated by the
synthesis, being largely Keynesian in macroeconomics and neoclassical in microeconomics.
The term ‘neoclassical synthesis’ appears to have been coined by Paul Samuelson to
denote the consensus view of macroeconomics which emerged in the mid-1950s in the
United States. This synthesis remained the dominant paradigm for another 20 years, in which
most of the important contributions, by Hicks, Modigliani, Solow, Tobin and others, fit quite
naturally. The synthesis had, however, suffered from the start from schizophrenia in its

15
relation to microeconomics, which eventually led to a serious crisis from which it is only now
re-emerging. I describe the initial synthesis, the mature synthesis, the crisis and the new
emerging synthesis. The term ‘neoclassical synthesis’ appears to have been coined by Paul
Samuelson to denote the consensus view of macroeconomics which emerged in the mid-
1950s in the United States. In the third edition of Economics (1955, p. 212), he wrote: In
recent years 90 per cent of American Economists have stopped being ‘Keynesian economists’
or ‘anti-Keynesian economists’. Instead they have worked toward a synthesis of whatever is
valuable in older economics and in modern theories of income determination. The result
might be called neo-classical economics

Exchange rate determination:

Exchange rate systems
For an open economy, the particular exchange rate system in use becomes important.
In Exchange rate we discussed some possible systems. In simple models, only two systems
are considered: a floating or a fixed exchange rate.
With a floating exchange rate, the exchange rate is determined as any price, that is, by
supply and demand. The central bank never intervenes in the market.
With a fixed exchange rate, the exchange is completely fixed. In reality, most countries
with a fixed rate allow the exchange rate to vary within certain limits. These variations are
disregarded and the central bank will always intervene to keep the exchange rate at its fixed
value.
Also remember the following notation:

Fig: Changes in exchange rates.

The classical model of exchange rate determination:

The classical model of exchange rate determination is the one we have used so far. This
section will consider the foundations of this model
The law of one price:

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 The classical model for exchange rate determination is based on the law of one price.
This law claims that there can be only one price for a given product at any given time. Gold,
for example, must cost more or less the same wherever you buy it.
If gold was traded for USD 30,000 per kilo in New York and for USD 40,000 per kilo in
Chicago, you would be able to make a lot of money by buying gold in New York and selling
it in Chicago. There would be opportunities for arbitrage – opportunities to make money
with no risk. Gold would be transported from New York to Chicago until the price difference
was eliminated.
The law of one price need not apply exactly due to the following reasons:
Transportation costs: If the price difference is less than the cost of transport, the
difference may remain.
Ease of access.: A soda in a convenience store is often more expensive than in a super
market. You pay slightly more for the convenience of the ease of access.
Government intervention: The government may, for example, by subsidizing electricity
for firms, create a market with two different prices for the same good.
For non-transportable goods and services, the price difference may be much larger.
Even if the price of a haircut is much higher in Chicago than in Boise, Idaho, there are no
strong arbitrage possibilities that will remove the price difference.
Purchasing Power Parity (PPP)
If we apply the law of one price to goods in different countries, we can derive the
purchasing power parity (PPP). If gold is trade in the U.S. at USD 30,000 per kilo and 1euro
costs USD 1.40, you can be pretty sure that gold will trade for around 30,000/1.4 ≈ 21,400
euro per kilo. If that was not the case, there would again be arbitrage opportunities (unless
there are restrictions on transporting gold across borders). If PF is the price of a good in the
foreign country, P is the price of the same good in our country and E is the exchange rate
(domestic / foreign) then PPP claims that P = PF*E
The Big Mac Index
Based on PPP, the Economist regularly publishes the "Big Mac Index". PF is then the
price of a Big Mac in the U.S. In February of 2009, PF was on average 3.54 USD and E =
1.28 USD / euro. According to PPP, a Big Mac should cost 2.77 euro in the euro area. In
reality, it costs on average 3.42 euro. We would need an exchange rate of 3.54 / 3.42 = 1.04
USD / euro for the PPP to be entirely correct for the Big Mac.
According to Big Mac index, the euro is over-valued by about 24% in relation to the
USD. The most expensive Big Mac, however, is found in Norway. Here a Big Mac costs
USD 5.79 at the current exchange rate making the Norwegian krona overvalued by 63%.
Exchange rate determination
In PPP, PF and P denote the domestic and foreign price of a particular good. If we
instead let PF and P denote price levels, we can derive the classical model of exchange rate
determination simply by dividing both sides in PPP by E: E = P/PF
If the UK is our home country and a basket of goods costs 12.0 million UK pounds

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(GBP) while the exact same basket costs 14.1 million euro in France, the exchange rate,
according to the classical model, ought to be 0.851 GBP/EUR or 1.175 EUR/GBP.
The exchange rate that we just calculated is often called the purchasing power adjusted
exchange rate. If this was the actual exchange rate, the price levels (in the same currency) in
the two countries would be the same. When we compared GDP per capita for various
countries in section 3.6, it was the purchasing power adjusted exchange rate that we used to
transform GDP into the same currency.
For countries where the GDP per capita is very different, the actual exchange rate is often
very far from the purchasing power adjusted exchange rate. The price level in countries with
a high GDP per capita is generally higher than the price level in countries with a low GDP per
capita (in the same currency). It is often for services and non-transportable goods where
prices deviate the most.
Inflation
If the price level in the home country and the foreign price level do not change, then,
according to the classical model of exchange rate determination, E will be constant. The same
is true if P and PF increase at the same rate, that is, if the home country has the same inflation
as the rest of the world: π = πF, where πF is the rate of inflation abroad.
If, however, π > πF (P increases faster than PF), then E will increase (our currency will
depreciate). For example, if π = 8% while πF = 5%, P increases by 8% while the PF increases
by 5% over the same period. P/PF will then be 1.08 / 1.05 ≈ 1.03 times larger than the old
value, that is, E will increase by about 3%. Our currency will have depreciated by 3% during
this period.
If πE is the rate of increase in the exchange rate (rate that our exchange rate depreciates),
the classical model predicts: πE ≈ π − π F
The rate of depreciation is (approximately) equal to the differences in inflation
between the countries.

4.8 The Mundell-Fleming model:

The Mundell–Fleming model, also known as the IS-LM-BoP (Balance of

Payments) model (or IS-LM-BP model), is an economic model first set forth (independently)
by Robert Mundell and Marcus Fleming. The model is an extension of the IS-LM model.
Whereas the traditional IS-LM model deals with economy under autarky (or a closed
economy), the Mundell–Fleming model describes a small open economy.
The Mundell–Fleming model portrays the short-run relationship between an economy's
nominal exchange rate, interest rate, and output (in contrast to the closed-economy IS-
LM model, which focuses only on the relationship between the interest rate and output). The
Mundell–Fleming model has been used to argue that an economy cannot simultaneously
maintain a fixed exchange rate, free capital movement, and an independent monetary policy.
This principle is frequently called the "impossible trinity," "unholy trinity," "irreconcilable

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trinity," "inconsistent trinity" or the "Mundell–Fleming trilemma."

REFERENCES
Economics: Principles in action by Arthur Sullivan & Steven M. Sheffrin – Pearson
Prentice Hall – 2003
http://facstaff.uww.edu/ahmady/courses/econ202/ps/sg6.pdf
http://userwww.sfsu.edu/pgking/690pdfs/adas.pdf
http://econport.gsu.edu/content/handbook/ADandS/AD/Shift.html
Keynesian Theory and the AD-AS Framework: A Reconsideration by Amitava Krishna
Dutt and Peter Skott – University of Massachusetts Amherst – Working paper 2005-11
P Turner – International Review of Economics Education, 2006
https://www.boundless.com/economics/monetary-policy/impact-of-fed-policies/the-
effect-of-expansionary-monetary-policy/
https://www.boundless.com/economics/fiscal-policy/introduction-to-fiscal-policy/how-
fiscal-policy-relates-to-the-ad-as-model/

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