8 Functions of the Money Market

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Chapter 11.2 11.4 Heiko Lampe

Aggregate demand and output

11.1 Overview

This chapter will take the Keynesian assumption that prices are constant as a starting

point. In this chapter the exchange rates will enter the game and we will observe, what

the Keynesian model is. The broad overview can be deducted from the figure below.

11.2 Short-run fluctuations output, employment and unemployment

In the short run capital is fixed. Firms can alter their production by labor usage, extra

hours and so on. Thus they deviate from their original output trend, which is described

as an output gap.

The relation between output growth and unemployment is known as Okuns Law. A

certain amount of output is linked to a certain amount of unemployment, holding the

number of workers fixed and the hours worked per worker. This can be represented in

a graph like:

U-Ubar = -g(Y-Ybar)

Ubar U= real unemployment rate

Ubar= medium run / trend /Blanchard

g = constant factor

Y = real GDP growth

Ybar = growth trend GDP

Ybaroutput

An increase of output in this model is possible when decreasing unemployment.

Unemployment


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11.3 The IS-LM Model in the open economy

Exogenous variables are given and do not have to be explained. Endogenous

variables have to be explained in the model. Some variables are exogenous or

endogenous depending on the exchange rate regime. When the nominal exchange

rate is fixed, the real exchange rate is exogenous if we assume the foreign anddomestic prices to be constant.

As discussed earlier, the total output is dependent of consumption, Investments and

government spending. Now we add to all this PCA, the primary current account. Thus

the exports and import enter the scene. PCA = X-Z = ExportsImports.

Import function: Z = Z(A, ) with A= domestic Absorption(C+I+G) and = real

exchange rate + +

Export function: X = X(A*, ) with A*= total foreign Absorption

+ -

If the domestic Absorption increases, the imports will increase, an increase in the

exchange rate will make it cheaper to buy outside and will increase imports as well.

Of course the latter effect is reversed for the export function. If the Absorption in the

foreign country increases however, the exports will increase as well.

For PCA = X Z follows: PCA = PCA (A, A*, )

- + -

The current account function can now be written as PCA = PCA (Y, Y*, )since the dependence on A is fundamentally a dependence on A - + -

Coming back to the 45 degree diagram with an open economy will give the same

picture as before. The DD-Equation is now a little longer and looks like:

DD = C (, Y T) + I(i, q) + G + PCA (Y, Y*, )

Here the q in the Investment function is Tobins q. The graph looks the same, but the

DD line is flatter to account for the fact, that the PCA declines as income increases,

because more is imported from abroad, reducing the net effect of an income increase.

The next graph will show how output adjusts to desired demand. If the DD line shifts

upward (due to an increase in government spending for example), the demand goes up

to point B, motivating the producers to increase production. The higher production

leads to higher income and thus new demand, resulting in the producers to increase

their production again. Thus we will end up in the new equilibrium point. What is

important is that the GDP or output will increase more than the initial increase in

government spending and there is a multiplier effect, the demand multiplier. This is

mathematically easily explained with the flatter DD line. However, the graph is on the

next page and it should not give any problems to follow the steps.


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The multiplier and the slope of the IS curve are interlinked. The larger the multiplier,

the flatter is the curve. This is due to the larger output increase resulting from a shiftof the DD curve. Graphically:


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If the DD becomes flatter due to a including of PCA (some effects are taken out of the

country via imports), the IS curve gets steeper. The shift has the same extent, but the

equilibrium output will be lower. Consequently, the IS gets steeper.

If marginal propensity to consume goes up, DD gets steeper. If marginal propensity to

import goes up, DD gets flatter. If the PCA goes up, the DD gets steeper as well

The multiplier is finite, because ofleakages. An increase in GDP is not fully

translated into new domestic demand via higher income. There are three leakages:

Taxes, savings and imports. The higher income may be saved, go to the government

or be used to import. Thus the multiplier is dependent of the marginal propensity to

save and import.

It is important to distinguish between shifts of and movements along the IS curve.

Every change of an exogenous variable shifts the curve. A change of an endogenous

variable causes a movement along the curve.

The small country assumption says that the domestic situation does not influence

the foreign. The foreign rate of return i* is exogenous. So if you can get money in the

domestic market and invest it in the foreign market at a better price, this is called

arbitrage, you will make the interest rate in the domestic market change and adjust.

Overall, with the expected exchange rate development the interest you can earn

domestically and in the foreign market are after changing your money back the same.This phenomenon is called interest parity. i=i* the domestic return is equal to the

foreign return. Since in this course the exchange rates are fixed that means that the

interest rates in both countries are the same and the small country adjusts to changes

in the big one (like Germany and The Netherlands years ago).

The LM curve is not directly affected by the interest parity condition. It just describe

the equilibrium in the domestic money market. Due to the small country assumption

however, the adjustment of the interest has to come over the money market. In

addition to that the money supply has to be regulated to hold the exchange rate fixed.


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Of course it is important to distinguish again between movements along the LM and

shifts of the LM. Here real money supply and the transaction costs are exogenous. In

the Figure on this page the exogenous change of nominal money supply shifts the

curve.

In this chapter we assume the wages and prices to be fixed. We can ignore the labor

market, because it will adjust passively. Supply adjusts on all markets to the demand.This is the key issue of the Keynesian approach to macroeconomic. In addition to that


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this chapter allows us to connect with the rest of the world by opening the economy.

This opening is to search in the IS curve. The LM curve stays unaffected. The

international financial market replaces the labor market and we have three markets

again to bring them into one general equilibrium.

The international financial market is just the fact that you should get the same returneverywhere. This is not dependent of GDP. The financial integration line captures

this:

i* financial integration line

GDP

i* is the foreign interest rate

Bringing this together with the usual IS-LM-Model gives us the Mundell-Fleming

model and looks like the graph below

IS LM

i* E financial integration line

GDP

Here we can observe the equilibrium of all three markets in point E.

The rest of this chapter will explain how GDP and interest rate respond on various

exogeneous disturbances. The approach is always the same: Find out which of the three curves will shift

What has to happen to make them go through one point again?

How does the economy move from one to the other equilibrium?

This has to be, because none of the markets can be in disequilibrium for a long time.

The financial integration line has to come to an equilibrium, because arbitrage does

not last long. The goods market will adjust with inventory and output movements.

The money market will clear very fast as well.

interestrate

interestrate


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11.4 output and interest rate determination under fixed exchange rates

An increase of the money supply will lead to a right shift of the LM-curve. Now there

are three possibilities: either the IS curve restores the equilibrium, or the financial

integration line, or the LM curve shifts back! Since the exchange rate is fixed, a

decrease of the interest rate would bring a lot of domestic investors out of the country.This would give pressure on the exchange rate, forcing the authorities to buy back the

own currency by using foreign assets. Finally that will decrease the money supply and

the LM curve will shift back again.An increase in the money supply implies a rightward shift of theLM. At point B (with a lower interest rate) capital outflowsforce the central bank to intervene and the money supply

contracts, until the economy returns to point A. Monetary policy

is ineffective.

This result leads us to the experience that the LM curve is endogenous and will adjust

always. So monetary policy is ineffective under fixed exchange rates. This problem

resulted in the invention ofcapital controls. In some countries it is not possible to

bring capital freely out of the country. So the domestic interest rate is a bit

independent of the world market, allowing for adjustments, which would be

impossible without the restrictions.

If any exogenous factor changes and the demand is increased, the results can be

observed in figure 11.14. The new IS-LM intersects comes along with a higher

interest rate and will thereby affect investments negatively which is called crowding

out. The LM will shift out, because of the capital inflow.


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8 Functions of the Money Market