Cronin Three Sector Macro HandbookVer2faculty.babson.edu/ricciardi/pages/mmssu6/MMS...2 This is explained in detail in Krugman, p.202-206. 3 Discussion of the overview of the three

Three Sector Macroeconomic Model

(Liquidity Preference Approach): A Handbook

by Cheryl Cronin

September 2014

DRAFT

The Three Sector Macroeconomic Model Page 2

INTRODUCTION This handbook presents an overview and analysis of a three sector model of the macroeconomy (liquidity preference view).1 It explains the details of the three macroeconomic markets (the goods market, the money market, and the foreign exchange market) and how they interact. Please note that this handbook is not intended to replace your textbook, your professor’s classroom lectures, or assigned exercises. It is intended to supplement them. You will find the handbook is most helpful after you’ve studied the related course materials in the textbook. References to the textbook are to Paul Krugman and Robin Wells, Macroeconomics: Third Edition (Princeton, NJ: Worth Publishers, 2013). We’ll refer to this textbook as Krugman, followed by the page number. (For example, Krugman, p. 100.) OVERVIEW In an open market economy, where goods and services freely flow between countries, changes or perturbations in one market result in adjustments or perturbations in other markets. The three markets (or sectors) we will examine include the goods market, the money market, and the foreign exchange market. Macroeconomic variables. We can categorize perturbations into two types of macroeconomic variables – exogenous and endogenous. Exogenous variables are independent variables, externally determined. Table 1. Exogenous Variables

Policy Name Agency Market Variable Description Fiscal policy State/Government Goods

Market G, T G =Government spending

T = Taxes (G-T) = Government spending minus taxes (defines whether or not there is a deficit)

Monetary policy

Central Bank Money Market

Ms Ms = money supply

Fiscal policy involves actions taken by the government regarding G (government spending) and/or T (taxes) to actively affect the macroeconomy. Monetary policy involves actions taken by a country’s central bank regarding the money supply to actively affect the macroeconomy. (We’ll discuss fiscal policy and monetary policy more later.)

1 According to Krugman, “the liquidity preference model of the interest rate…says that the interest rate is determined by the supply and demand for money in the market for money.” (Krugman, p.453.) Our model uses the liquidity preference model of the money market rather than the loanable funds model of the interest rate. Both models are analytically similar. (See Krugman, p.455.) The liquidity preference model is closer to Keynes’s exposition and provides useful insights into the dynamics of financial instability and crisis.


Endogenous variables are dependent variables. Changes to these variables are the result of systemic changes resulting from exogenous shocks. Negative changes are typically described as economic ailments. Note that for endogenous variables, there is no agency listed. These variables are not actively changed but are rather changed as the result of some other event or circumstance. Table 2. Endogenous Variables

Policy Name Agency Market Variable Description ---------- ---------- Goods

Market Y Y = aggregate output, the level

of real activity, typically measured as GDP (or GNP)

---------- ---------- Goods Market

P P = aggregate price level, price indicators such as CPI, PPI (wholesale price indicators), GDP deflators2

---------- ---------- Money Market

r r = interest rate (“the” interest rate, the default risk-free interest rate of short term government debt)

---------- ---------- Foreign Exchange Market

e e = exchange rate

Three Sector Macroeconomic Model – Big Picture.3 Before we begin looking more closely at the markets individually, let’s take a quick look at the three sector macroeconomic model as a whole. The model is depicted from the perspective of one national economy. (It doesn’t matter what nation. It can be any nation. But each market is examined from the perspective of the same nation.) As you can see in Figure 1 below, the Goods Market is described by a graph with Y (the total value of goods, total output, real GDP) on the horizontal axis and P (the aggregate price level) on the vertical axis. The Money Market includes the supply of money (M) on the horizontal axis and the interest rate (r) on the vertical axis. Note that the Goods Market and the Money Market together make up the national economy (that is, the economy of the nation you are examining). The Foreign Exchange Market (abbreviated fx) does not have labels on the horizontal and vertical axes because the axis labels vary depending on the currency of the nation you are examining and the currency to which you are comparing it. We’ll look at this more closely when we get to the detailed analysis of the Foreign Exchange Market. 2 This is explained in detail in Krugman, p.202-206. 3 Discussion of the overview of the three sector macroeconomic model and Figure 1 (below) are based on Joseph Ricciardi, Managing at the Crossroads: Business, Government, and the International Economy: Class Presentation, Babson College, January 21, 2014.


Notice also that capital flows to and from the national economy through the Foreign Exchange Market to the rest of the world. Likewise, goods flow to and from the national economy through the Foreign Exchange Market to the rest of the world. Figure 1. Three Sector Macroeconomic Model – Overview

GOODS MARKET Let’s look at the goods market graph in more detail. First we’ll look at aggregate demand, then at aggregate supply, and then we’ll look at them put together.

☼Make sure you read Krugman, Chapter 12, “Aggregate Demand and Aggregate Supply.” There is a lot of helpful detail in there.

Aggregate Demand. ☼Here’s a very important equation:

AD = C+I+G+(X-Im) This equation means that aggregate demand is equal to the sum of consumer spending, investment spending, government spending and net exports (which is exports minus imports).


The aggregate demand equation uses the following abbreviations: AD = aggregate demand C = consumer spending I = investment spending G = government spending (X – Im) = NE = net exports, which is the same as exports minus imports Figure 2. Goods Market – Aggregate Demand

In Figure 2, AD is the aggregate demand curve. We’ve labelled it with the equation AD = C+I+G+ (X-Im) as a reminder that aggregate demand equals consumer spending plus investment spending plus government spending plus net exports (which is exports minus imports). (Remember that Y stands for real output. That is what is being measured on the horizontal axis of the goods market graph. P stands for aggregate price level. That is what is being measured on the vertical axis of the goods market graph.) Please review Krugman, p.342-344, which introduces the aggregate demand curve, explains what movement along the aggregate demand curve is, and explains why the aggregate demand curve is downward sloping. ☼Please also review Krugman, p.346-347, which explains shifts of the aggregate demand curve.


Parameterization of Aggregate Demand.4 Let’s look at factors that shift aggregate demand. In this discussion, we assume that price is held constant. (That is, we’ll be looking at the effects of changes in certain parameters while leaving price unchanged so that the effect of the shock is clear.) If you look at Figure 3 below, you’ll notice a new line labelled P1. It is a flat horizontal line. For this discussion, we are assuming that price is held constant at aggregate price level P1. Figure 3. Goods Market - Parameterization of Aggregate Demand

☼To summarize the factors that shift aggregate demand, let’s examine the new equation that appears in Figure 3:

AD = ƒ ( P ǀ Wealth, Real r, expect, P.exp, Y*, exch rate) What does each part of the equation mean? Let’s look at the beginning of the equation first. AD stands for aggregate demand. The symbol ƒ means “a function of,” and P stands for aggregate price level. The symbol ǀ means “given”. The items that follow the given are the shift parameters of aggregate demand. We outline these in Table 3.

4 Discussion of the Parameterization of Aggregate Demand is based on Joseph Ricciardi, Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, January 28, 2014.


Table 3. Goods Market - Shift Parameters of Aggregate Demand

Name What it means Wealth Wealth (such as physical

capital/investment, stock market, real estate values – valuation changes in assets)

Real r The real interest rate (the default risk-free interest rate of short term government debt)

Expect Expectations, animal spirits (the business climate of expectations)

P.exp Expected increase in future prices (expected future inflation)

Y* Growth rate of foreign GDP Exch rate Exchange rate (the strength of

the home currency) We can thus read the equation as follows:

AD = ƒ ( P ǀ Wealth, Real r, expect, P.exp, Y*, exch rate) “Aggregate demand is a function of the price level given constant wealth, real interest rate, expectations, expected future inflation, the growth rate of foreign GDP, and the exchange rate.” What does this mean? If the variables of wealth, the real interest rate, expectations, expected future inflation, the growth rate of foreign GDP and the exchange rate are held constant, the quantity demanded will vary inversely to changes in the price level. The constitutes a movement along the demand curve. Conversely, if you hold the aggregate price level constant, changes to any one of these parameters can shift the aggregate demand curve left or right. Parametric Shifts: We’ve already seen that the variables of C (consumer spending), I (investment spending), G (government spending) and NE (net exports) can shift the aggregate demand curve left or right. Now we have additional variables that can result in parametric shifts in the aggregate demand curve (AD) left or right: wealth, the real interest rate, expectations, expected future inflation, the growth rate of foreign GDP, and the exchange rate of the home currency. What happens when one of these parameters changes? Let’s add several columns to our Shift Parameters of Aggregate Demand table and then discuss it further.


Table 4. Goods Market - Shift Parameters of Aggregate Demand - Detailed

Name What it means What happens with an increase?5

Type of relationship

Wealth Wealth (such as physical capital/investment, stock market values, real estate values)

↑Wealth => ↑Qd at P1 (that is, AD shifts right) ↑AD

Positive

Real r The real interest rate (the inflation adjusted default risk-free interest rate of short term government debt)

↑Real r => ↓ C and ↓I => ↓Qd at P1 (AD shifts left) ↓AD

Negative (or inverse)

Expect Expectations, animal spirits (the business climate of expectations)

↑Expect => ↑Qd at P1 (AD shift right) ↑AD

Positive

P.exp Expected increase in future prices (expected future inflation)

↑P.exp => ↑Qd at P1 (AD shifts right) ↑AD

Positive

Y* Growth rate of foreign GDP by a trading partner

↑Y* =>↑ Net Exports => ↑Qd at P1 (AD shifts right) ↑AD

Positive

Exch rate Exchange rate (the strength of the home currency)

↑Exch rate (appreciation) => ↓Net Exports => ↓Qd at P1 (AD shifts left) ↓AD


Let’s look at each parameter a little more closely to explain the shorthand used in Table 4. Note that when you see ↑, read it as “an increase in” and when you see =>, read it as “leads to”. (When used in connection with AD, ↑ means AD shifts right, ↓ means AD shifts left.) Wealth. What happens when wealth increases? An increase in wealth leads to an increase in the quantity of goods demanded at price level 1 (which is being held constant.) The aggregate demand curve shifts right (↑AD). This is a positive relationship because both wealth and AD are moving in the same direction. Real r. What happens when the real interest rate increases? An increase in the real interest rate leads to a decrease in consumer spending and investment spending which leads to a decrease in the quantity of goods demanded at price level 1 (which is being held constant.) The aggregate demand curve shifts left (↓AD). This is a negative (or inverse) relationship because real r and AD are moving in opposite directions. One is increasing, and the other is decreasing. Expect. What happens when expectations increase? An improvement in economic outlook leads to an increase in the quantity of goods demanded at P1. The aggregate demand curve shifts right (↑AD). This is a positive relationship. 5 What happens with a decrease? With a decrease, the effect on AD would be the opposite. (The type of relationship, however, stays the same.)


P.exp. An expectation of future inflation leads to an increase in the quantity of goods demanded now at P1. The aggregate demand curve shifts right (↑AD). (This may seem counter-intuitive. It may help to think of it as people deciding to buy now before prices go higher.) This is a positive relationship. Y*. An increase in the growth rate of foreign GDP leads to an increase in exports in the home country (and therefore an increase in net exports) which leads to an increase in the quantity demanded at P1. (An increase in the growth rate of foreign GDP has an accelerator effect, inducing purchases of our exports to the foreign country.) The aggregate demand curve shifts right (↑AD). This is a positive relationship. Exch rate. An increase in the exchange rate of the home currency (appreciation) leads to a decrease in exports and an increase in imports (and decrease in net exports) which leads to a decrease in the quantity demanded at P1. This shifts the aggregate demand curve left (↓AD). This is a negative relationship. Aggregate Supply. A typical short-run aggregate supply curve6 looks like this: Figure 4. Goods Market – Aggregate Supply

Notice that we have the same vertical axis labelled P, which stands for the aggregate price level. We also have the same horizontal axis labeled Y (real output). We have labeled the point Yf

6 Throughout this discussion, the aggregate supply curve refers to the short-run aggregate supply curve.


where the end of the aggregate supply curve intersects with the horizontal axis. This marks the limits of potential GDP.7 Parameterization of Aggregate Supply.8 Let’s look at factors that shift aggregate supply. As with aggregate demand, in this discussion we also assume that price is held constant at aggregate price level P1. Figure 5. Goods Market – Parameterization of Aggregate Supply

☼To summarize the factors that shift Aggregate Supply, let’s examine the new equation that appears in Figure 5:

AS = ƒ ( P ǀ Factor Prices, P.exp, Supply Shocks, Resource Supply, Q/L, Instit Eff) What does each part of this equation mean? AS stands for aggregate supply. As we’ve seen above, the symbol ƒ means “a function of,” and P stands for aggregate price level. The symbol ǀ means “given”. The items that follow the given are the shift parameters of aggregate supply.

7 Potential GDP is what a country’s GDP would be if it were operating at full employment and using all its resources. Potential PDP is generally greater than real GDP, due to inefficiencies. Source: “What is Potential GDP?” http://www.wisegeek.com/what-is-potential-gdp.htm. (Retrieved 7/17/2014). 8 Discussion of the parameterization of aggregate supply is based on Joseph Ricciardi, Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, January 28, 2014.


Table 5. Goods Market - Shift Parameters of Aggregate Supply

Name What it means Factor Prices The prices of the factors of

production (labor, capital, energy). These include nominal wages, capital goods and energy input prices.

P.exp Expectation of future prices, expected future inflation

Supply Shocks Positive or negative supply shocks. For example, a commodities boom or recession.

Resource Supply Resource discovery or depletion. For example, more oil reserves are found, the population increases, or the potential labor force (labor endowment) increases

Q/L Q/L Productivity (output divided by labor input. For example, technological innovation would increase productivity.

Instit Eff Institutional Efficiencies We can thus read the equation as follows:

AS = ƒ ( P ǀ Factor Prices, P.exp, Supply Shocks, Resource Supply, Q/L, Instit Eff) “Aggregate supply is a positive function of the aggregate price level given constant factor prices, expected future inflation, supply shocks, resource supply, productivity and institutional efficiencies.” If the variables -- factor prices, expected future inflation, supply shocks, resource supply, productivity and institutional efficiencies -- are held constant, aggregate supply will vary positively with the aggregate price level. Conversely, if you hold the aggregate price level constant, any one of these variables can shift the aggregate supply curve left or right depending on how the variable changes. What happens when one of these variables changes? Let’s add several columns to our Shift Parameters of Aggregate Supply table and then discuss it further.


Table 6. Goods Market - Shift Parameters of Aggregate Supply - Detailed

Name What it means What happens with an increase?9

Type of relationship

Impacts Potential GDP?

Factor Prices

The prices of the factors of production (labor, capital, energy). These include nominal wages, capital goods and energy input prices.

↑Factor Prices =>↓AS (AS shifts left)


No

P.exp Expectation of future prices, expected future inflation

↑P.exp => ↓AS (AS shifts left) Idea is to hoard now and sell later at higher price.


No

Supply Shocks

Positive or negative supply shocks. For example, a commodities recession.

Positive supply shock => ↑AS (AS shifts right)

Positive No

Resource Supply

Resource discovery or depletion. For example, more oil reserves are found, the population increases, or the potential labor force (labor endowment) increases

↑Resource supply => ↑AS (AS shifts right)

Positive Yes

Q/L Q/L Productivity (output divided by labor input. For example, technological innovation would increase productivity.

↑Productivity => ↑AS (AS shifts right)

Positive Yes

Instit Eff Institutional Efficiencies ↑Insitutional efficiencies => ↑AS

Positive Yes

Let’s look at each parameter a little more closely to explain the shorthand used in Table 6. As before, note that when you see ↑, read it as “an increase in” and when you see =>, read it as “leads to”. (When used in connection with AS, ↑ means AS shifts right, ↓ means AS shifts left.) Factor Prices. What happens when factor prices increase? An increase in factor prices causes the aggregate supply curve to shift left (↓AS). For example, if nominal wages increase, it is more expensive to produce the same amount of output, so less is produced. This is a negative relationship. (Conversely, if factor prices go down, the aggregate supply curve shifts right.) Note the final column on Table 6. It is labelled “Impacts Potential GDP?” Changes in some factors impact Potential GDP. That is, they shift the Potential GDP curve either to the left or to the right -- in the manner of changes to the production possibilities frontier (PPF). Changes in

9 What happens with a decrease? With a decrease, the effect on AS would be the opposite. (The type of relationship stays the same.)


other factors do not impact Potential GDP. Changes in Factor Prices do not affect Potential GDP. P.exp. What happens when expectations of future inflation change? An increased expectation of future inflation leads to a left shift of the aggregate supply curve. (Suppliers hoard goods now in anticipation of being able to sell them later for higher prices. Overall, less goods are available for purchase now.) This is a negative relationship. Changes in expectations of future inflation do not affect Potential GDP. Supply Shocks. What happens when more supplies are available? A positive supply shock leads to a right shift of the aggregate supply curve. The aggregate supply curve shifts right. This is a positive relationship. It does not affect Potential GDP. Resource Discovery/Depletion. What happens when more resources are discovered? A discovery in resources leads to a right shift of the aggregate supply curve. This is a positive relationship. Changes in resource discovery or depletion do affect Potential GDP. A discovery in resources moves Potential GDP to the right. Q/L. What happens when productivity increases? An increase in productivity leads to a right shift of the aggregate supply curve. This is a positive relationship. Changes in productivity do affect Potential GDP. An increase in productivity moves Potential GDP to the right. Instit Eff. What happens when there is an increase in institutional efficiencies? An increase in institutional efficiency leads to a right shift of the aggregate supply curve. This is a positive relationship. Changes in institutional efficiency do affect Potential GDP. An increase in institutional efficiency moves Potential GDP to the right. AS-AD Together – The determination of equilibrium P and Y. To understand what is happening in the goods market, we examine the aggregate supply curve and the aggregate demand curve together. This section will look at short run adjustments to a negative demand shock, a positive demand shock, a negative supply shock and a positive supply shock using the 1-2-3 exposition10 of the logical dynamics at play, producing a new equilibrium in the goods market. We’ll examine each of these cases in detail, using graphs, a “shorthand” explanation, and a detailed written explanation. ☼In each case, we are looking for answers to two questions:

• What happens to P (the aggregate price level)? • What happens to Y (real GDP)?

10 The 1-2-3 exposition is based on Joseph Ricciardi, Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, Spring 2014.


NEGATIVE DEMAND SHOCK. Figure 6. Goods Market – AS-AD Together – Negative Demand Shock

Shorthand description of Negative Demand Shock Written description of Negative Demand Shock 1 AD = AS Initial Equilibrium P1, Y1 SHOCK – Reduction in Demand Qd is reduced from point 1 to point 2 ↓AD

1 Start at initial equilibrium. Aggregate demand equals aggregate supply at point P1, Y1. There is a negative demand shock which produces a reduction in demand. The quantity demanded is reduced from point 1 to point 2. At the current price level (P1) AD shifts left to AD’

2 AD < AS disequilibrium – prices fall Movement along AS from point 1 to point 3

(overall, producers have excess supply, unsold goods, distress sales, price goes down, reduction in output as prices fall)

Movement along AD’ from point 2 to point 3 (overall, consumers buy more as prices fall)

2 Aggregate demand is less than aggregate supply. This is a disequilibrium. Prices fall. Aggregate supply is affected as producers find themselves with excess supply and unsold goods. Producers hold distress sales. Prices go down. At the same time, there is a reduction in output by producers as prices fall. This is represented on the aggregate supply curve as movement along the aggregate supply curve from point 1 to point 3. At the same time, aggregate demand is affected as consumers buy more as prices fall. This is represented as movement along the AD’ curve from point 2 to point 3.

3 AD’ = AS New equilibrium at point 3 ↓P lower aggregate price level ↓Y lower real GDP (lower level of economic activity). End result is reduced prices and reduced output compared to the initial equilibrium

3 There is a new equilibrium at point 3. (AD’ equals AS.) The end result is reduced prices (↓P) and reduced output (↓Y) compared to the initial equilibrium.


POSITIVE DEMAND SHOCK. Figure 7. Goods Market – AS-AD Together – Positive Demand Shock

Shorthand description of Positive Demand Shock Written description of Positive Demand Shock 1 AD = AS Initial Equilibrium P1, Y1 SHOCK – Increase in Demand Qd is increased from point 1 to point 2 ↑AD at current price level P1.

1 Start at initial equilibrium. Aggregate demand equals aggregate supply at point P1, Y1. There is a positive demand shock which produces an increase in demand. The quantity demanded is increased from point 1 to point 2. The aggregate demand curve shifts right to AD’

2 AD > AS disequilibrium – prices increase Movement along AS from point 1 to point 3

(overall, producers have insufficient supply, not enough inventory, shortages, price goes up and production increases as prices increase)

Movement along AD’ from point 2 to point 3 (overall, consumers buy less as prices increase)

2 Aggregate demand is greater than aggregate supply. This is a disequilibrium. Prices increase. Aggregate supply is affected as producers find themselves with insufficient supply and inventory shortages. Price goes up. At the same time, there is an increase in output by producers as prices goes up. This is represented on the aggregate supply curve as movement along the aggregate supply curve from point 1 to point 3. At the same time, aggregate demand is affected as consumers buy less as prices increase. This is represented as movement along the AD’ curve from point 2 to point 3.

3 AD’ = AS New equilibrium at point 3 ↑P higher aggregate price level ↑Y higher real GDP (higher level of economic activity) End result is increase in prices and increase in output compared to initial equilibrium

3 There is a new equilibrium at point 3. (AD’ equals AS.) The end result is increased prices (↑P) and increased output (↑Y) compared to the initial equilibrium.


NEGATIVE SUPPLY SHOCK. Figure 8. Goods Market – AS-AD Together – Negative Supply Shock (Stagflation)

Shorthand description of Negative Supply Shock.

Written description of Negative Demand Shock.

1 AD = AS Initial Equilibrium P1, Y1 SHOCK – (Negative Supply Shock, Affects Potential Output. Example: natural disaster) Qs is reduced from point 1 to point 2 ↓AS at initial price level P1

1 Start at initial equilibrium. Aggregate demand equals aggregate supply at point P1, Y1. There is a negative supply shock which in this case produces a reduction in supply and reduces Potential GDP. (For example, a natural disaster destroys capital and land.) The quantity supplied is reduced from point 1 to point 2 at P1. The aggregate supply curve shifts left to AS’. (Potential GDP also shifts left from Yf to Yf’.)

2 AS < AD disequilibrium – prices rise Movement along AS’ from point 2 to point 3

(producers can’t produce more due to shortages, despite increase in prices)

Movement along AD from point 1 to point 3 (consumers buy less as price increases)

2 Aggregate supply is less than aggregate demand. This is a disequilibrium. Prices begin to rise. Producers produce a little more as prices rise but can’t produce as much as they would like due to shortages, despite increase in prices. This is represented as movement along AS’ from point 2 to point 3. At the same time, consumers buy less as the aggregate price level rises. This is represented as movement along the AD curve from point 1 to point 3.

3 AS’ = AD New equilibrium at point 3 (as well as new potential output) ↑P higher aggregate price level ↓Y lower real GDP (lower level of economic activity) End result is increased prices and reduced output (and lower Potential GDP) compared to initial equilibrium. STAGFLATION

3 There is a new equilibrium at point 3. (AS’ equals AD.) The end result is an increased aggregate price level (↑P) and reduced output (↓Y) compared to the starting point. (In this case, there is also a lower Potential GDP.) This is a condition known as STAGFLATION.


POSITIVE SUPPLY SHOCK. Figure 9. Goods Market – AS-AD Together – Positive Supply Shock

Shorthand description of Positive Supply Shock Written description of Positive Demand Shock 1 AD = AS Initial Equilibrium P1, Y1 SHOCK – (Positive Supply Shock. Example: discoveries of huge oil deposits) Qs is increased from point 1 to point 2 at P1 ↑AS

1 Start at initial equilibrium. Aggregate demand equals aggregate supply at point P1, Y1. There is a positive supply shock which in this case produces an increase in supply and increases Potential GDP. (For example, there are discoveries of hug oil depositions.) The quantity supplied increases from point 1 to point 2. The aggregate supply curve shifts right to AS’. (Potential GDP also shifts right from Yf to Yf’.)

2 AS > AD disequilibrium – prices fall Movement along AS’ from point 2 to point 3

(Producers produce more as supplies are more abundant. Excess supplies => distress sales. Downward pressure on prices.)

Movement along AD from point 1 to point 3 (consumers buy more as price goes down)

2 Aggregate supply is greater than aggregate demand. This is a disequilibrium. Prices begin to fall. Producers produce more as supplies are more abundant. Excess supplies lead to distress sales and downward pressure on the aggregate price level. This is represented as movement along AS’ from point 2 to point 3. At the same time, consumers buy more as prices fall. This is represented as movement along the AD curve from point 1 to point 3.

3 AS’ = AD New equilibrium at point 3 (as well as new potential output in this case) ↓P lower aggregate price level ↑Y higher output (higher level of economic activity) End result is decreased prices and increased output (and higher Potential GDP) compared to initial equilibrium.

3 There is a new equilibrium at point 3. (AS’ equals AD.) The end result is a lower aggregate price level (↓P) and higher output (↑Y) compared to the starting point. (In this case, there is also a higher Potential GDP.)


Some Notes Regarding the Shock Diagrams.11 MONEY MARKET Definition of Money. Throughout the handbook, when we refer to money or the money supply, we will be working with M1 (currency and checkable deposits). (See Krugman, chapter 14, “Money, Banking, and the Federal Reserve System,” especially p.412-416.)

M1 = C + D Where: C = currency D = checkable deposits M1 equals currency plus checkable deposits. T-Accounts of Banks. Review Krugman, p.418-419 regarding the t-accounts of banks. You should understand the difference between assets and liabilities and how the reserve ratio affects how much money banks can loan out. It’s crucial to understand this before moving to multiple deposit creation/destruction. Multiple Deposit Creation (Destruction). Banks create money by accepting deposits and making loans. (See Krugman, p.422-427.) Let’s look at multiple deposit creation in more depth. It will be helpful to understand this when we are looking at monetary policy later. Money is created through an iterative process of loan creation and deposit creation where money is deposited in the bank, some of that money is kept in reserve (depending on the required reserve ratio) and the balance is then loaned out (asset creation for the bank) and the loan proceeds are deposited in another bank, which keeps part of it in reserve and loans out the excess, etc.

11 Potential GDP. Note that demand shocks do not affect Potential GDP. Only supply shocks affect Potential GDP. First, determine whether a shock is a demand shock or a supply shock. If it is a demand shock, Potential GDP will not be affected. If it is a supply shock, determine whether or not it affects Potential GDP. (See Table 6.) For example, in the negative supply shock case in Figure 8 above, the negative supply shock was an example of resource depletion, and that is one of the aggregate supply factors that have an impact on Potential GDP. If the supply shock does not impact Potential GDP, the end point of the AS curve would stay the same. In a negative supply shock, Yf would be on the same point on the horizontal axis, and the AS curve would shift left but keep the same end point. You’d have a shallower curve with the same end point. (Conversely, in a positive supply shock that does not impact Potential GDP, the end point of the AS curve would stay the same, Yf would be on the same point on the horizontal axis, and the AS curve would shift right but keep the same end point. You’d have a steeper curve with the same end point.) Supply Shocks and the Ineffectiveness of Fiscal Policy. Remember that fiscal policy involves changes in G (government spending), T (taxes) or net deficit (G-T). Unlike aggregate demand, which can be influenced by fiscal policy, aggregate supply cannot. The government has a hard time responding to shifts in the aggregate supply curve. (See Krugman, p.362-364.)


Multiple Deposit Creation: Example with T-Accounts.12 Let’s first look at multiple deposit creation using t-accounts. Let’s assume you start with $10,000 and a reserve ratio of 20%. Person A deposits $10,000 in Bank A. Initially, Bank A’s Loans account is unchanged and its Reserves account increases $10,000. On the Liability side, checkable deposits rise by $10,000. At this point, the money supply is unchanged. (See Table 7.) Table 7 Bank A – after initial $10,000 Deposit

Assets Liabilities Loans unchanged Reserves with the Fed $10,000

Deposits $10,000

Next, Bank A holds 20% ($2000) of the deposit in reserve and loans out $8000. Loans in Bank A increase by $8000. Reserves in Bank A decrease by $8000 to $2000 in compliance with reserve requirements. Deposits are unchanged, remaining at $10,000. (See Table 8.) Table 8 Bank A – after bank makes loan of $8000

Assets Liabilities Loans +$8000 Reserves $10,000-$8000 = $2000

Deposits $10,000

At this point, Bank A is “loaned up” – there are no further excess reserves to lend. Bank B then receives the proceeds of the loan, $8000, as a deposit. Its t-account looks like this: Table 9 Bank B – after deposit of $8000

Assets Liabilities Loans unchanged Reserves $8000

Deposits $8000

The money supply has increased by $8000, the amount of the new deposit from the loan issued at Bank A.

12 Based on Joseph Ricciardi, “The Banking System and Its Regulation: The Money Supply Process,” Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, February 11, 2014.


With a 20% reserve ratio, Bank B needs to keep $1600 of the $8000 on reserve and has $6400 to loan out. After making this loan, Bank B’s t-account looks like this: Table 10 Bank B – after bank makes loan of $6400

Assets Liabilities Loans +$6400 Reserves $8000 - $6400 = $1600

Deposits $8000

Bank B has Loans of $6400 and Reserves of $1600. Deposits remain unchanged at $8,000. The proceeds of the loan will be deposited elsewhere, increasing money supply (by virtue of the newly created deposits) by an additional $6400. Assume the $6400 is deposited in Bank C. Bank C then has Assets-Reserves of $6400 and Liabilities-Deposits of $6400. Table 11 Bank C – after deposit of $6400

Assets Liabilities Loans unchanged Reserves $6400

Deposits $6400

Of the $6400 deposit, Bank C must keep 20% or $1280 in reserve. It loans out the balance of $5120. Its t-account then looks like this: Table 12 Bank C – after bank makes loan of $5120

Assets Liabilities Loans +$5120 Reserves $6400- $5120= $1280

Deposits $6400

Bank C has Loans of $5120 and Reserves of $1280. Deposits remain unchanged at $6,400. At this point, the money supply has increased by an additional $5120, the amount which was loaned by Bank C. This iterative process continues until the money available to be loaned is exhausted. To determine the maximum amount of deposits, use the multiplier, which is one divided by the reserve ratio, and multiply that by the amount of the initial deposit. In this case, you’d have


Change in Deposits = 1/rr * R = 1 / 0.2 * 10,000 = 50,000 $50,000 is the amount of deposits that would result from the initial $10,000 deposit. $10,000 of the $50,000 would be the initial deposit, and $40,000 would be new money creation. This is a helpful equation to ☼calculate the maximum change in deposits:

∆Deposits = 1/rr x ∆R where rr is the required reserve ratio and ∆R is the infusion of new reserves associated with the initial deposit. The stock of deposits supported by a new quantity of reserves, ∆R, equals the amount of new reserves, ∆R, multiplied by one divided by the required reserve ratio (the deposit multiplier). To ☼calculate the amount of newly created deposits, simply subtract the amount of initial reserves from the total stock of deposits:

Newly created Deposits = ∆Deposits - ∆R Multiple Deposit Creation: Example Using a Table.13 Here’s another way to look at Multiple Deposit Creation, using a table.

13 Based on Joseph Ricciardi, “The Banking System and Its Regulation: The Money Supply Process,” Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, February 11, 2014.


Table 13. Multiple Deposit Creation – The Banking System.

Bank

1 2 3 4 Acquired

Reserves and Deposits

Required Reserves (Reserve

Ratio = 0.2)

Excess Reserves

(1-2)

Amount Bank can

Lend; New Money

Created = 3 Bank A $100.00 $20.00 $80.00 $80.00 Bank B 80.00 16.00 64.00 64.00 Bank C 64.00 12.80 51.20 51.20 Bank D 51.20 10.24 40.96 40.96 Bank E 40.96 8.19 32.77 32.77 Bank F 32.77 6.55 26.21 26.21 Bank G 26.21 5.24 20.97 20.97 Bank H 20.97 4.19 16.78 16.78 Bank I 16.78 3.36 13.42 13.42 Bank J 13.42 2.68 10.74 10.74 Bank K 10.74 2.15 8.59 8.59 Bank L 8.59 1.72 6.87 6.87 Bank M 6.87 1.37 5.50 5.50 Bank N 5.50 1.10 4.40 4.40 Other Banks 21.99 4.40 17.59 17.59

$400.00

Here we see Bank A having an initial amount of acquired reserves and deposits in the amount of $100. In other words, Bank A receives a deposit of $100. We multiply the $100 in Column 1 times the required reserve ratio of 0.2 to get a required reserves amount of $20 in Column 2. We subtract Column 2 from Column 1 to get the Excess Reserves in the amount of $80 in Column 3. The amount the bank can lend (which is also the amount of new money created) is the same as the excess reserves. Bank A has $80 of Excess Reserves in Column 3 and Bank A therefore has $80 to lend in Column 4. Bank A lends this $80 to Bank B and the process continues down through all the Banks until a total amount of $400 of new deposits are created. Remember new deposits created equals the change in deposits (which equals one divided by the required reserve ratio times the initial deposit) minus the initial deposit. In this case, newly created deposits = (1/rr * R) – R = (1/.2*100) – 100 = 500-100 = 400. Multiple Deposit Creation (Destruction) – Notes. ☼*Note that in Multiple Deposit Creation, the excess reserve is what is available to lend out. Each bank creates new money up to the limit of its excess reserves.


☼Note that there are several pieces of information you need to be able to track money creation/destruction.

• the required reserve ratio (which is abbreviated as rr) • the amount of the initial reserves (which is abbreviated as R)

Also, remember that in order to have money creation, the reserve ratio must be less than 100%. This is known as fractional reserves. (If all the money had to be held in reserve, there would be no money to lend out.) Finally, note that check clearing involves no money creation (or destruction). Multiple Deposit Destruction. Multiple Deposit Destruction works in a similar fashion to multiple deposit creation, only in reverse. On the Liabilities side, money is withdrawn from deposits, and then on the Assets side money is subtracted from loans in an iterative process of deposit destruction. The Deposit Multiplier.14 We’ve noted the deposit multiplier above when we discussed money creation. Let’s summarize the highlights here for ease of reference. The deposit multiplier – simple model. In the simple model, the deposit multiplier equals one divided by the reserve ratio.

Deposit multipliersimple = 1/rr Where rr = the reserve ratio Money multiplier - in reality15. In reality, not all money is deposited in banks. Some is held as currency. Recall, the money supply, M1, is equal to the stock of currency plus deposits, M1 = C + D. The total stock of Money is determined not only by the stock of deposits. It includes currency in circulation. So, in reality, the textbook explains that the money multiplier equals the ratio of the money supply to the monetary base. (Remember, the monetary base is the bank reserves plus currency in circulation.)

Money multiplierreality = money supply/monetary base Money multiplier – in reality – accounting for “leakages”.16 Another way to calculate the money multiplier takes into account leakages from the multiple deposit creation process:

Money multiplierreality=

(!+ !)(!!+ !+ !)

14 This summary is based on Krugman, p.424-426. 15 See Krugman, p.424-426. 16 From Joseph Ricciardi, “The Banking System and Its Regulation: The Money Supply Process,” Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, March 4, 2014.


Where: k = public preference for currency e = bank preference for excess reserves rr = required reserve ratio The money multiplier will be smaller than the deposit multiplier (1/rr) because currency held by the public and excess reserves held by banks is not “relent,” reducing the total extent of deposit creation. Money, the Monetary Base and the Multiplier - Summary We saw above that the money supply, also called M1, equals currency plus deposits. (M1 = C + D). M1 also equals the Monetary Base times the Money Multiplier. Remember, the Monetary Base is Bank Reserves plus Currency in Circulation. (See ☼Krugman, p.425.) Monetary Base = R + C.

M1 = C + D = (R+C)*Multiplier17 Money Supply Curve18 Figure 10 below is a graph of the money market. The horizontal axis is the quantity of money. The vertical axis is r, the interest rate. MS is the Nominal Money Supply Curve, in this case drawn as a vertical orange line. MS crosses the horizontal axis at point M . Point M is the quantity of money which is chosen by the Federal Reserve (or a country’s central bank). MS is a vertical line because the quantity of money does not vary with changes in the interest rate. The Fed (or another country’s central bank) uses monetary policy to set the quantity of money supplied, regardless of the interest rate.

18 Description and graph of the money supply curve are From Joseph Ricciardi, “The Banking System and Its Regulation: The Money Supply Process,” Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, March 4, 2014.


Figure 10. Money Market – Money Supply Curve19

Tools of the Central Bank. ☼The three tools of the central bank are:

• Open market operations (open market purchase and open market sale) • Discount rate / interbank reserves rate, e.g. the federal funds rate. • Required reserve ratio

☼These tools are explained clearly in Krugman, p.428-430. When the central bank uses monetary policy, it is using one of these tools. The most widely used tool is open market operations. Let’s first look more closely at open market operations, and then we’ll discuss monetary policy and the uses of the three tools of the central bank more broadly. Open Market Operations by the Central Bank There are two types of open market operations: open market purchases and open market sales.. We’ll look first at an open market purchase to see how it increases the money supply. Then we’ll look at an open market sale to see how it decreases the money supply.

19 Based on Joseph Ricciardi, “The Banking System and Its Regulation: The Money Supply Process,” Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, March 4, 2014.


Table 14

An open market purchase20 of $100 million Treasury Bills Central Bank t-account

Assets Liabilities Treasury Bills + $100 million (a) Monetary Base =

Currency in circulation Bank Reserves +$100 million (d)

Commercial Banks t-account

Assets Liabilities Treasury Bills – $100 million (b) Reserves + $100 million (c) Loans

Deposits

What happens in an open market purchase of $100 million? The Central Bank (for the U.S., this is the Federal Reserve) purchases $100 million in U.S. Treasury bills from private commercial banks in an open market purchase. (a) The Central Bank Assets-Treasury Bills increases $100 million. (b) The Commercial Banks Assets-Treasury Bills decreases $100 million (c) The Commercial Banks Assets-Reserves increases $100 million (d) The Central Bank Liabilities-Bank Reserves (which is part of the monetary base) increases $100 million. (Basically, the Central Bank is purchasing Treasury Bills. The Central Bank is “paying for” the Treasury Bills by adding to the reserves of the commercial banks. It is done these days by a click of a mouse, so to speak, which increases the Reserves account at the commercial banks. See Krugman, p.430.) The increase in the monetary base will lead to an increase in the money supply via multiple deposit creation as banks lend out part of their new excess reserves.

20 From Krugman, p.430, Figure 14-8, “Open-Market Operations by the Federal Reserve” and Joseph Ricciardi, “The Banking System and Its Regulation: The Money Supply Process,” Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, March 4, 2014.


Table 15

An open market sale21 of $100 million Central Bank t-account

Assets Liabilities Treasury Bills – $100 million (a) Monetary Base =

Currency in circulation Bank Reserves – $100 million (d)

Commercial Banks t-account

Assets Liabilities Treasury Bills + $100 million (b) Reserves – $100 million (c) Loans

Deposits

What happens in an open market sale of $100 million? The Central Bank sells 100 million in U.S. Treasury bills from private commercial banks in an open market sale. (a) The Central Bank Assets-Treasury Bills decreases $100 million. (b) The Commercial Banks Assets-Treasury Bills increases $100 million (c) The Commercial Banks Assets-Reserves decreases $100 million (d) The Central Bank Liabilities-Bank Reserves (which is part of the monetary base) decreases $100 million This will lead to a decrease in the money supply via multiple deposit destruction as banks reduce their loans in response to a fall in their reserves. Monetary Policy. As we alluded to above, a nation’s central bank can take action that will lead to an increase or a decrease of the money supply in an effort to change interest rates (and affect overall spending). Monetary policy refers to these interventions by the Central Bank to alter the stock of liquidity and, thereby, the market rate of interest. Let’s look first at the central bank’s options to increase the money supply, then at the central’s options to decrease the money supply. We’ll then look at how money supply and money demand work together to affect the interest rate in the money market.

21 From Krugman, p.430, Figure 14-8 and Joseph Ricciard, “The Banking System and Its Regulation: The Money Supply Process,” Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, March 4, 2014.


Central bank options to increase the money supply. The central bank has three options to increase the nominal money supply.

• Open market purchase (a type of open market operation, described above). This is a routine operation of the central bank. Open market purchase => ↑reserves and ↑monetary base => ↑MS An open market purchase leads to an increase in reserves and an increase in the monetary base which leads to an increase in the money supply. (The money supply curve shifts right.)

• Reduction in the Discount Rate ↓Discount rate => ↑borrowing at the discount window => ↑borrowed reserves => ↑MS A reduction in the discount rate leads to an increase in borrowing at the discount window which leads to an increase in borrowed reserves which leads to an increase in the money supply. (The money supply curve shifts right.) This instrument, while used less frequently, is important for its “announcement effect,” signaling to markets the intended state of liquidity conditions targeted by the policy authorities. As a tool, there may be a lot of “slippage”; e.g. you could lower the discount rate and not have banks borrow if there is not sufficient loan demand. (In contrast, an open market purchase works very straightforwardly.)

• Decrease in the required reserve ratio ↓rr => ↑multiplier => ↑MS A decrease in the reserve ratio leads to an increase in the multiplier (because banks have to hold less reserves) which leads to an increase in the money supply. (The money supply curve shifts right.) This is typically used for an emergency or crisis.

Let’s look at a nominal money supply increase on the money market graph.


Figure 11. Money Market – Money Supply Increase

As a result of the action of the central bank (either an open market purchase, a reduction in the discount rate or a reduction in the required reserve ratio), the nominal money supply curve shifts right from MS to MS’. The quantity of money supplied increases from point 1 to point 2 at interest rate r1. (The quantity of money supplied will be the same regardless of the interest rate, which is why the money supply curve is a vertical line.) Central bank options to decrease the money supply. The central bank has three options to decrease the nominal money supply.

• Open market sale (a type of open market operation). This is a routine operation of the central bank. Open market sale => ↓reserves and ↓monetary base => ↓MS An open market sale leads to a decrease in reserves and a decrease in the monetary base which leads to a decrease in the money supply. (The money supply curve shifts left.)

• Increase in the Discount Rate ↑Discount rate => ↓borrowing at the discount window => ↓borrowed reserves => ↓MS An increase in the discount rate leads to a decrease in borrowing at the discount window which leads to a decrease in borrowed reserves which leads to a decrease in the money supply. (The money supply curve shifts left.) This is used infrequently.

• Increase in the required reserve ratio ↑rr => ↓multiplier => ↓MS


An increase in the reserve ratio leads to a decrease in the multiplier (because banks have to hold more reserves) which leads to a decrease in the money supply. (The money supply curve shifts left.) This is typically used for an emergency or crisis.

Let’s look at a nominal money supply decrease on the money market graph. Figure 12. Money Market – Money Supply Decrease

As a result of the action of the central bank (either an open market sale, an increase in the discount rate or an increase in the required reserve ratio), the nominal money supply curve shifts left from MS to MS’. The quantity of money supplied decreases from point 1 to point 2 at interest rate r1. Real Money Supply. In our analysis of the money market, we use the real money supply (M1/Aggregate price level) not just the nominal money supply (M1). ☼NOTE: THIS IS NOT IN KRUGMAN! ☼Real money supply = M1/Aggregate price level. Up to this point, we’ve been looking at cases where the central bank acts to make a change in the nominal money supply. There are other ways to shift the money supply curve left or right, without the central bank acting to change the money supply. ☼If the aggregate price level increases (↑P) and the nominal money supply stays the same, the real money supply curve shifts LEFT, due to the reduction in purchasing power of the nominal money stock. (Note: the increase in the denominator with no change in the numerator makes the resulting expression smaller.)


↑P => ↓MSreal Let’s repeat: ☼An increase in the aggregate price level (with no change to the nominal money supply) leads to a left shift of the money supply curve. ☼Conversely, if the aggregate price level decreases (↓P) and the nominal money supply stays the same, the money supply curve shifts RIGHT.

↓P => ↑MSreal

☼A decrease in the aggregate price level (with no change to the nominal money supply) leads to a right shift of the money supply curve. We’ll look at this more closely when we put the money supply curve and money demand curve together on the same graph. For now, just be aware that changes in the goods market (changes to the aggregate price level) can have spillover effects to the money market. Changes to the aggregate price level in the goods market can shift the money supply curve left or right without any action being taken by the central bank! Money Demand. Before we put the money supply curve (MS) and the money demand curve (MD) together, let’s look briefly at the money demand curve. We are using the liquidity preference approach. (The loanable funds approach is equivalent. See Krugman, p.281-287. Krugman discusses the liquidity preference approach on p.453-455.) According to Keynes, there are three motives for liquidity preference:22

• Transaction Motive: to bridge the gap between income receipts and payment commitments (people want to have money available to pay what they owe)

• Precautionary Motive: the desire for security as a future cash equivalent of total resources. (People want to have cash on hand for future emergencies.)

• Speculative Motive: the desire to secure a profit from knowing better than the market what the future will bring. (People want to have money on hand to speculate.)

In sum, the liquidity preference approach argues that, other things being equal, people prefer to be liquid, to have cash on hand. People must be compensated in order to give up money (currency or checkable deposits) for other safe, but less liquid assets, such as government bonds. This preference helps us understand how the interest rate is determined. If interest rates are too low, people will prefer cash, because it is not worthwhile to them to hold bonds. As interest rates rise, bonds become more desirable, because the reward for giving up cash and holding bonds is greater. Money demand is determined by the level of economic activity and the interest 22 Based on Joseph Ricciard, “The Banking System and Its Regulation: The Money Supply Process,” Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, March 4, 2014.


rate. The higher the level of economic activity, the higher the demand for money for transactions purposes. The higher the interest rate, the lower the demand for money.23 A typical money demand curve looks something like this: Figure 13. Money Market – Money Demand Curve

Equilibrium in the Money Market. According to the liquidity preference model of the interest rate, the interest rate is determined by the supply and demand for money.

23 From Joseph Ricciardi, “Money Demand,” Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, March 4, 2014. See also “Liquidity Preference,” Encyclopedia Brittanica. http://www.britannica.com/EBchecked/topic/343190/liquidity-preference (Retrieved 7/27/2014).


Figure 14. Money Market – Equilibrium in the Money Market24

If you are at point a Md < Ms Disequilibrium => buy bonds => ↑Pbonds => ↓r

If you are at point a in Figure 14, money demanded is less than the money supplied. This is a disequilibrium. Excess money balances leads to an increase in the buying of bonds, which leads to an increase in the price of bonds, which leads to a decrease in the interest rate. (↓r). (You move from point a on the money demand curve to point E (equilibrium).

If you are at point b Md > Ms Disequilibrium => sell bonds => ↓Pbonds → ↑r

If you are at point b in Figure 14, money demanded is greater than the money supplied. This is a disequilibrium. Illiquidity leads to the selling of bonds, which leads to a decrease in the price of bonds, which leads to an increase in the interest rate (↑r). (You move from point b on the money demand curve to point E (equilibrium).

24 Based on Krugman, “Figure 15-3, Equilibrium in the Money Market,” p.454 and Joseph Ricciardi, “Money Demand,” Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, February 11, 2014.


☼MS and MD Together – Effect of an Increase in the Money Supply on the Interest Rate. Let’s look at the money supply curve (MS) and the money demand curve (MD) together. We’ll first look at the effect of an increase in the money supply on the interest rate. (The shock which increases the money supply could be the central bank’s increasing open market purchases, lowering the discount rate, or lowering the reserve ratio.) Figure 15. Money Market – Effect of Increase in Money Supply on Interest Rate25

Shorthand description of INCREASE in Money Supply Written description of INCREASE in Money Supply 1 Ms = Md

Equilibrium at interest rate, r1 SHOCK – increase in the Ms at r1 ↑MS

1 Money supply equals money demand. There is equilibrium at point M1, r1 A SHOCK occurs which increases the money supply at interest rate 1 to point 2. The money supply curve shifts right.

2 Ms > Md Disequilibrium at r1 Excess liquidity Buy Bonds => ↑Pbonds => ↓r

2 Money supply is greater than money demand. This is a disequilibrium. There is excess liquidity. In the aggregate, people buy bonds. This leads to an increase in the price of bonds which leads to a decrease in the interest rate from point 2 to point 3.

25 Figure 15 is based on Krugman, Figure 15-4, “The Effect of an Increase in the Money Supply on the Interest Rate,” p.455.


3 Movement from point 1 to point 3 along the Md curve to new equilibrium at point 3

End result is larger stock of money at ↓r

3 As the opportunity cost of holding money comes down, the preference for liquidity increases. There is movement from point 1 to point 3 along the money demand curve to a new equilibrium at point 3.

The end result is a larger stock of money at a lower interest rate (↓r)

☼MS and MD Together – Effect of a Decrease in the Money Supply on the Interest Rate Next, we’ll look at the effect of a decrease in the money supply on the interest rate. (The shock which decreases the money supply could be the central bank’s increasing open market sales, increasing the discount rate, or increasing the reserve ratio, as we discussed above.) Figure 16. Money Market – Effect of Decrease in Money Supply on Interest Rate

Shorthand description of DECREASE in Money Supply

Written description of DECREASE in Money Supply

1 Ms = Md

Equilibrium at interest rate r1 SHOCK – decrease in the Ms at r1 ↓MS

1 Money supply equals money demand. There is equilibrium at point M1, r1 A SHOCK occurs which decreases the money supply at interest rate 1 to point 2. The money supply curve shifts left.


2 Ms < Md Disequilibrium at r1 Illiquidity Sell Bonds => ↓Pbonds => ↑r

2 Money supply is less than money demand. This is a disequilibrium. There is illiquidity. In the aggregate, people sell bonds. This leads to a decrease in the price of bonds which leads to an increase in the interest rate from point 2 to point 3.


End result is smaller stock of money at ↑r

3 As the opportunity cost of holding money increases, the preference for liquidity decreases. There is movement from point 1 to point 3 along the money demand curve to a new equilibrium at point 3.

The end result is a smaller stock of money at a higher interest rate (↑r)

The Bond Market, Portfolio adjustment & interest rate determination – a Closer Look. Let’s take a closer look at what is happening in bond markets when the money supply increases or decreases. Figure 17. Money Market – A Closer Look at Bonds

Let’s look more closely at each graph.


Figure 17A. Increase in money supply. What happens to bond prices when the money supply increases? Look at point 2 in Figure 15 (a few pages back). There is excess liquidity. In the aggregate, people buy bonds. As we can see in Figure 17A, an increase in bond demand causes the bond demand curve to shift right. There is a new equilibrium at the intersection of Pb2 (Pricebonds2) and Bd2 (Bonddemand2), which is a higher bond price than Pb1. An increase in the money supply leads to an increase in bond demand, which leads to an increase in the price of bonds. Figure 17B. Decrease in money supply. What happens to bond prices when the money supply decreases? Look at point 2 in Figure 16 (one page back). There is illiquidity. In the aggregate, people sell bonds. Figure 17B shows that an increase in the supply of bonds causes the bond supply curve to shift right. There is a new equilibrium at the intersection of Pb2 (Pricebonds2) and Bs2 (Bondsupply2), which is a lower bond price than Pb1. A decrease in the money supply leads to an increase in the supply of bonds (bond sales to get liquid), which leads to a decrease in the price of bonds. Effects of Expansionary and Contractionary Monetary Policy on Aggregate Demand. ☼Read Krugman, p.458-459. Figure 18. Effects of Expansionary and Contractionary Monetary Policy – Spillover Effects on the Goods Market


Expansionary Monetary Policy. Look at the expansionary monetary policy section of Figure 18. What happens when a country’s central bank, such as the Fed in the U.S., adopts an expansionary monetary policy? As we’ve already seen, an expansionary monetary policy increases the money supply which leads to a lower interest rate. The lower interest rate in the money market has spillover effects to the goods market. The lower interest rate then leads to higher investment spending and higher consumer spending. Remember that AD = C + I + G + NE. If I and C are increasing, so is AD. An increase in investment spending and consumer spending leads to an increase in aggregate demand. The aggregate demand curve shifts to the RIGHT. Contractionary Monetary Policy. Conversely, look at the contractionary monetary policy section in Figure 18. A contractionary monetary policy decreases the money supply which leads to a higher interest rate. The higher interest rate in the money market has spillover effects to the goods market. The higher interest rate leads to lower investment spending and lower consumer spending. We know that AD = C + I + G + NE. If I and C are decreasing, so is AD. A decrease in investment spending and consumer spending leads to a decrease in aggregate demand. The aggregate demand curve shifts to the LEFT. Effects of Aggregate Price Level on Money Supply. If a shock starts in the goods market, it has spillover effects to the money market. Increase in Aggregate Price Level. As we discussed above (p.30), we use the real money supply (the nominal money supply divided by the aggregate price level) in our analysis of the money market. If a shock occurs in the goods market which results in an increase in the aggregate price level (↑P) and the nominal money supply stays the same, the real money supply curve shifts LEFT. ↑P => ↓MSreal. The real money supply curve shifts left. Let’s look at a graph of this. (See Figure 19.)


Figure 19. Effects of Increase in Aggregate Price Level on Money Supply

An increase in the aggregate price level in the goods market leads to a decrease in the real money supply in the money market, which leads to an increase in the interest rate. Decrease in Aggregate Price Level. Conversely, if a shock occurs in the goods market which results in a decrease in the aggregate price level (↓P) and the nominal money supply stays the same, the real money supply curve shifts RIGHT. ↓P => ↑MSreal. The real money supply curve shifts right. Let’s look at a graph of this. (See Figure 20.)


Figure 20. Effects of Decrease in Aggregate Price Level on Money Supply

A decrease in the aggregate price level in the goods market leads to an increase in the real money supply in the money market, which leads to a decrease in the interest rate. FOREIGN EXCHANGE MARKET Let’s turn to the Foreign Exchange Market. ☼Read Krugman, Chapter 19, “Open-Economy Macroeconomics,” p.549-576. Back in Figure 1, we looked at the overview of the three sector macroeconomic model. The third sector is the foreign exchange market, where currencies are exchanged. When a national economy interacts with another national economy, it does so through the foreign exchange market. Before capital and goods can move from one national economy to another national economy, they pass through the foreign exchange market, where the currency is exchanged to settle tranactions. In our model, we only look at two currencies at a time in the foreign exchange market – domestic and foreign currencies.


Current Account Effect and Capital Account Effect. 26 Exchange rates are determined in response to the net effect of two forces at play in the foreign exchange market: the current account effect and the capital account effect. The Current Account Effect refers to pressure on exchange rates resulting from changes in a country’s net trade position. Changes in P (the aggregate price level) and Y (real GDP) in the goods market produce changes in the country’s net export position which, in turn, drives the net demand or supply for foreign exchange in the foreign exchange market. The Current Account of the Balance of Payments tracks the flow of funds associated with international trade. It is abbreviated CA. Table 16 summarizes how the goods market influences the current account effect. (It assumes a floating exchange rate and mobile capital.)

26 Explanation of the current account effect and capital account effect is from Joseph Ricciardi, “Reading Guidelines, Class 5,” Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, February 19, 2014.


Table 16. Current Account Effect (assumes floating exchange rate, mobile capital)

Info from Goods Market

Explanation What Happens to Domestic Currency Supply or Demand

What Happens to Net Exports?

Current Account (CA) Effect

↓P ↓Y

Lower P and lower Y lead to an increase in net exports, resulting in less domestic currency sales in search of foreign currency and net buying of domestic currency

Net orders to buy => ↑D (Orders to buy lead to increased demand)

Net exports increase

Positive current account effect

CA+ ↑P ↑Y

Higher P and higher Y lead to a deterioration in net exports, resulting in greater domestic currency sales in search of foreign currency to import cheaper foreign goods

Net orders to sell => ↑S (Orders to sell lead to increased supply)

Net exports decrease

Negative current account effect

CA- ↑P ↓Y (STAGFLATION)

Higher P leads to a deterioration in net exports. Reduced Y, however, improves net exports. The resulting impact on Fx market will depend on the relative strengths of the P and Y effects.

If P > Y Orders to sell => ↑S If P < Y Orders to buy => ↑D

Net exports Decrease Net exports Increase

Negative current account effect

CA-

Positive current account effect

CA+ ↓P ↑Y

Lower P leads to an improvement in net exports. Increased Y, however, decreases net exports. The resulting impact on Fx market will depend on the relative strengths of the P and Y effects.

If P > Y Orders to buy => ↑D If P < Y Orders to sell => ↑S

Net exports Increase Net exports Decrease

Positive current account effect CA+ Negative current account effect

CA- Capital Account Effect - refers to pressure on exchange rates resulting from changes in the magnitude and direction of a country’s capital flows. Changes in international interest rate differentials associated with changes in r (the real interest rate) in the domestic money market. The capital account deals with international capital flows. (Krugman uses the terminology financial account rather than capital account. See Krugman, p.552.) It is abbreviated KA. Table 17 summarizes how the money market influences the capital account effect. (It assumes a floating exchange rate, mobile capital markets, and that foreign interest rates are unchanged.)


Table 17. Capital Account Effect (assumes floating exchange rate, mobile capital)

Info from Money Market

Explanation What Happens to Domestic Currency Supply or Demand

Capital Account (KA) Effect

↓r Lower domestic interest rate => capital outflows => national currency sales to purchase higher yielding assets abroad. Sell domestic currency, buy foreign currency, buy higher yield foreign assets

Orders to sell => ↑S

(Orders to sell lead to increased

supply)

KA- ↑r Higher domestic interest rate =>

capital inflows => increased foreign currency purchases of domestic currency to purchase higher yielding domestic assets Sell foreign currency, buy domestic currency, buy higher yield domestic currency denominated assets

Orders to buy => ↑D

(Orders to buy lead to increased

demand)

KA+

☼Orders to Buy and Orders to Sell. Note that orders to buy domestic currency and orders to sell domestic currency, by convention and to be consistent, have the following effects: Orders to buy => ↑Demand (orders to buy domestic currency lead to an increase in demand) Orders to sell => ↑Supply (orders to sell domestic currency lead to an increase in supply) It is helpful to keep this in mind when graphing the current account and capital account effects on the supply and demand for domestic currency. ☼Is capital mobile? When considering the current account effect and the capital account effect, it is necessary to know whether capital is mobile or not. If there are no country risk factors or government controls that impede capital movement, you can assume capital is mobile. Typically, in the business press the magnitude of the current account (CA) or the capital account (KA) is not known with precision. Our goal is to understand in what direction they are moving and to determine how that affects the foreign exchange market. If you are in a scenario where capital is mobile, assume that the KA effect is larger and use the KA direction. When capital is mobile, the KA effect trumps. When capital is not mobile, the KA effect is blunted, and you should assume the CA effect is larger. ☼Be sure to state your assumption about whether capital is mobile or not clearly in your analysis. SCENARIO 1. In order to get a picture of what happens to the foreign exchange market, let’s look at a scenario, starting with a shock and following it through all three markets.


Shock: The central bank engages in expansionary monetary policy (for example, an open market purchase). Which market should we start with? This is a monetary shock, so we start in the money market. Assumptions: we are looking at the effects from the perspective of the United States. The exchange rate is floating and capital is mobile. For the foreign exchange market, we want to examine how the shock will affect the exchange of US dollars and Mexican pesos. Figure 21. Scenario 1 – Money Market (U.S.)


Shorthand description Written description 1 Ms = Md

Initial equilibrium at M1, r1 SHOCK – expansionary monetary policy (open market purchase) increase in the Ms at r1 ↑MS

1 Money supply equals money demand. There is an initial equilibrium at point M1, r1. A SHOCK occurs (expansionary monetary policy- e.g. open market purchase) which increases the money supply at interest rate 1 to point 2. The money supply curve shifts right. Note that we are using the real money supply. The aggregate price level, P1, stays the same. The nominal money supply changes from MS1 to MS2. The money supply curve shifts right.







Next, we move to the goods market.


Figure 22. Scenario 1 – Goods Market (U.S.)

Shorthand description Written description 1 AD = AS Initial Equilibrium P1, Y1 Spillover effects from expansionary monetary policy. ↓r => ↑I and ↑C => ↑AD Qd is increased from point 1 to point 2 ↑AD

1 Start at initial equilibrium. Aggregate demand equals aggregate supply at point P1, Y1. There are spillover effects from the expansionary monetary policy. The decrease in the interest rate leads to an increase in investment spending and an increase in consumer spending which leads to an increase in aggregate demand. The quantity demanded is increased from point 1 to point 2. The aggregate demand curve shifts right to AD’






3 AD’ = AS New equilibrium at point 3 ↑P higher aggregate price level ↑Y higher real GDP (higher level of economic activity) End result is increase in prices and increase in output compared to starting point

3 There is a new equilibrium at point 3. (AD’ equals AS.) The end result is increased prices (↑P) and increased output (↑Y) compared to the starting point.

Let’s turn now to the foreign exchange market. ☼Remember: Exchange rates move in response to the net effect of two forces: 1) the Current Account (CA) effect - changes in net exports resulting from changes in the aggregate price level (P) and real output (Y) 2) the Capital Account (KA) effect – changes in the direction of capital flows associated with changes in the interest rate (r).27 What is the information we are bringing into the foreign exchange market? What happened to P (aggregate price level) and Y (real output) in the goods market? What happened to r (real interest rate) in the money market? ↑P, ↑Y from the goods market ↓r from the money market Assumptions: floating exchange rate; capital is mobile

27 Joseph Ricciardi, “Reading Guidelines, Class 5,” Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, February 19, 2014.


Figure 23. Scenario 1 – Foreign Exchange Market

Before we get to the analysis, let’s first explain a little about the graph. Remember that in this scenario we are comparing U.S. dollars to Pesos, from the perspective of the U.S. Notice that the label on the horizontal axis is $/t, which is the flow of U.S. dollars over time. On the vertical axis, we have Peso/$, Pesos to U.S. dollars. We begin with the supply curve S and the demand curve D, which intersect at point 1, with exchange rate e1. For our analysis, we start by describing the current account (CA) effect and the capital account (KA) effect. Shorthand description

Written description

(Exchange rate is floating. (Capital is mobile.) Point 1 equilibrium S=D at exchange rate e1

(The exchange rate is floating.) (Capital is mobile.) We begin at equilibrium at point 1. Supply equals demand at exchange rate e1.


Trade/Current Account - Trade/Current Account - ↑PUS, ↑YUS => ↓XUS, ↑IMUS,=> ↓NE

CA- A current account deficit Sell U.S. dollars, buy pesos, buy cheaper Mexican goods Higher supply of dollars, lower exchange rate (Dollar will depreciate)

A higher aggregate price level and higher real output lead to a decrease in US exports and an increase in US imports which leads to a decrease in net exports. In the foreign exchange market, there is a net selling of dollars and buying of pesos in order to buy cheaper Mexican goods. The increased supply of US currency places downward pressure on the Peso/$ exchange rate. This is a negative current account effect (CA-) On Figure 23, notice that the supply curve has shifted from S to S1. The space between S and S1 is labeled the CA (current account) effect.

Finance/Investment (Capital Account) - Finance/Investment (Capital Account) - ↓r => capital account outflow Sell dollars, buy pesos, buy higher yield Mexican assets

KA- Supply of dollars increases (Dollar will depreciate)

A lower interest rate leads to a capital account outflow. In the aggregate, people sell dollars, buy pesos and buy higher yielding Mexican assets. The supply of dollars increases. The dollar will depreciate. On Figure 23, notice that the supply curve has shifted again, from S1 to S2. The space between S1 and S2 is labelled the KA (capital account) effect.

Foreign Exchange Market Results Foreign Exchange Market Results Point 3. New equilibrium at exchange rate e2. Lower exchange rate, higher supply of currency Dollar depreciates

Overall, the dollar will depreciate. If you look at figure 23, the exchange rate has dropped from exchange rate e1 to exchange rate e2 at point 3. There is a lower exchange rate with a higher supply of dollars. The dollar depreciates.


Balance of Payments CA- KA- OSB- OR+

Balance of Payments28 The current account effect is negative. The capital account effect is negative. (Official reserves are positive.) The Overall Settlement Balance (OSB) is negative.

For our analysis, we stop at this point, having examined the first-round effects of the initial shock in all three sectors. (There are second-round effects, but we will not examine them in this handbook.) ☼Remember: when determining the Current Account Effect and the Capital Account Effect and what will happen in the foreign exchange market, you need to know:

• Is the exchange rate fixed or floating? • Is capital mobile?

☼When writing out your scenarios, make sure you note your assumptions regarding whether the exchange rate is fixed or floating and whether capital is mobile or not. It is helpful to the person reading your analysis and will also serve as reminder to you as you proceed. Up to this point, we have assumed that that exchange rate was floating and capital was mobile. This is not always the case. Exchange Rates – Fixed or Floating. Remember that exchange rates can be either fixed or floating. According to Krugman: “A country has a fixed exchange rate when the government keeps the exchange rate against some other currency at or near a particular target…A country has a floating exchange rate when the government lets market forces determine the exchange rate.” (Krugman, p.569.) We have already looked at a scenario where we assumed that the exchange rate was floating. Let’s look at a FIXED exchange rate. When a country has a fixed exchange rate, the government acts to keep the exchange rate of its domestic currency versus some other currency at or near a particular target. It does this through the intervention of its central bank. Depending on what it is trying to do, the central bank will either buy or sell the foreign currency. 28 For discussion of Balance of Payments, see Krugman, p.550-555. The Overall Settlement Balance (OSB) summarizes whether there is a net offer or demand for domestic currency in the foreign exchange market. OR stands for Official Reserve transactions. The sum of the current account, capital account and official reserve transactions is always zero. (See also “Facts Behind the Figures,” The Economist, Sept 18, 2003 print edition, http://economist.com/printededition/PrinterFriendly.cfm?Story_ID=2050748) (Retrieved 2/22/2014).


Table 18. When the Central Bank Buys or Sells Foreign Currency

BUYING FOREIGN CURRENCY

SELLING FOREIGN CURRENCY If the central bank is buying foreign currency, it is an open market purchase => ↑MS This leads to an increase in the domestic money supply.

If the central bank is selling foreign currency, it is an open market sale => ↓MS This leads to a decrease in the domestic money supply.

Table 18 summarizes the effects of the central bank’s buying or selling of foreign currency. We will refer to this table as we walk through a scenario with a fixed exchange rate regime. SCENARIO 229. For this scenario, let’s assume the United States is in recession, so the federal government implements a fiscal stimulus. Let’s look at the effects of the stimulus on the U.S. goods market, the U.S. money market, and the exchange rate of the U.S. dollar relative to the euro. Let’s also assume that the U.S. has a fixed exchange rate with respect to the euro and that there are strict capital controls in the U.S. financial markets. ☼Ask yourself these questions:

• What is the nature of the shock? • What is the nature of the exchange rate regime? Is it fixed or flexible? • Is capital mobile?

What is the nature of the shock?

Expansionary fiscal policy, positive demand shock (start in goods market) What is the nature of the exchange rate regime? Is it fixed or flexible?

Fixed exchange rate Is capital mobile?

Capital is not mobile Let’s work through the scenario. We’ll pay particular attention to the effects of the fixed exchange rate and the assumption that capital is not mobile. Government stimulus means increased government spending (↑G), lower taxes (↓T), increased transfers (↑Transfers). (See Krugman, p.188, 378-380). This is a positive demand shock. Remember that AD = C+I+G+(X-Im). The aggregate demand curve shifts to the right.

29 Discussion of the U.S. fiscal stimulus scenario is based on Joseph Ricciardi, Managing at the Crossroads: Business, Government, and the International Economy: Course Materials and Class Presentation, Babson College, February 19, 2014


Figure 24. Scenario 2 – Goods Market (U.S.)

Shorthand description Written description 1 AD = AS Initial Equilibrium P1, Y1 SHOCK – Fiscal stimulus - ↑G, ↓T, ↑transfers – positive demand shock Increase in Demand Qd is increased from point 1 to point 2 ↑AD Aggregate demand curve shifts to the right

1 Start at initial equilibrium. Aggregate demand equals aggregate supply at point P1, Y1. There is a positive demand shock (fiscal stimulus) which produces an increase in demand. The quantity demanded is increased from point 1 to point 2. The aggregate demand curve shifts right to AD’






3 AD’ = AS New equilibrium at point 3 ↑P higher aggregate price level ↑Y higher real GDP (higher level of economic activity) End result is increase in prices and increase in output (and lower unemployment) compared to starting point

3 There is a new equilibrium at point 3. (AD’ equals AS.) The end result is increased prices (↑P) and increased output (↑Y) and lower unemployment compared to the starting point.

Next we move to the money market. In Figure 25, note that the central bank has not intervened in the money supply. The nominal money supply has not changed. However, the money supply curve is going to shift to the left due to the increase in the aggregate price level (↑P). In the money market, we look at the real money supply (MS/P). A larger number in the denominator of the fraction makes the number smaller. (See also Figure 19. For a graph of the change in bond prices, see Figure 17B.)


Figure 25. Scenario 2 – Money Market (U.S.)


Equilibrium at M1, r1 SHOCK – fiscal stimulus (↑G or ↓T) Note: assuming no action by central bank However ↑P in goods market Because P2>P1, ↑P => ↓MS (real money supply) decrease in the Ms at r1 ↓MS money supply curve shifts left

1 Money supply equals money demand. There is equilibrium at point M1, r1 A SHOCK occurs. It is a fiscal stimulus (such as an increase in government spending and or a decrease in taxes) which leads to an increase in the aggregate price level in the goods market. Because P2 (aggregate price level 2) is greater than P1 (aggregate price level 1), an increase in P leads to a decrease in the real money supply. The money supply at interest rate 1 moves from point 1 to point 2. The money supply curve shifts left.

2 Ms < Md Disequilibrium at r1 Illiquidity Sell Bonds => ↓Pbonds => ↑r

2 Money supply is less than money demand. This is a disequilibrium. There is illiquidity. In the aggregate, people sell bonds. This leads to a decrease in the price of bonds which leads to an increase in the interest rate from point 2 to point 3.



End result is smaller stock of money at ↑r

3 As the opportunity cost of holding money increases, the preference for liquidity decreases. There is movement from point 1 to point 3 along the money demand curve to a new equilibrium at point 3.

The end result is a smaller stock of money at a higher interest rate (↑r)

Next, we move to the foreign exchange market. Figure 26. Scenario 2 – Foreign Exchange Market)

Shorthand description

Written description

(Exchange rate is fixed) (Capital is not mobile.) Point 1 equilibrium S=D at exchange rate e1 SHOCK: Fiscal stimulus (↑G, ↓T) – expansionary fiscal policy with trade/current account and financial/capital account effects

(The exchange rate is fixed.) (Capital is not mobile.) We begin at equilibrium at point 1. Supply equals demand at exchange rate e1. There is a SHOCK – a fiscal stimulus (with an increase in government spending and/or a decrease in taxes). This is an expansionary fiscal policy with trade/current account and financial/capital account effects.


Trade/Current Account - Trade/Current Account - ↑PUS, ↑YUS => ↓XUS, ↑IMUS,=> ↓NE

CA- A current account deficit Sell U.S. dollars, buy euros, buy cheaper European goods (this is a supply effect) ↑supply of U.S. dollars

A higher aggregate price level and higher real output lead to a decrease in US exports and an increase in US imports which leads to a decrease in net exports. In the foreign exchange market, there is a net selling of dollars and buying of euros in order to buy cheaper European goods. There is a higher supply of US currency at a lower exchange rate. This is a negative current account effect (CA-) On Figure 26, notice that the supply curve has shifted from S to S1. The space between S and S1 is labeled the CA (current account) effect.

Finance/Investment (Capital Account) - Finance/Investment (Capital Account) - ↑r => capital inflows Buy U.S. dollars, sell euros, buy higher yield U.S. asset => ↑D for U.S. dollars Demand for U.S. dollars increases (this is a demand effect) Positive capital account effect

KA+ However, capital is not mobile so it blunts the KA effect – KA effect is small

A higher interest rate leads to capital inflows. In the aggregate, people buy U.S. dollars, sell euros and buy higher yielding U.S. assets. The demand for dollars increases. The dollar will appreciate. This is a positive capital account effect. However, capital is not mobile so it blunts the capital account effect. The capital account effect is small. On Figure 26, notice that the demand curve has shifted from D to D1. The shift is small because the capital account effect is blunted because capital is not mobile. The space between D and D1 is labelled the KA (capital account) effect.


Foreign Exchange Market Results Foreign Exchange Market Results Note: without intervention, from the combination of the CA effect and the small KA effect, the exchange rate would drop from e1 to a new equilibrium at point 3 (the intersection of D1 and S1), with an exchange rate of e2. This would be a depreciation of the U.S. dollar. However, the U.S. is operating under a fixed exchange rate policy with respect to the euro, so the U.S. Central Bank (the Fed) intervenes to keep the exchange rate fixed at or very close to exchange rate e1. (We’ll explain more about this in a moment.) End result is new equilibrium at exchange rate e1 at point 4. Exchange rate remains at or very close to exchange rate e1.

Note, without intervention, from the combination of the current account (CA) effect and the small capital account (KA) effect, the exchange rate would drop from exchange rate e1 to a new equilibrium at point 3 (the intersection of demand curve 1 and supply curve 1), with an exchange rate of e2. This would be a depreciation of the U.S. dollar. However, the U.S. is operating under a fixed exchange rate policy with respect to the euro, so the U.S. Central Bank (the Fed) intervenes to keep the exchange rate fixed at or very close to exchange rate e1. (We’ll explain more about this in a moment.) The end result is a new equilibrium at exchange rate e1 at point 4. The exchange rate remains at or very close to exchange rate e1.

Balance of Accounts CA- KA+ OR+ OSB-

Balance of Accounts The current account effect is negative. The capital account effect is positive. Capital is not mobile so the current account trumps the capital account. (Official reserves are positive.) The Overall Settlement Balance (OSV) is negative.

Central Bank Intervention.30 Let’s look at what the central bank (the Fed) does to intervene to keep the exchange rate fixed at e1. We already noticed that without the intervention of the central bank, the dollar would depreciate to e2. The Fed needs to prop up the value of the dollar. It does that by undertaking an open market sale.31 The central bank is going to sell euros to buy dollars. This increases the demand

30 Discussion of the intervention by the central bank is based on Joseph Ricciardi, Managing at the Crossroads: Business, Government, and the International Economy: Course Materials, Babson College, February 26, 2014. 31 As we saw in Table 18, if the central bank intervenes by selling foreign currency, it is an open market sale. If the central bank intervenes by buying foreign currency, it is an open market purchase.


for U.S. dollars and shifts the demand curve right to D2 and restores the exchange rate to e1 at point 4. An open market sale of foreign currency also reduces the domestic money supply in the money market. This shifts the money supply curve to the left. Let’s look at the t-accounts for the central bank intervention, then we’ll revisit the money market. Table 19. T-accounts for open market sale of foreign currency by the Fed.

U.S. FEDERAL RESERVE

Assets Liabilities Government Securities Direct Loans Gold & SDR OTHER ASSETS (fx €) – (a)

Monetary Base = Currency in circulation Bank Reserves – (d) Treasury Deposits Foreign Deposits $

U.S. BANKS

Assets Liabilities $ Reserves – (c) $ Deposits – (b) (a) The Fed’s buying of U.S. dollars is accomplished by a reduction in Federal Reserve Assets-Other Assets (fx €). The Fed is selling euros and buying dollars. (b) As the Fed buys U.S. dollars, sellers of dollars draw down on dollar deposits in U.S. banks. (c) This reduces the U.S Banks Assets - $ Reserves (d) and this reduces the Federal Reserve Liabilities – Bank Reserves, which leads to a reduction in the monetary base, which in turn leads to a reduction in the money supply, shifting the money supply curve left.32 Note: we consider the effects of the central bank’s intervention to keep the exchange rate fixed as first round effects. We need to revise our money market chart to reflect the effects of the intervention.

32 On the European side, the reduction in Fed liabilities is offset by an increase in euro liabilities to the European central bank, corresponding to increased European central bank holdings of U.S. dollar foreign currency reserves.


Figure 27. Scenario 2 – Money Market (U.S.) (Revised)

As we saw in Figure 25, without the central bank intervention, we would have been at interest rate r2 at point 3. Now, however, the central bank’s open market sale has led to a decrease in the nominal money supply. The money supply curve has shifted left to MS2/P2 (a smaller money supply MS2 over the same aggregate price level P2). The end result is an even higher interest rate, r3, at point 5. Central bank cannot fix both the exchange rate and the interest rate under a fixed exchange rate regime. When we first looked at the money market, we saw that the central bank could intervene in the money market to affect the monetary base, the money supply, and thus the interest rate. Under a fixed exchange rate, the central bank is working to keep the exchange rate at or near a particular exchange rate. The interest rate will rise or fall as a result. The central bank cannot fix both the exchange rate and the interest rate under a fixed exchange rate regime. Before we move on, let’s look at a few quick questions regarding scenario 2.


Table 20. Scenario 2 – Quick Questions

What is the short-term effect on:

Effect Description

U.S. real GDP ↑ U.S. real GDP increases

Government budget deficit ↑ As part of stimulus, government spending (G) increases and taxes (T) decrease

Money supply ↓ An increase in the aggregate price level in goods market leads to a decrease in the real money supply (while the nominal money supply remains unchanged). This negative effect is reinforced by the effects of the central bank’s intervention in the foreign exchange market, which shifts the money supply curve even further left

International value of the dollar

Unchanged With the fixed exchange rate and the central bank’s intervention, the international value of the dollar against the euro remains unchanged. (Without the intervention, the value of the dollar would depreciate.)

Interest rates ↑ Interest rates rise due to the increase in aggregate price level in the goods market and the effects of the central bank’s intervention in the foreign exchange market

Level of U.S. international euro reserves ↓ The level of U.S. international euro reserves

falls (the central bank sells euros and buys dollars)

Real investment spending ↓ Investment spending falls as a result of higher interest rates

Unemployment rate ↓ The unemployment rate falls. (In Figure 24, the distance between Y2 and Yf (potential GDP) is smaller than the distance between Y1 and Yf. The unemployment rate falls.)

Inflation ↑ Inflation (aggregate price level) increases


SCENARIO 333. Let’s suppose that Venezuela is suffering high unemployment and poor GNP growth. At the same time, Venezuela suffers from an enormous current account deficit that it financed through borrowing in the international capital markets. Assume the Venezuelan bolivar is freely fluctuating. Explain the effects of Venezuelan expansionary monetary policy. ☼Ask yourself these questions:



Expansionary monetary policy (start in money market) What is the nature of the exchange rate regime? Is it fixed or flexible?

Flexible/floating exchange rate Is capital mobile?

It is not directly stated. There are no country risk factors or government controls that impede capital movement, so we assume capital is mobile.

Figure 28. Scenario 3 – Money Market (Venezuela).

33 Discussion of the Venezuelan scenario draws heavily from Joseph Ricciardi, Managing at the Crossroads: Business, Government, and the International Economy: Course Materials and Class Presentation, Babson College, February 26, 2014.



Initial equilibrium at M1, r1 SHOCK – expansionary monetary policy (open market purchase) increase in the Ms at r1 ↑MS

1 Money supply equals money demand. There is an initial equilibrium at point M1, r1. A SHOCK occurs (expansionary monetary policy-open market purchase) which increases the money supply at interest rate 1 to point 2. The money supply curve shifts right. Note that we are using the real money supply. The price, P1, stays the same. The nominal money supply changes from MS1 to MS2. The money supply curve shifts right.







Next, we move to the goods market.


Figure 29. Scenario 3 – Goods Market (Venezuela)

Shorthand description Written description 1 AD = AS Initial Equilibrium P1, Y1 Spillover effects from monetary policy. ↓r => ↑I and ↑C => ↑AD Qd is increased from point 1 to point 2 ↑AD

1 Start at initial equilibrium. Aggregate demand equals aggregate supply at point P1, Y1. There are spillover effects from the expansionary monetary policy. The decrease in the interest rate leads to an increase in investment spending and an increase in consumer spending which leads to an increase in aggregate demand. The quantity demanded is increased from point 1 to point 2. The aggregate demand curve shifts right to AD’






3 AD’ = AS New equilibrium at point 3 ↑P higher aggregate price level ↑Y higher real GDP (higher level of economic activity) End result is increase in prices and increase in output compared to starting point

3 There is a new equilibrium at point 3. (AD’ equals AS.) The end result is increased prices (↑P) and increased output (↑Y) compared to the starting point.

Let’s turn now to the foreign exchange market. ↑P, ↑Y from the goods market ↓r from the money market Assumptions: floating exchange rate; capital is mobile



(Remember that in this scenario we are comparing Venezuelan bolivares to U.S. dollars, from the perspective of Venezuela. Notice that the label on the horizontal axis is Bs/t, which is the flow of bolivares over time. On the vertical axis, we have $/Bs, U.S. dollars to bolivares. We begin with the supply curve S and the demand curve D, which intersect at point 1, with exchange rate e1.) Shorthand description

Written description

(Exchange rate is floating. (Capital is mobile.) Point 1 equilibrium S=D at exchange rate e1

(The exchange rate is floating.) (Capital is mobile.) We begin at equilibrium at point 1. Supply equals demand at exchange rate e1.


Trade/Current Account - Trade/Current Account - ↑P, ↑Y => ↓X, ↑IM,=> ↓NE

CA- A current account deficit Sell bolivares, buy U.S. dollars, buy cheaper U.S. goods Higher supply of currency, lower exchange rate (bolivar will depreciate)

A higher aggregate price level and higher real output lead to a decrease in Venezuelan exports and an increase in Venezuelan imports which leads to a decrease in net exports. In the foreign exchange market, there is a net selling of bolivares and buying of U.S. dollars in order to buy cheaper U.S. goods. There is a higher supply of bolivares at a lower exchange rate. This is a negative current account effect (CA-) On Figure 30, notice that the supply curve has shifted from S to S1. The space between S and S1 is labeled the CA (current account) effect.

Finance/Investment (Capital Account) - Finance/Investment (Capital Account) - ↓r => capital account outflow Sell bolivares, buy U.S. dollars, buy higher yield U.S. assets

KA- Supply of bolivares increases (bolivar will depreciate)

A lower interest rate leads to a capital account outflow. In the aggregate, people sell bolivares, buy U.S. dollars and buy higher yielding U.S. assets. The supply of bolivares increases. The bolivar will depreciate. On Figure 30, notice that the supply curve has shifted again, from S1 to S2. The space between S1 and S2 is labelled the KA (capital account) effect.

Foreign Exchange Market Results Foreign Exchange Market Results Point 3. New equilibrium at exchange rate e2. Lower exchange rate, higher supply of currency Bolivar depreciates

Overall, the bolivar will depreciate. If you look at figure 30, the exchange rate has dropped from exchange rate e1 to exchange rate e2 at point 3. There is a lower exchange rate with a higher supply of bolivares. The bolivar depreciates.

Balance of Accounts CA- KA- OR+ OSB-

Balance of Accounts The current account effect is negative. The capital account effect is negative. (Official reserves are positive.) The Overall Settlement Balance (OSV) is negative.


Table 21. Scenario 3 – Quick Questions


Effect Description

Domestic interest rate ↓ Interest rate goes down

Domestic GDP ↑ Venezuelan real GDP increases

Gross private domestic investment ↑ ↓r => ↑I. The reduction in the interest rate

leads to an increase in domestic investment spending.

Unemployment rate ↓ The unemployment rate falls. (In Figure 29, the distance between Y2 and Yf (potential GDP) is smaller than the distance between Y1 and Yf. The unemployment rate falls.)

Inflation rate ↑ Aggregate price level increases

Current account balance - Current account (CA) balance is negative

Capital account balance - Capital account (KA) balance is negative

Office Reserves + In the Balance of Accounts, Official Reserves are positive.

Again, for our analysis, we stop at this point, having examined the first-round effects of the initial shock in all three sectors. (There are second-round effects, but we will not examine them in this handbook.) SCENARIO 4. Suppose the Russian central bank believes the Russian economy is growing too fast. The Russian central bank decides to increase their key interest rate from 5.5% to 7%. Explain the effects of this policy using the three sector macroeconomic model. (For the foreign exchange market, examine the exchange rate of the Russian ruble relative to the U.S. dollar.) ☼Ask yourself these questions:



Assume the key interest rate is the discount rate. Increasing the discount rate leads to a decrease in borrowing and a smaller nominal money supply. (↑ key interest rate => ↓borrowing, ↓MS). This is contractionary monetary policy. (Start in money market)

What is the nature of the exchange rate regime? Is it fixed or flexible? Flexible/floating exchange rate


Is capital mobile? It is not directly stated. There are no country risk factors or government controls that impede capital movement, so we assume capital is relatively mobile relative to the U.S.

SIMULATION34 Assume: Key interest rate is the discount rate. Contractionary monetary policy. ↑key interest rate=> ↓borrowing, ↓MS Figure 31. Scenario 4 - Money Market (Russia)

1 Ms = Md

Initial equilibrium at M1, r1 SHOCK – increase in key interest rate (discount rate) => ↓borrowing and ↓MS MS curve shifts left to MS2 2 Ms < Md. Disequilibrium at r1, Illiquid, sell bonds => ↓Pbonds => ↑r 3 As rate increases, demand decreases. Movement from point 1 to point 3 along the Md

curve to new equilibrium at point 3 End result is smaller stock of money at higher interest rate ↑r

34 We run this scenario as a simulation, using the shorthand description for our analysis and dropping the written description we had used up to this point to clarify the shorthand notation.


Figure 32. Scenario 4 – Goods Market (Russia)

1 Equilibrium AS = AD at P1,Y1

SHOCK – ↑discount rate (contractionary monetary policy) which leads to ↑r ↑r => ↓I, ↓C => ↓AD (negative demand shock) AD curve shifts left to AD’ 2 AD < AS disequilibrium, reduction in output as prices fall

Movement along AS curve from point 1 to point 3 Excess supply, unsold goods, distress sales, price goes down and producers produce less as price falls Movement along AD’ curve from point 2 to point 3 Consumers buy more as prices fall

3 new equilibrium AD’ = AS at point 3 ↓P lower aggregate price level ↓Y lower level of output (more unemployment)



1 equilibrium S = D at exchange rate e1 Trade/Current Account ↓P => ↑X, ↓Im, = ↑NE ↓Y CA+ Sell dollars, buy rubles, buy cheaper Russian goods ↑demand for rubles Capital Account ↑r => capital inflows, capital seeking higher yields Sell dollars, buy rubles, buy higher yielding ruble denominated assets KA+ ↑demand for rubles

Balance of Accounts CA+ KA+ OR- OSB+

Russian capital markets are relatively mobile with respect to U.S. dollar Both CA and KA ↑demand


3 End up at new equilibrium S = D at point 3, exchange rate e2 Higher exchange rate Ruble appreciates Table 22. Scenario 4 – Quick Questions


Effect Description

Domestic GDP ↓ Domestic GDP decreases

Interest rate ↑ Interest rate increases

Nominal money supply ↓ Nominal money supply decreases

Inflation ↓ Inflation decreases

Unemployment ↑ Unemployment increases

Value of ruble ↑ Value of ruble increases

Current Account + Current account effect is positive

Capital Account + Capital account effect is positive

SCENARIO 5. Suppose U.S. consumers cut down on spending because they anticipate an economic downturn. Explain the effects of this policy using the three sector macroeconomic model. (For the foreign exchange market, examine the exchange rate of the U.S. dollar relative to the euro.) ☼Ask yourself these questions:



Negative demand shock (expectations decrease). A decrease in expectations leads to lower AD. AD curve shifts left. Start in the goods market.

What is the nature of the exchange rate regime? Is it fixed or flexible? We assume a flexible/floating exchange rate

Is capital mobile? It is not directly stated. There are no country risk factors or government controls that impede capital movement, so we assume capital is relatively mobile.


SIMULATION. Negative demand shock from decrease in expectations. Assume floating exchange rate and capital mobility. Figure 34. Scenario 5 – Goods Market (U.S.)

1 Equilibrium AS = AD at P1,Y1

SHOCK – decrease in expectations. Negative demand shock. ↓expectations => ↓AD AD curve shifts left to AD’ 2 AD < AS disequilibrium, reduction in output as prices fall

Movement along AS curve from point 1 to point 3 Excess supply, unsold goods, distress sales, price goes down and producers produce less as price falls Movement along AD’ curve from point 2 to point 3 Consumers buy more as prices fall

3 new equilibrium AD’ = AS at point 3 ↓P lower aggregate price level ↓Y lower level of output (more unemployment)


Figure 35. Scenario 5 – Money Market (U.S.)

1 Ms = Md

Initial equilibrium at M1, r1 SHOCK – decrease in expectations => ↓AD => ↓P Lower aggregate price level => higher real money supply (with no action by the central bank) P2 < P1, real money supply MS1/P2 > MS1/P1 increase in the Ms at r1 ↑MS 2 Ms > Md Disequilibrium at r1 Excess liquidity, Buy Bonds => ↑Pbonds => ↓r 3 Movement from point 1 to point 3 along the Md curve to new equilibrium at point 3 End result is larger stock of money at ↓r



1 equilibrium S = D at exchange rate e1 Trade/Current Account ↓P => ↑X, ↓Im, = ↑NE ↓Y CA+ Sell euros, buy U.S. dollars, buy cheaper U.S. goods; ↑demand for U.S. dollars Capital Account ↓r => capital account outflow Sell U.S. dollars, buy euros, buy higher yield euro-denominated assets KA- ↑supply of U.S. dollars U.S. capital markets are relatively mobile with respect to the euro CA effect increases demand for U.S. dollars. KA effect increases supply of U.S. dollars. Capital is mobile so KA effect trumps the CA effect.

Balance of Accounts CA+ KA- OR+ OSB-


4 End up at new equilibrium S = D at point 4, exchange rate e2 Lower exchange rate Dollar depreciates SCENARIO 6 (Intervention to shore up foreign currency)35. For our final scenario, let’s assume that the United States has a fixed exchange rate relative to the pound, at $1.5/£. Let’s assume events have led to a depreciation of the pound, and the Fed decides to intervene to shore up the pound. This is a complicated scenario. Let’s start by looking at what the Fed needs to do to shore up the pound. Figure 37. Scenario 6 – Foreign Exchange Market (Fed intervention to shore up £)

Exchange rate e1 is below the fixed exchange rate of $1.5/£. The Fed intervenes with an open market purchase of pounds, shifting the demand curve from D to D1 which leads to an increase in the exchange from e1 to $1.5/£.

35 Discussion of the Fed intervention to shore up the pound is based on Joseph Ricciardi, Managing at the Crossroads: Business, Government, and the International Economy: Course Materials and Class Presentation, Babson College, February 26, 2014.


This will have spillover effects to the U.S. money market. ☼Remember, when the central bank buys foreign currency, it is an open market purchase. This leads to an increase in the domestic money supply. Let’s look at the t-accounts to understand this further. Table 23. Scenario 6 – Fed Intervention to Shore Up the £ - T-Accounts (U.S.) U.S. FEDERAL RESERVE

Assets Liabilities Government Securities Direct Loans Gold & SDR OTHER ASSETS (fx £) + (a)

Monetary Base = Currency in circulation Bank Reserves + (d) Treasury Deposits Foreign Deposits $

U.S. BANKS

Assets Liabilities $ Reserves + (c) $ Deposits + (b) (a) The Fed makes dollar payments to sellers of pounds. The U.S. Federal Reserve Assets-Other Assets (fx £) account increases. (b) The folks in England who sold the pounds now have dollars to deposit in U.S. banks. U.S. Banks Liabilities-$ Deposits increases. (c) This increases the U.S. Bank Assets-$ Reserves (d) and increases the U.S. Federal Reserve Liabilities-Bank Reserves, which is part of the monetary base. The increase in the monetary base leads to an increase in the money supply via the money multiplier. Interestingly, the Fed’s intervention has a different effect on the United Kingdom. Table 24. Scenario 6 – Fed Intervention to Shore Up the £ - T-Accounts (U.K.) BANK OF ENGLAND

Assets Liabilities Government Securities Direct Loans Gold & SDR OTHER ASSETS (fx $)

Monetary Base = Currency in circulation Bank Reserves - (c) Treasury Deposits Foreign Deposits £ + (d)


U.K. BANKS

Assets Liabilities £ Reserves - (b) £ Deposits - (a) (a) Sellers of pounds reduce deposits in UK banks. U.K. Banks Liabilities-£ Deposits decreases. (b) This decreases the U.K. Bank Assets-£ Reserves. (c) and decreases the Bank of England Liabilities-Bank Reserves, which is part of the monetary base. The decrease in the monetary base leads to a decrease in the money supply via the money multiplier. (d) The reduction in Bank of England Liabilities-Bank Reserves is offset by an increase in the Bank of England Liabilities-Foreign Deposits £. (These are pound liabilities of the Bank of England owned by the Fed. This account corresponds to the increase in the Fed’s Assets-Other Assets fx £.) Note that this increase is not in the monetary base for the Bank of England. Let’s work through the rest of the scenario from the U.S. perspective to see the spillover effects of the Fed’s intervention in the foreign exchange market. We discussed above that the Fed’s intervention was an open market purchase. (The Fed was purchasing foreign currency, in this case, pounds.) As we learned earlier, an open market purchase is expansionary monetary policy which creates an increase in the money supply. Figure 38. Scenario 6 – Money Market (U.S.)


1 Ms = Md

Initial equilibrium at M1, r1 SHOCK – expansionary monetary policy (open market purchase) increase in the Ms at r1 ↑MS 2 Ms > Md Disequilibrium at r1 Excess liquidity, Buy Bonds => ↑Pbonds => ↓r 3 Movement from point 1 to point 3 along the Md curve to new equilibrium at point 3 End result is larger stock of money at ↓r Remember, we learned from the textbook (see Krugman, p.458-459) that expansionary monetary policy leads to a lower interest rate in the money market and an increase in aggregate demand in the goods market. Figure 39. Scenario 6 – Goods Market (U.S.)

1 AD = AS Initial Equilibrium P1, Y1 Spillover effects from expansionary monetary policy. ↓r => ↑I and ↑C => ↑AD Qd is increased from point 1 to point 2 ↑AD




Movement along AD’ from point 2 to point 3 (overall, consumers buy less as prices increase) 3 AD’ = AS New equilibrium at point 3 ↑P higher aggregate price level ↑Y higher real GDP (higher level of economic activity) End result is increase in prices and increase in output compared to starting point In this scenario, the short-term effects of the Fed’s intervention in the foreign exchange rate of the pound are a decrease in the interest rate and an increase in the aggregate price level and real output. Sterilization. Let’s suppose that the U.S. is already facing increasing inflation, and the Fed does not wish to increase U.S. inflation by its intervention in the foreign exchange market. If the Fed wished to neutralize the effects of its foreign exchange market intervention, it could undertake sterilization. For example, the Fed could perform an open market sale to offset the consequences of its foreign exchange market intervention. CONCLUSION. ☼When facing a scenario

• remember to ask yourself these questions: o What is the nature of the shock? o What is the nature of the exchange rate regime? Is it fixed or flexible? o Is capital mobile?

• State your assumptions clearly • Follow the effects from market to market

With practice, analyzing scenarios gets easier. There are a limited number of possible shocks and possibilities for exchange rate regimes and capital mobility. The more practice you have, the easier the analysis will be.


Appendix 1 List of Scenarios

Scenario # Description Country Starts on

Handbook Page Scenario 1 Monetary Shock

Expansionary monetary policy Open market purchase Floating exchange rate (Peso to U.S. dollar) Capital is mobile

U.S. 44

Scenario 2 Fiscal Stimulus Positive demand shock Fixed Exchange Rate (Euro to U.S. dollar Capital is not mobile T-Accounts of the Fed and U.S. Banks

U.S. 51

Scenario 3 Monetary Shock Expansionary monetary policy Floating exchange rate (U.S. dollar to bolivar) Capital is mobile

Venezuela 61

Scenario 4 Monetary Shock Contractionary monetary policy Floating exchange rate (U.S. dollar to ruble) Capital is mobile

Russia 67

Scenario 5 Negative Demand Shock Floating exchange rate (Euro to U.S. dollar) Capital is mobile

U.S. 71

Scenario 6 Central bank intervention in foreign exchange market Open market purchase (Expansionary monetary policy) Capital is mobile T-Accounts of the Fed and U.S. Banks as well as the Bank of England and U.K. Banks

U.S. (also includes partial examination from UK perspective)

75


INDEX aggregate demand, 4-5, parameterization of (shift parameters of), 6-9 aggregate price level, 6

effects of an increase of aggregate price level on real money supply, 30-31, 38-39 effects of a decrease of aggregate price level on real money supply, 31, 39-40

aggregate supply, 9-13, parameterization of (shift parameters of) 9-13 balance of accounts

scenario 1, 49 scenario 2, 57 scenario 3, 66 scenario 4, 70 scenario 5, 74

bonds, 36-37 scenario 1, 45 scenario 2, 54 scenario 3, 62 scenario 4, 68 scenario 5, 73 scenario 6, 77

capital account effect, 43 capital mobility, 43-44 current account effect, 41-42 demand shock

negative, 14, 71-72 positive 15, 51-53

exchange rate effect of increase on aggregate demand, 8, 9 move in response to the net effects of the current account and capital account, 41-43, 47 floating, 50 fixed 50-51 central bank cannot fix both the exchange rate and the interest rate at the same time, 59

expectations (animal spirits) effect of increase on aggregate demand, 8, 9 effects of decrease, 71-72

factor prices, effect of increase on aggregate supply, 11-13 fiscal policy, 2, expansionary 51-57 foreign exchange market, overview, 3, 41-44

scenario 1, 47-51 current account effect, 41-42 capital account effect, 43 orders to buy and orders to sell domestic currency, 43 capital mobility, 43-44 orders to buy foreign currency (open market purchase), 50 orders to sell foreign currency (open market sale), 50 scenario 2, 55-57


central bank intervention due to fixed exchange rate, 57-59 central bank cannot fix both the exchange rate and the interest rate at the same time, 59 scenario 3, 65-66 scenario 4, 70-71 scenario 5, 74 scenario 6, 75-77 central bank intervention to shore up foreign currency, 75-77

foreign GDP, effect of increase in growth rate on aggregate demand, 8, 9 future inflation

effect of expectation of increase on aggregate demand, 8, 9 effect of increase in expectations on aggregate supply, 11-13

goods market, 3, 4-18 scenario 1, 46-47 scenario 2, 51-53 scenario 3, 63-64 scenario 4, 69 scenario 5, 71-72 scenario 6, 78-79

institutional efficiencies, effect of increase on aggregate supply, 11-13 liquidity preference, 2, 31-32 macroeconomic variables, 2-3

exogenous, 2 endogenous, 3

monetary policy, 2, 27-31 tools of the central bank, 25-31 options to increase the nominal money supply, 27-29 options to decrease the nominal money supply, 29-30 real money supply, 30-31 effects of an increase of aggregate price level on real money supply, 30-31, 38-39 effects of a decrease of aggregate price level on real money supply, 31, 39-40 expansionary 37-38, 44-45, 46-47, 61-62, 77-78 contractionary 37-38, 67-68 open market operations by the central bank, 25-30 open market purchase, 26 open market sale, 27 orders to buy foreign currency (open market purchase), 50 orders to sell foreign currency (open market sale), 50 central bank cannot fix both the exchange rate and the interest rate at the same time, 59

money demand, 31-32 money market, 18-40

equilibrium in, 32-33 scenario 1, 41-45 scenario 2, 53-59 scenario 3, 61-62 scenario 4, 67-68


scenario 5, 73 scenario 6, 77-78

money multiplier, 23-24 simple, 23 in reality, 23-24

money supply curve, 24-30 effect of increase in money supply on the interest rate, 34-35 effect of decrease in money supply on the interest rate, 35-36

money, definition of, 18 multiple deposit creation/destruction, 18-23

example with t-accounts, 19-21 example with table, 21-22

multiple deposit destruction, 23 open market operations by the central bank, 25-30

open market purchase, 26 open market sale, 27 orders to buy foreign currency (open market purchase), 50 orders to sell foreign currency (open market sale), 50 example of the Fed’s open market purchase of pounds, 75-76, 77-78 effects of the Fed’s intervention to shore up the pound on the Bank of England and banks in the U.K., 76-77

potential GDP, 18 productivity, effect of increase on aggregate supply, 11-13 real interest rate, 7, 24-25

effect of increase on aggregate demand, 8 effect of increase in money supply on the interest rate, 34-35, 38-39 effect of decrease in money supply on the interest rate, 35-36, 39-40 expansionary monetary supply, 37-38, 44-45, 46-47 contractionary monetary policy, 37-38 central bank cannot fix both the exchange rate and the interest rate at the same time, 59

resource supply, effect of increase on aggregate supply, 11-13 sterilization, 79 supply shock

negative, 16 positive, 17 and ineffectiveness of fiscal policy, 18

supply shocks, effect of increase on aggregate supply, 11-13 t-accounts, 18

example of multiple deposit creation, 19-21 for open market sale of foreign currency, 58 for the Fed’s intervention to shore up the pound, 75-76 for the impact on the Bank of England from the Fed’s intervention to shore up the pound, 76-77

three sector macroeconomic model, 3-4 wealth, effect of increase on aggregate demand, 8

Documents

Cronin Three Sector Macro HandbookVer2faculty.babson.edu/ricciardi/pages/mmssu6/MMS...2 This is explained in detail in Krugman, p.202-206. 3 Discussion of the overview of the three