Macroeconomic Graphic Art
Macroeconomic Graphic Art
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This website contains selected illustrations of macroeconomics graphic art accompanied by descriptive matter. Instructors and students are welcome to use the illustrations and descriptive matter as they wish. Corrections and suggestions are welcome.
2. Income and Expenditure Dynamics
3. Leakages and Injections
4. Exports and Imports
5. Government Expenditures and Taxes
6. Equilibrium Real Output
7. Money Demand and Supply
8. Money Market Dynamics
9. Investment Demand
10. IS-LM Analysis
11. Aggregate Demand and Supply
12. AD-AS Dynamics
You may click on the symbol <> at the end of any chapter to return to the CONTENTS.
Figure 4-1 portrays a so-called "Keynesian cross" diagram which relates aggregate expenditures to real aggregate income or output.
The aggregate expenditure (AE) schedule is plotted on a set of coordinate axes with expenditures (E) on the vertical axis, and real aggregate income or output (Y) on the horizontal axis.
The AE schedule overlies a 45-degree reference line in panel (a) which serves as an equilibrium condition path, E=Y. The economy represented in the model can be in equilibrium between income/output (Y) and expenditures on output (E) only where the AE schedule crosses the E=Y path. The equilibrium income/output level, Y1, can be found by dropping a vertical line from the intersection of the curves to the horizontal axis.
The types of expenditures which can be represented in the vertical dimension include consumption (C), private sector investment (I), government purchases (G), and the net of exports less imports (X-M). This net is the economy's trade balance. It is in surplus if X exceeds M, or in deficit if M exceeds X. Aggregate expenditure is thus the sum of these expenditures, or
(1) AE = C + I + G + (X - M).
The shape of the AE schedule is dominated by the shape of the consumption function:
(2) C = f ( Y | P, r, . . . ).
Implicitly, the agggregate expenditures function can also be specified as
(3) AE = f ( Y | P, r, . . . )
The non-income determinants of consumption, including the price level (P), the real interest rate (r), and any other relevant determinants, are assumed to be constant in order to plot the path of the consumption function in two dimensions (E and Y). The consumption function slopes upward at an angle less than 1.0 (ratio of "rise" to "run") and has a vertical axis intercept above the origin. A linear equation for the consumption function would appear as
(4) C = c0 + c1Y
where c0 is the expenditure axis intercept and c1 is the slope of the consumption function. This slope, called by John Maynard Keynes the marginal propensity to consume or MPC, is positive and slightly greater than 0.9 in time-series data for the United States. Cross sectional studies using household data typically estimate MPC values in the 0.4 to 0.6 range.
The locus of the AE schedule is the vertical summation of the consumption function plus I, G, and (X-M) expenditures. The AE schedule might diverge from the C function because a progressive income tax takes larger proportions of increasing incomes, because import spending tends to increase with income, or because private sector investment spending varies with the income level. The total of such expenditures is understood to be the rate of spending per time period, conventionally the year.
Logic suggests that the consumption function may not be perfectly linear. Since for most people as incomes rise it becomes progressively more difficult to expend additions to income on consumer goods, the aggregate consumption function is likely to have some, however slight, downward concavity as illustrated in Figure 4-2.
A second order (or quadratic) form of such a consumption function would take the form
(5) C = c0 + c1Y + c2Y2
where c1 is positive and has a value less than one, and c2 is negative and has a value only slightly greater than zero. The MPC or slope of this function changes as income changes. Its value at any level of output is its first derivative, c1 + 2c2Y, evaluated at that output level.
Any income/output rate greater than Y1, such as Y2 in Figure 4-3, is a disequilibrium that results in an excess of output relative to aggregate spending.
Such a disequilibrium manifests itself as an accumulation of inventories by business firms in the amount from J to K. Managements of firms in an over-expanded macroeconomy should not be surprised to find their inventories building up. Data about increasing inventories serve as an indicator that the economy has overexpanded relative to demand conditions.
Because inventory accumulation in excess of desired levels is costly to firms, managements might consider efforts to stimulate sales by cutting prices (reducing list prices, offering discounts off list, or running sales). If firm managements cannot or are not willing to reduce prices, they may have to reduce their rates of production by cutting back on the usage of material inputs and the employment of labor. As more and more firms respond to the inventory pile-ups by cutting back on output rates and employment, the economy's output rate will adjust toward the equilibrium level again.
How such a situation of inventory accumulation come about? The dotted line AE2 (parallel to AE1 and above it) in Figure 4-3 illustrates a former locus of the aggregate expenditure curve which passed through point J. Y2 was the equilbrium rate of output when aggregate expenditure was at AE2. A decrease of aggregate expenditure from AE2 to AE1 created the disequilibrium characterized by the J to K amount of inventory accumulation. As a general rue, any shift of AE creates a disequilibrium situation and calls into operation inventory adjustment processes. AE shifts when there is a change of any of its components, C, I, G, or (X - M). The consumption function shifts when autonomous consumption, c0, changes, or it may change attitude if the values of parameters c1 or c2 change.
Another important managerial implication follows from any income/output level less than Y1, such as Y3 in Figure 4-4.
Such a disequilibrium results in an excess of spending relative to output, manifested by inventory depletion of amount from L to M. Firms experiencing falling inventories and rising order backlogs should increase production rates by employing more labor and increasing materials usage.
How might the economy have gotten to output rate Y3 with
inventory depletion in the amount of L to M? The dotted line AE3 in Figure 4-4 illustrates a former level of aggregate expenditure. Y3 was the equilibrium rate of output when aggregate expenditure was at AE3. An increase of aggregate expenditure from AE3 to AE1 created the L to M inventory depletion condition and called into operation the inventory adjustment process. An increase of any of the components of AE would have caused it to increase.
Panel (a) of Figure 4-5, import spending (M), taxes paid (T), and saving after taxes (S) constitute leakages from the income stream.
The schedule labeled S + T + M in panel (b) of Figure 4-5 represents the total of the leakages of income during the period. The shape of the total leakage schedule is dominated by the shape of the saving function which can be derived from the C function with taxes applied. A linear form of the saving function would take the form
(6) S = -c0 + (1 - c1)Y.
Keynes referred to the saving function slope, (1 - c1), as the marginal propensity to save, or the MPS. The value of the MPS is positive and is the complement to the MPC in the sense that consumers can use disposable income for only two purposes, spending for consumption or saving, and these two possibilities exhaust the disposable income. This relationship leads to the following three identities,
(7) MPC + MPS = 1,
(8) MPC = 1 - MPS,
and
(9) MPS = 1 - MPC.
These identities confirm that the MPS and the MPC are complements. The saving function has a positive slope, both because the level of saving varies directly with the level of income, and because a progressive income tax system takes successively larger proportions of increasing incomes.
Offsetting the leakages from the income stream are injections in the form of private sector investment (I), government purchases (G), and purchases of exports (X) by foreigners. The total of such injections during the period is represented by the schedule labeled I + G + X. The total injections schedule is represented as a horizontal line because no one of the injection components is thought to be functionally related to the level of income to any significant degree.
The intersection of the leakage schedule with the injections schedule occurs at the equilibrium rate of output, and corresponds to the output level at which the AE schedule intersects the E=Y path in panel (b). Income/output levels above (to the right of) Y1 result in excesses of leakages over injections by the same amount as the corresponding inventory accumulations identified in panel (b). Income levels below (to the left of) Y1 produce excesses of injections over leakages in the same amount as the corresponding inventory depletions identified in panel (b).
If the consumption schedule in panel (a) of Figure 4-1 were to shift upward because the value of c0 increased, the saving schedule in panel (b) of Figure 4-1 would shift downward by the same amount, thereby decreasing the amount saved at all income levels. If the consumption schedule were to shift downward, the saving schedule would shift upward by the same amount. The aggregate expenditure schedule would shift in the same direction and by the same amount as the shift in the consumption schedule.
A nation's export spending corresponds to imports by foreigners of the nation's goods and services. While export spending is certainly a function of foreign incomes, it is not determined by the nation's domestic income. Hence, the amount of export spending at any time can be taken to be autonomous of domestic income and represented as a horizontal line at the current level of exports. The equation for the export function is
(2) X = x0
where the parameter x0, the vertical axis intercept, is a constant determined outside of the economy (i.e., in other economies).
Spending by citizens of the nation on foreign goods and services is a direct function of the nation's domestic income, other things remaining the same for domestic and foreign rates of inflation (%DP), exchange rates (Exg), and other possible determinants, i.e.,
(3) M = f(Y | %DP, Exg, ... ).
The import function takes the linear form
(4) M = m0 + m1Y,
or the quadratic form
(5) M = m0 + m1Y + m2Y2.
The linear form is illustrated in panel (a) of Figure 5-1.
Parameter m0, the vertical axis intercept, may be positive because cheap or inferior foreign made goods can serve consumption needs when incomes are low or have fallen. Parameter m1, the slope of the import function, may be positive though small (under 0.2) for nations not highly dependent on trade. It may be substantially larger for nations which are more highly dependent on trade. The value of parameter m2, often not greatly different from zero, may take a positive or negative sign depending upon attitudes of the population with respect to imports. In the linear form of the import function, slope parameter m1 may be interpreted as the society's "marginal propensity to import."
The export and import functions for a nation like the United States may appear something like those in panel (a) of Figure 5-1. The nation's trade is "in balance" at income level Y1. It is in deficit (X < M), for all income levels greater than Y1, and in surplus (X > M) at any level of income lower than Y1. The trade balance itself may be computed as the difference beteen exports and imports,
(6) (X - M) = (x0 - m0) - m1Y,
and depicted as the single function in panel (b) of Figure 5-1. The vertical axis intercept in equation (6) is (x0 - m0). The (X - M) schedule shifts in the same direction as the X schedule and the opposite direction as the M schdule in panel (a). For example, if imports increase at all income levels (i.e., the M schedule shifts upward), the trade balance will deteriorate and (X - M) will shift downward. If the trade balance was in surplus before the increase of M, the surplus will diminish or become a deficit. If it was already in deficit, the deficit will become larger. The opposite direction changes occur for a decrease of imports.
The M schedule shifts in response to changes of non-income determinants of imports such as relative rates of inflation or exchange rates. An increase of the domestic inflation rate relative to foreign inflation rates makes foreign goods appear more attractive. This causes the import schedule to shift upward by increasing the value of m0. Opposite direction import schedule shifts follow upon a decrease of the domestic inflation rate relative to foreign inflation rates. A depreciation of the domestic currency (i.e., appreciation of foreign currencies) makes foreign made goods appear more expensive and causes imports to decrease. This shifts the import schedule downward by decreasing the value of m0. The opposite-dirction shifts occur if the domestic currency appreciates relative to foreign currencies (or they depreciate relative to the domestic currency).
Government expenditures (G) are considered by macroeconomists to be at the discretion of political decision makers or programmed by the political process, and thus are not amenable to behavioral modeling. The equation of the government expenditures function is
(7) G = g0,
where g0 is a constant determined by the political process. It may increase or decrease as a matter of political determination
The total leakage schedule, S + T + M in Figure 4-5 is dominated by the shape of the saving schedule, S, which is derived from the consumption function. But the saving schedule is also affected by the characteristics of the tax system.
To a single tax payer in the United States, the Internal Revenue Service's tax system would appear as a stair-step function as illustrated in panel (a) in Figure 5-2, with steps corresponding to tax brackets. The system illustrated has five income brackets which may be identified as
bracket 1, any income from 0 to ya,
bracket 2, any income above ya to yb,
bracket 3, any income above yb to yc,
bracket 4, any income above yc to yd,
bracket 5, any income above yd.
The tax rate applicable to the highest bracket reached by the income of a person is described as his or her "marginal tax rate." For example, if a person receives y1 income during a certain year, his or her income reaches bracket 4.
When the tax liabilities for all tax payers are plotted together against income, the "steps" smooth out to approximate a continuous function. The corresponding aggregate tax function may take any of several possible shapes, depending upon how the brackets and applicable rates are structured. A tax rate system may be described as proportional if the same tax rate applies to all tax payers and all income "brackets" irrespective of their income levels. A mathematical function describing such a tax system would take the linear form,
(8) T = t0 + t1Y.
The intercept parameter t0 may be positive, zero, or negative. Slope parameter t1 is positive and is the universally applicable tax rate. It may be interpreted as the society's "marginal propensity to pay taxes" or the government's "marginal propensity to tax." If t0 is zero and t1 is positive as illustrated in panel (b) of Figure 5-2, the tax rate system would approximate a so-called flat tax which has been advocated by Steve Forbes in his various runs for the U.S. presidency. A positive value for t0 would require a minimum tax be paid by all citizens, even those whose incomes are low or zero. Some flat tax proponents have advocated exempting an initial bracket of income. This would require that parameter t0 be negative but that no tax be collected (or paid) on ncomes for which the tax function is below the horizontal axis. A non-zero t0 (positive or negative) would render the constant rate tax "non-flat" since average tax rates would no longer be equal to marginal tax rates.
A negative value for t0 accompanied by a positive value for t1 as illustrated in panel (c) of Figure 5-2 would function as a so-called negative income tax as has been advocated by economist Milton Friedman. Under such a system, lower-income citizens would receive "tax" payments from the government (the negative taxes), rather than pay taxes to the government. Low-income citizens would "break into" the tax paying realm once their incomes rose to exceed the horizontal axis intercept of the tax function. A variant of this system would have the tax function to start from its horizontal axis intercept by exempting an initial bracket of income, and then apply taxes to all incomes greater than the initial exempted bracket.
Most real-world tax rate systems are progressive in the sense that tax rates increase as incomes increase. The mathematical form of such an aggregate tax function must be a second order equation,
(9) T = t0 + t1Y + t2Y2.
In a progressive tax rate system, parameters t1 and t2 are positive but parameter t0 may be negative, zero, or positive. Since t2 is positive, the tax rate function increases at an increasing rate as represented by tax functions T1 and T2 in panel (d) of Figure 5-2. The parameter t0 of tax function T1 is zero, so it intersects the origin.
Panel (e) of Figure 5-2 depicts a regressive tax rate system in which t1 is positive but t2 is negative. Intercept parameter t0 may be positive, zero (as illustrated), or negative. Governments of Western nations usually attempt to avoid structuring their tax systems as regressive, but parts of a nation's tax system may in fact turn out to be regressive. Sales and value-added taxes often turns out to be regressive because these taxes are applicable only to expenditures, not to the tax payer's entire income. Because ever higher-income tax payers tend to expend ever smaller portions of their incomes, sales and value-added taxes as a proportion of income turn out to be a declining rate, and thus are regressive. This may also be true of excise taxes and some property taxes.
In a progressive tax rate system such as the example illustrated in panel (d) of Figure 5-2, the marginal rate (the slope of the tax function) is always higher than the average rate (the computed tax liability divided by the income). In a proportional or flat tax rate system, the marginal rate is equal to the average rate for any income. In a regressive tax rate system, the marginal rate is lower than the average rate for any income.
A purely hypothetical construct called a "lump-sum" tax often is used for simplicity in illustrating the impact upon the consumption and saving schedules of implementing a tax or changing tax rates. Such a tax would take a specified amount of tax revenue (the "lump sum") from the economy irrespective of the economy's income level. In such a tax system, parameter t0 is positive and parameter t1 is zero so that the tax function is linear and horizontal as illustrated in panel (f) of Figure 5-2.
Panel (a) of Figure 5-3 illustrates a progressive income tax rate function with an initial exempted income bracket similar to tax rate function T2 in Panel (d) of Figure 5-2. Superimposed over this tax rate function is the government expenditure function as a horizontal line at expenditure level g0. Panel (b) of Figure 5-3 illustrates the government budget function, (T - G), as the difference between the tax rate function and the expenditure function
(10) (T - G) = (t0 - g0) + t1Y + t2Y2.
The vertical axis intercept in equation (10) is (t0 - g0). In this illustration, any aggregate income level lower than Y2 yields a government budget deficit, i.e., T < G. The government's budget is "in balance" at income level Y2. The government's budget is in surplus at any aggregate income level greater than Y2. And since the tax rate system is progressive, the budget surplus grows at an accelerating rate as aggregate income increases above income level Y2.
All of the leakages and injections together determine the equilibrium rate of real output. Panel (a) of Figure 4-4 depicts the summation of three types of injections, all autonomous of income, i.e., drawn as horizontal lines. The equation of the "total injections" schedule is
(11) I + G + X = i0 + g0 + x0.
Several simplifying assumptions underlie the leakage schedules. One is that the consumption and saving functions are linear with equations
(12) C = c0 + c1Y
and
(13) S = -c0 + (1 - c1)Y.
Two other simplifying assumptions are that a lump-sum tax of t0 is imposed by government and imports are a constant level m0 which is unaffected by income. In the following illustrations, the MPC (c1) is about 0.6 so that the MPS (1 - c1) is approximately 0.4.
Any tax must be paid at the expense of both consumption spending and saving, but the effects upon the two are asymmetrical. Consumption decreases (shifts downward) by the MPC proportion of the tax. Panel (c) of Figure 5-4 illustrates that the imposition of the tax also shifts the saving schedule downward and parallel to itself by the MPS proportion of the tax. The equation of the "taxed saving schedule" is
(14) St = -c0 - (1 - c1)t0 + (1 - c1)Y,
(14') St = (-c0 - t0 + c1t0) + (1 - c1)Y.
The vertical axist intercept in equation (14') is (-c0 - t0 + c1t0). In this and subsequent illustrations, the locus of the pre-tax saving schedule is represented by a dashed line.
In Panel (d) of Figure 5-4, the whole amount of the lump-sum tax is added to the taxed saving schedule. The equation becomes
(15) St + T = -c0 - (1 - c1)t0 + t0 + (1 - c1)Y,
(15') St + T = (-c0 + c1t0) + (1 - c1)Y.
The vertical axis intercept in equation (15') is (-c0 + c1t0). In panel (e) of Figure 5-4, the constant amount of imports, m0, is added to the St + T schedule. The equation of the "total leakage schedule" is
(16) St + T + M = -c0 - (1 - c1)t0 + t0 + m0 + (1 - c1)Y,
(16') St + T + M = (-c0 + c1t0 + m0) + (1 - c1)Y.
The vertical axis intercept in equation (16') is (-c0 + c1t0 + m0).
Finally, panel (f) of Figure 5-4 brings together the injections schedules from panel (a) and the leakages schedules from panel (e) to demonstrate that at output rate Y1 the leakage total is just equal to the injections total. At any rate of output lower than (to the left of) Y1, injections into the income stream exceed leakages from it, causing the output rate to increase. At any rate of output greater than (to the right of) Y1, leakages exceed injections, causing the output rate to decrease.
If the equations of the total leakage and total injections equations are known or can be estimated from available empirical data, it should be possible to treat the two equations as a set for simultaneous solution of the equilibrium value of Y1.
Careful inspection of panel (f) of Figure 5-4 reveals that there are several other schedule intersections at output rate Y1. The investment schedule I intersects the after-tax saving schedule St at output rate Y1. This means that there is no saving deficit or surplus relative to investment spending. The I + G schedule intersects the St + T schedule at Y1. Since, St = I, this implies that the government's budget is also in balance, i.e., (T - G) = 0. And, since the St + T + M schedule also intersects the I + G + X schedule when St = I and T = G, this implies that trade is also in balance, i.e., (X - M) = 0. The happy coincidence of these three balances is purely for illustrative purposes, and is not likely to occur in any real world market-organized economy.
Panel (f) of Figure 5-4 is constituted as panel (b) of Figure 5-5. Above it in panel (a) are the corresponding consumption and aggregate expenditure schedules. The pre-tax consumption schedule is represented by the dashed line with equation (12) above.
The MPC proportion of the tax, c1, is paid at the expense of consumption spending, so the equation of the "taxed consumption function" becomes
(17) Ct = (c0 - c1t0) + c1Y.
which has vertical axis intercept (c0 - c1t0). Ct lies below the C schedule by the MPC proportion of the tax, c1t0. To the taxed consumption schedule is added investment spending I, government purchases G, and net exports (X - M). Since (X - M) = 0, Panel (a) does not show a separate amount added for (X - M). The equation of the aggregate expenditures schedule is thus
(18) AE = Ct + I + G + (X - M) = (c0 - c1t0 + g0 + x0) + c1Y,
in which the vertical axis intercept is (c0 - c1t0 + g0 + x0) and the slope is c1.
The AE schedule intersects the E=Y line at output rate Y1. At any output rate greater than Y1, aggregate expenditure is less than output, inventories accumulate, and business decision makers can be expected to cut back on production rates by decreasing the usage of inputs until again the rate of output matches aggregate expenditures on them.
At any output rate less than Y1, aggregate expenditure is greater than the amount of output being produced, inventories are depleting, and business decision makers can be expected to increase rates of output by increasing the usage of inputs until again the rate of output matches aggregate expenditure on them.
These relationships lead to the conclusion that Y1 is the equilibrium rate of output, both because aggregate expenditure matches output in Graph (a), and because total injections are just equal to total leakages in Graph (b). Any output rate other than Y1 is a non-equilibrium output rate, a condition which sets in motion forces of adjustment in the form of inventory accumulation or depletion. The adjustment process continues until the equivalence of the output rate to the aggregate expenditure is restored.
In Figure 5-6, two of the simplifying assumptions are dropped. The tax which is imposed on this economy is no longer a lump-sum tax, but rather is a proportional or flat-tax tax with equation
(19) T = t1Y.
The "marginal propensity to pay tax," t1, is around 20 percent in the following illustration. This tax function is similar to that illustrated in panel (b) of Figure 3-2.
The import schedule is no longer a constant amount. Rather, it is an increasing function of income as illustrated in Figure 5-1. The import function equation is
(20) M = m1Y.
The "marginal propensity to import," m1, is around 15 percent in this illustration. We may observe that the after-tax saving schedule St retains its vertical axis intercept coincident with that of the pre-tax saving schedule, but the slope of St has become shallower by the MPS proportion of the tax. The equation of the after-tax saving schedule is
(21) St = -c0 + (1 - c1)Y - (1 - c1)t1Y,
(21') St = -c0 + (1 - c1 + c1t1)Y.
In equation (21'), the vertical axis intercept is -c0 and the slope is (1 - c1 + c1t1). To the St schedule is added the full amount of the flat tax to constitute schedule
(22) St + T = -c0 + (1 - c1)Y - (1 - c1)t1Y + t1Y,
(22') St + T = -c0 + (1 - c1 + c1t1 + t1)Y.
In equation (22'), the slope remains unchanged from that in equation (21'), but the slope increases to (1 - c1 + c1t1 + t1). To this schedule is added the import schedule to constitute the total leakage schedule
(23) St + T + M = -c0 + (1 - c1)Y - (1 - c1)t1Y + t1Y + m1Y,
(23') St + T + M = -c0 + (1 - c1 + c1t1 + t1 + m1)Y.
The vertical axis intercept of the total leakage schedule remains c1, but the slope has increased to (1 - c1 + c1t1 + t1 + m1). The total leakage schedule is upward sloping for three reasons: saving, the tax rate system, and imports are all direct functions of income.
Careful examination of panel (b) of Figure 5-6 reveals that at the Y1 output rate, after tax saving is greater than investment, so that there is a saving surplus, (St - I) > 0. But government expenditures exceed tax revenues so that the government's budget is in deficit, i.e., (T - G) < 0. It is also true that at output level Y1, imports exceed exports so that trade is in deficit, i.e., (X - M) < 0. But since the sum of the leakages is just equal to the sum of the injections at Y1, the government's budget deficit is being financed by a combination of the saving surplus and the trade deficit, i.e., (T - G) = (St - I) + (M - X).
Panel (a) of Figure 5-6 shows that the after-tax consumption schedule Ct has rotated downward from the pre-tax consumption schedule by the MPC proportion of the tax. To Ct is added the investment schedule I, and to Ct + I is added government purchases G to locate the schedule Ct + I + G. Since trade is in deficit, i.e., (X - M) < 0, the deficit is subtracted from Ct + I + G so that AE lies below Ct + I + G. The equilibrium level of output Y1 lies at the intersection of Ct + I + G + (X - M) with E = Y.
Figure 5-7 differs from 5-6 in that the tax rate system is progressive as illustrated in panel (e) of Figure 5-2. Even if the pre-tax consumption function is linear, the taxed consumption function, Ct in panel (a) of Figure 5-7, is curved downward by the progressivity of the tax rate system. The greater the progressivity of the tax rate system, the more downward curved will be Ct and the aggregate expenditure schedule after the government purchases and export spending schedules are added to Ct. The progressive tax also has the effect of curving the taxed saving function, St in Graph (b) of Figure 5-7, as well as the total leakage schedule after taxes and imports are added to St All conclusions derived from Figure 5-6 in regard to equilibrium and non-equilibrium outputs apply to the scenario depicted in Figure 5-7.
Two further conclusions may be deduced from the progressive tax scenario. Once the government's budget reaches surplus, the surplus will increase at an increasing rate. For output rates greater than Y1, the wedge between the AE schedule and the E=Y line widens at an increasing rate, and thus become ever more difficult to "fill up" with additional injection spending as income continues to increase with on-going growth.
Although economists no longer hold in high esteem Keynes' tripartite specification of motives for holding money balances (transactions, precautionary, and speculative), the modern theory of the demand for money does identify three important determinants, the real income level, the real interest rate, and the price level. We start with a real money demand function,
(1) Md/P = f(Y,r,...),
where Md is the demand for nominal money balances. Y is the same real aggregate income or output rate in the aggregate expenditures graphs, and r is the real interest rate. Panel (d) of Figure 6-1 illustrates the relationship between Md/P and Y, assuming a given rate of interest and all other possible determinants, or
(2) Md/P = f ( Y | r, ...).
In this representation, Md/P varies directly with the income level on the premise that at higher aggregate income levels, people will need to hold larger money balances to meet greater transactions requirements.
The angle at which the Md/P = f ( Y | r, ...) schedule rises from the horizontal axis represents the proportion of aggregate income which people tend to hold in the form of money balances. For example, if people tend to hold money balances equal to approximately 20 percent of their annual income, the Md/P = f ( Y | r, ...) schedule would rise at an angle of 9 degrees (20 percent of 45 degrees) from the horizontal. The slope of the Md/P = f ( Y | r, ...) schedule is determined by the society's payments conventions as well as its perceptions of need for liquidity. The less often people are paid, e.g., monthly rather than weekly, the greater are the money balances needed to meet transactions liquidity needs, and the steeper will be the slope of the Md/P = f ( Y | r, ...) schedule.
Technological advances in computing and communications, such as the advent of automatic teller machines (ATMs), electronic funds transfers (ETFs), and credit and debit cards, may enable people to economize on their money holdings, and tend to flatten the slope of the Md/P = f ( Y | r, ...) schedule. Legislative changes which fundamentally change the definition of money (such as the Depository Institutions Deregulation and Monetary Control Act of 1980 in the U.S.) can also have an effect on the slope of the Md/P = f ( Y | r, ...) schedule.
Given the slope of the Md/P = f ( Y | r, ...) schedule, the current level of aggregate income, Y1, suggests that society will hold L1 real money balances to meet transactions requirements. If aggregate income increases or the Md/P = f ( Y | r, ...) schedule becomes more steeply sloped, the income-related quantity of money demanded, L, will increase; it will decrease if the income level decreases or if the Md/P = f ( Y | r, ...) schedule becomes more shallowly sloped.
The income-related real demand for money, L1 as indicated in panel (c) of Figure 6-1, can serve in panel (d) as a pseudo axis for locating the total money demand function represented there. The best perspective for examining panel (d) is after rotation of Figure 5-1 by 90 degrees clockwise so that the r axis of panel (d) is vertical, and the L axis is horizontal. With this perspective, the dashed line at the L1 level extended into the coordinate space of Graph (d) can serve as a pseudo r axis for locating the money demand function related to the interest rate,
(3) Md/P = f ( r | Y1, ...),
as it appears in panel (d). The money demand function shown in panel (d) is simply a different perspective on the same money demand function shown in panel (c). The only difference is in what is assumed to be variable and what is assumed to be constant. If income increases to a higher level, Y2 (not depicted in Figure 5-1), the function Md/P = f ( r | Y2, ...) would appear shifted to the right from its locus Md/P = f ( r / Y1, ...) shown in panel (d).
The money demand function of panel (d) exhibits an inverse relationship relative to r because of the opportunity cost of holding money which yields no interest income, or interest income which is less than available on other interest-bearing assets. The higher the interest rate on non-money assets, the greater the opportunity cost of holding low- or no-interest money balances, hence the smaller the quantity of such balances held. People are willing to hold larger money balances at lower interest rates on non-money assets because the opportunity cost is lower in terms of the interest income foregone.
With the r axis as vertical and the L axis as horizontal in panel (d) of Figure 6-1, the money supply function, Ms, starts at a point on the horizontal axis and exhibits a positive slope. This horizontal axis intercept represents the money stock in circulation irrespective of interest rates. This quantity may be presumed to be determined by actions of the central bank when a monetary aggregate is taken to be the object of monetary policy.
The upward slope of Ms is attributable to aspects of commercial bank behavior that are not directly controllable by a central bank, and in the absence of which the money supply curve would be vertical. One is the tendency of commercial banks to hold smaller excess reserves at higher interest rates because of the opportunity cost of foregone income since the reserves do not support additional lending. When commercial banks commit their excess reserves by issuing additional loans, money is created as a by-product, thus rendering Ms interest elastic.
A second and perhaps more significant effect is that when market interest rates rise relative to the central bank's discount rate (i.e., the rate at which it lends to commercial banks), commercial banks tend to increase their borrowings of reserves from the central bank in order to support additional lending. Again, money creation is a by-product of the lending activity, and this also renders the Ms function interest elastic. We should also note that the central bank could make the money supply function appear to be perfectly elastic (i.e., horizontal) with respect to the interest rate by targeting a particular interest rate rather than a monetary aggregate. What it actually does is to manipulate the upward-sloping money supply curve so that its intersection with the Md/P = f (r |...) schedule is a horizontal equilibrium path.
Yet another reason that the MMs function might have some positive slope (diverging from the vertical) is that the public tends to economize on its cash holdings as interest rates rise on yield-bearing assets. This leaves more reserves within the banking system to support additional lending.
Figure 6-1 can be used to examine money market dynamics:
Given the loci of the Md/P = f ( Y | r, ...) and Ms schedules, there is only one interest rate that can equilibrate the demand for money with the supply of money, that at the intersection of the two curves. Any other interest rate will be one of disequilibrium with an excess quantity demanded or supplied of money. For example, at an interest rate r2 (not shown) above r1, the quantity supplied of money exceeds the quantity demanded to be held by the population. In their efforts to rid themselves of the excess money balances, people may buy other financial instruments (e.g., bonds), increasing the demand for them and depressing their yield rates (i.e., their interest rates).
A falling interest rate in the market for any single financial instrument will be transmitted to markets for other financial instruments by arbitrage, i.e., the simultaneous purchase and sale of instruments in different markets. Thus, the interest rate will fall from the level of r2 and continue to fall until it reaches r1, the level at which people will be pleased to hold the outstanding money supply.
People may also attempt to rid themselves of excess money balances by purchasing consumer goods; this will have the effect of increasing AE in panel (b) and AD in panel (a), thereby causing real output to increase and pressuring prices upward.
Alternately, if the interest rate happens to be below r1, the quantity of money demanded would be greater than the quantity supplied. In their efforts to get more money to hold, people may sell other financial instruments, thereby increasing the supply of them coming onto their markets, depressing their prices, and increasing their yield rates. These rising rates will be transmitted to other financial instrument markets via arbitrage, causing interest rates to continue to rise until the level of r1 has been reached and equilibrium results. People may also attempt to get more money to hold by cutting back on their consumption expenditures relative to their income receipts; this will tend to lower AE in Graph (a), thereby decreasing real output rather than interest rates.
We have thus far begged the question of why the interest rate might be above or below its equilibrium level. Such a situation occurs naturally as a result of a shift of either the MS or the Md/P = f ( Y | r, ...) schedule in Graph (e) in Figure 6-1. For example, if the Md/P = f ( Y | r, ...) schedule increases (shifts right), the present interest rate r1 instantaneously becomes too low for money market equilibrium, and sets in motion an adjustment process as described above. The principal reasons for the Md/P = f ( Y | r, ...) schedule to shift to the right are increases in real income or changes in income receipt patterns. The same disequilibrium situation would emerge consequent upon a decrease (i.e., leftward shift) of MS, which is most likely brought about by monetary policy actions. The opposite disequilibrium situation (where the interest rate is too high) would emerge if either Md/P decreases or MS increases.
Like panel (d), panel (e) of Figure 6-1 should also be viewed so that
r is on the vertical axis. With this orientation, the horizontal axis is
I, the volume of investment spending. The investment demand schedule, Id,
plotted in this coordinate space exhibits an inverse relationship with
the interest rate. The downward slope reflects the fact that interest is
a cost to the investor, irrespective of whether financing is from external
sources (selling stock, issuing bonds, borrowing from banks) or internal
sources (retained earnings, depreciation allowances).
Keynes referred to the investment demand schedule as the "marginal efficiency of investment" and noted that it is likely to be a highly volatile relationship much influenced by the psychological expectations of private sector investors. If investment decision makers have confidence in the economy, the Id function will tend to shift rightward and be more interest elastic. But if business confidence collapses, the Id function will shift leftward toward the vertical axis and become much more interest inelastic. This latter phenomenon is often suggested as an initiating factor in the great depression of the
1930s.
Given the locus of the Id function in panel (e) of Figure 6-1, a rising interest rate (caused by an increase of Md/P or a decrease of MS in panel (e)) would induce business managers to cut back, cancel, or delay investment plans, thereby reducing the volume of investment spending from its previous level, I1. A falling interest rate would reduce the cost of borrowing, thereby increasing the level of investment spending above I1.
The volume of investment spending may also change when the ID function
shifts, even if the interest rate is stable (as it might be if the central
bank employs an interest rate target). Improving business confidence would
be expected to shift the Id curve rightward, thereby increasing the volume
of investment spending at the current interest rate. Collapsing business
confidence which shifts the Id function to the left would result in decreasing investment spending.
The volume of investment spending, I1 (determined by relationships portrayed in panel (e) of Figure 6-1), is one of the components of aggregate expenditure shown in panel (a) of Figure 6-1, as well as one of the injections included within the I1 + G + X schedule illustrated in panel (b). Therefore, when the income level changes in panel (c), the Md/P = f ( Y | r, ...)
schedule shifts in Graph (d) causing the interest rate to change, thereby affecting the volume of investment spending as illustrated by relationships in panel (e), which shifts the injections schedule in panel (c), the AE schedule in panel (a) so as to change the equilibrium level of income, Y.
The model illustated in Figure 6-1 is indeterminant. The equilibrium income
level has to be known in order to determine the equilibrium income level!
It is because of this indeterminacy that "IS-LM" analysis was developed
to allow a graphic simultaneous solution of the system. The economy accomplishes the simultaneous solution of itself through the iterative process of trial and error in the various markets which are integral to the macroeconomic system. However, in a dynamic world, equilibrium is a moving target, a condition which is ever pursued but perhaps never actually achieved.
Figure 6A-1 depicts four sets of coordinate axes and brings forward two
functions from Figure 6-1. Panel (a) of Figure 6A-1 contains the total leakage schedule, S + T + M, from Panel (b) in Figure 6-1. Panel (c) in
Figure 6A-1 shows the sum of the investment demand function, Id, from panel (e) of Figure 6-1, plus government purchases and export spending injections. Panel (b) of Figure 6A-1 contains a 45 degree reference line labeled S=I which serves as an equilibrium path for leakages (represented by S) and injections (I).
The object of analysis in Figure 6A-1 is to derive a new schedule from
the information in panels (a), (b), and (c), to be plotted in panel (d).
The graphic method for deriving the new schedule is to start at a point
on the leakage schedule in panel (a) and draw a box around the four graphs
by finding corresponding points on the three known schedules. The box corner in panel (d) locates a point on the new schedule. The box-drawing process can be repeated as many times as desired, starting from a new point on the leakage schedule each time, to locate additional points along the new schedule.
The newly derived schedule is referred to as an IS schedule because coordinates of points along it represent combinations of the interest rate and the income level which equilibrate injections into the income stream with leakages from it (I for the investment injection and S for the saving leakage). It should be noted that the IS schedule is not a behavioral function, but rather a high-level abstraction derived from behavioral functions. It is in effect an equilibrium condition path for the real sector of the macroeconomy.
Panel (g) of Figure 6A-2 brings forward the Md/P = f (Y | ...) function from panel (c) of Figure 6-1. Panel (e) of Figure 6A-2 contains the Md/P = f (r | ...) function from panel (d) of Figure 6-1, but
only the portion of it lying to the right of the pseudo vertical axis determined by the quantity of money demanded for transactions purposes in panel (c) of Figure 6-1. Panel (f) of Figure 6A-2 shows a 45-degree "budget line" (similar to the budget line of indifference curve analysis) which intersects either axis at the level of the current money supply in circulation. Coordinates of points along the MM line represent possible divisions of the money supply between transactions and asset requirements for holding money balances. Increases of the money supply shift the MM schedule outward, away from the origin; decreases of the money supply shift the MM schedule toward the origin, but always parallel to itself and at angles of 45 degrees from the axes.
The object of analysis in Figure 6A-2 is to derive another new schedule
from information contained in panels (e), (f), and (g), to be plotted in
the axes of panel (d). The box-drawing technique employed for Figure 6A-1
is also used in Figure 6A-2. Box corners in Graph (d) are found by starting at points along the Md/P = f (Y | ...) function in Graph (g), and drawing to corresponding points along the schedules in panels (f), and (e). The box corners in panel (d) trace out the so-called LM schedule (L for liquidity demand and M for money supply). Coordinates of points along the LM schedule represent combinations of the interest rate and the income level which equilibrate the demands for money with the supply of money. The LM schedule may be regarded as an equilibrium path for the monetary sector. It too is a high-level abstraction derived from behavioral functions.
The final step in the analysis is to bring the IS and LM schedules together as illustrated in Figure 6A-3. There is only one combination of the income level and the interest rate, that at the intersection of the two schedules, Ye and re, which will provide for equilibrium in both the real and the monetary sectors. Any other point in IS-LM coordinate space represents disequilibrium in either or both of the sectors. Disequilibrium conditions result from changes which shift underlying behavioral functions and therefore also the IS or LM schedules. It is these two additional schedules that are needed in order to make the macro model determinant in the sense of simultaneous equation solution. But it should be noted that equilibrating forces at work in the economy bring about the equivalent of a simultaneous equation solution in a graphic or algebraic model.
The "Keynesian Cross" analysis go a long way
toward explaining macroeconomic phenomena, but it contains a serious deficiency. It is not convenient to analyze the causes or consequences of inflation or deflation since the price level is not represented explicitly on any of the associated coordinate axes. In Keynesian theory, price level changes must be inferred from other relationships, and the consequences of price level changes can only be "talked into the analysis." This omission led during the 1960s to the development of another graphic vehicle for macroeconomic analysis that complements the Keynesian models. This newer model may be employed to examine the implications for the price level in a normally operating and growing economy.
Figure 7-1 is a short run macroeconomic analysis depicting the economy's aggregate demand (AD), its long-run aggregate supply (LRAS), and its short-run aggregate supply (SRAS) as functions of the price level. For a market-driven economy, the normal operating capacity, N1, is achieved when its installed plant and equipment are operating at about 80 to 85 percent of rated capacity, and unemployment is no more than 4 or 5 percent of the labor force. This is the irreducible amount of unemployment attributable to structural changes and frictions of adjustment in a dynamic market economy.
In its short-run manifestation, the "long-run aggregate supply" curve, LRAS in Figure 7-1, is fixed along a vertical path above N1. It is represented as a vertical line in conformance with the "classical dichotomy" between real and nominal causation. In the long run the real productive capacity of an economy does not vary (i.e., is perfectly inelastic) with respect to changes of the price
level, a nominal quantity, but it may vary with changes of real phenomena,
i.e., real matters such as resource availability, productivity, and technological changes. The long run changes of these real phenomena may be depicted in the short-run analysis as shifts or drifts of LRAS to the right with on-going growth, or as leftward shifts consequent upon supply-shocks that may have lasting adverse effects on the economy's output capacity.
Modern macroeconomic theory acknowledges the possibility of a short-run relationship between real output and the price level with the SRAS curve. This curve may be coincident with the LRAS curve if input
price changes match the pace of output price changes. But SRAS may diverge from LRAS and attain some degree of upward slope if input prices adjust more slowly than do output prices. Although the normal operating capacity of the economy can be exceeded temporarily, it is likely that the SRAS curve becomes ever more steeply upward sloped the farther the economy attempts to operate above its normal capacity. Also, the SRAS curve may become quite shallowly sloped if managers become resistant to cutting prices or if published price lists must be honored until new catalogs
or menus can be printed.
In The General Theory of Employment, Interest, and Money, John Maynard
Keynes asserted that both wages and prices tend to behave asymmetrically,
i.e., they freely rise in response increases of demand or decreases of supply, but they are "sticky" in the downward direction when demand decreases or supply increases. To the extent that wages and prices are more inflexible in the downward direction than in the upward direction, the SRAS may tend to be more shallowly upward sloped for price level changes below the current level, but more steeply sloped for price level
changes above the current level.
The wages of labor and the prices of non-labor inputs tend to rise more slowly than do final-goods prices. The effect is to cause a divergence between the short-run aggregate supply curve and the long-run aggregate supply curve. Because of the slowness of response of input owners relative to output producers in adjusting their respective prices, the SRAS curve may attain some positive slope (diverging from the vertical) even though the LRAS is vertical.
Economists of the Rational Expectations school of thought theorize that if the world were populated exclusively by people who form expectations rationally, there would be no divergence of the SRAS from the LRAS. But in the imperfect world in which we live, only the few people who form expectations rationally are able to adjust their prices apace with producer prices. For rational expectations decision makers, the SRAS would be vertical and coincident with the LRAS. Even so, to the extent that other members of the population fail to forecast accurately, the SRAS curve diverges from LRAS to exhibit an upward slope.
The SRAS curve may change shape over time. If inflation has not been a problem recently and is not expected in the near future, when it does occur the SRAS may have a very shallow upward slope which diverges only slightly from the horizontal. This is the same as to say that the majority of the population is surprised by the rising prices. But as inflation becomes an on-going problem which is recognized and expected, the SRAS will become ever more steeply upward-sloped and approach the locus of the vertical LRAS.
The classical Quantity Theory of Money can be represented by the identity, MV = PY, where M is the money stock, V is the income velocity of money, P is an index of the price level, and Y is real output. If this identity is solved for Y = MV/P, aggregate demand AD can be substituted for Y so that AD = MV/P. Then, if the money stock and income velocity both remain constant, it can be seen that AD varies inversely with the price level, and a graph of it would follow a unitarily elastic downward sloping path when plotted in the coordinate space of Figure 7-1. However, the modern version of the quantity theory of money recognizes that V probably does vary directly with the price level because a changing price level affects the nominal rate of interest which affects velocity. The effect of the changing velocity is to render the AD curve somewhat more inelastic than it would have been in a constant-velocity world.
The LRAS curve also shifts to the right in the long run as N increases,
carrying with it the SRAS curve. A so-called "supply-side" hypothesis is that rightward progress of LRAS may have been retarded in the post World War II period due to the disincentive effect of progressive taxation and the costs to the business community of governmental regulation. It has even been suggested that the LRAS has drifted leftward and the SRAS curve upward and to the left at an almost imperceptible pace in response to these forces. But the SRAS curve may also shift in the short run in response to supply shocks and changing perceptions of costs by producers when inflation or deflation occurs.
Both the output level (Y) and the price level (P) of the economy tend to
change in response to shifts of the short-run aggregate demand and aggregate supply
curves. In Figure 7-2, an increase of aggregate supply curve from SRAS1 to SRAS2 results in an excess of output relative to demand expenditures at the current price level, with the consequence of inventory accumulation of E'-E1. The effort by firms to "move" the accumulating stocks will tend to put downward pressure upon prices which may be manifested in reduced list prices, increased discounts off of list prices, or sales.
The macroeconomic adjustment to the rightward shift of the SRAS curve is
a movement downward along the AD curve from E1 to E2
as output increases to Y2 and the price level falls. If the
rightward-shift of SRAS is attributable to a growth phenomenon, then the
normal operating capacity of the economy will increase to N2
and the LRAS will become vertical above it. The managerial implications
of a rightward shift of the LRAS curve are clear: productive capacity can
be expanded and output increased, although prices may have to be lowered.
In Figure 7-3, a rightward-shift of aggregate demand from AD1 to AD2 produces an excess of demand relative to output at the current price level, and results in inventory depletion of E'- E1. If inventories have become swollen in the past, the depletion may be desirable and occasions no immediate response. However, eventually firms must respond to the depleting inventories or "stock-out" and, in effect, be out of business in those items.
One adjustment to an inventory draw-down is to take the occasion of the
strong market to raise prices, although in many cases it may not be possible to implement desired price increases until new menus or catalogs can be distributed. If the economy is operating below its normal capacity, another means of stemming the inventory depletion is to increase output rates by accelerating assembly processes and using more labor and material inputs. Increased labor usage can be accomplished by extending work hours with overtime, adding shifts, calling back to work employees who have been laid off, or hiring new employees.
Demand pull inflation is attributable to a rightward shift of the
aggregate demand curve. Graphically, the adjustment proceeds along
the SRAS curve from E1 to E2 with consequent demand-pull inflation from P1 to P2. If the new output exceeds the normal operating capacity of the economy, N1, the availability of additional materials inputs may be limited by supply bottlenecks which will eventually result in rising materials costs. Also, this output expansion will tighten the labor market and bid wage rates upward. When these upward price pressures eventually become translated into rising input costs, managers likely will revise production targets and schedules downward, with a consequent leftward shift of short-run aggregate supply until it reaches SRAS2. The price level increase from P2 toward P3 may be understood as cost-push inflation which is attributable to a leftward or upward shift of the aggregate supply curve. The cost-push inflation comes to an end only when the output level has returned to the economy's normal operating capacity which is sustainable in the long run. The aggregate demand increase achieved no lasting increase of real output, but resulted in price inflation from P1 to P3.
As illustrated in Figure 7-4, a collapse of aggregate demand which shifts
AD1 to AD2 results in inventory accumulation and
induces an adjustment downward along the SRAS curve from E1
toward E2. Unemployment worsens as production levels are cut
in response to the increasing inventories, and prices begin to soften.
The price level decrease from P1 to P2 may be regarded as demand pull deflation since it resulted from a decrease of aggregate demand. However, as we have noted above, prices may be somewhat sticky in the downward direction. If prices cannot change to absorb some of the AD collapse, the brunt of the adjustment must be borne by falling output, possibly as far as E'.
If some price deflation does occur, the lower prices eventually are translated
into lower production costs. Employers and production planners may alter
their plans to increase output, especially after inventories have begun
to deplete. This will have the effect of increasing aggregate supply to
SRAS2, with adjustment from E2 toward E3
until there is a return to N1, the normal operating capacity
of the economy. In such a soft or weakening economy, managers should expect to slow production rates and orders of materials, and may have to cut prices. This second stage of price level decline might be thought of as cost push deflation since it followed from the increase of short-run aggregate supply. However, since output tends to return to its level before the demand collapse, it may be more appropriate for managers to try to hold production rates constant while letting inventory variation absorb the effects of the demand collapse.
Figure 7-5 illustrates an aggregate supply decrease from SRAS1
to SRAS2 due to a supply shock. Product shortages emerge as output falls, and inventories begin to shrink. In such a market environment, prices
become firmer and managers may be tempted to take the occasion to announce
price increases. As the higher prices become translated into increased
production costs, cost-push inflation from P1 to P2
ensues in the adjustment from E1 toward E2. With
worsening unemployment which lowers spendable income, aggregate demand
can be expected to fall toward AD2, tending to bring prices
back to original level before the shock. The economy adjusts along the
path from E2 toward E3.
When the falling prices become translated into decreasing production costs, managers may revise production plans and increase output to replenish depleted inventories. Aggregate supply will shift back toward SRAS1. With the fall of prices and the recovery of the economy, aggregate demand will increase toward its original position, AD1, and output will return to N1, the normal operating capacity of the economy. The adjustment path may pass near to E4 before returning E1. Market and inventory realities may force managers to make the adjustments in production rates and prices just described, but since both aggregate output and prices will tend to return to their pre-shock levels, a better strategy (as in the case of a demand collapse) may be to try to weather the storm by holding constant both prices and production levels, while letting inventories serve as the shock absorber.
A supply-side hypothesis is that a continuing leftward or upward drift
of the SRAS curve may be attributable to the disincentive effects of
progressive income taxation and to the costs of governmental regulation
of business. This leftward shift of SRAS results in on-going cost-push inflation. The growth of real output may slow, or output may decrease absolutely. Economists have referred
to the combination of on-going inflation combined with slow output growth
as "stagflation." There appears to be no automatic mechanism which
will tend to return the economy to its normal operating capacity when SRAS
continues an upward-leftward drift. Some hypothesize that the on-going
inflation will create an inflation psychology in which managers
begin to raise their prices in anticipation of future cost increases
In this depiction, the left-hand floor axis is the price level, P. The right-hand floor axis is real output, Y. The vertical dimension is expenditures, E. Aggregate demand is represented by the (blue) curved surface ABCD, with functional specification
(1) AD = g ( P, Y | r, ... ).
In this specification AD is the dependent variable and P and Y are the principal independent variables. The real interest rate, r, and all other independent variables are assumed constant. The (green) long run aggregate supply surface, Y1ZMN, intersects
the aggregate demand surface along path JJ' which corresponds to price level P1. The path FJ' above P1J locates the two dimensional aggregate expenditure function at the intersection of aggregate demand ABCD with long run aggregate supply Y1ZMN.
P1J' is the E=Y equilibrium path which rises at an angle of 45 degrees from the floor. When panel (a) of Figure 7-6 is viewed from the perspective of the 0Y axis so as to collapse it into two dimensions, it appears as depicted in Graph (b), which corresponds to Figure 4-1. When panel (a) of Figure 7-6 is viewed from above, it appears as depicted in panel (c), which corresponds to Figure 7-1. In panel (a) of Figure 7-6, any shift of the aggregate demand surface or the long run aggregate supply surface will change the intersection of the two and the corresponding price level, thereby shifting the aggregate expenditure curve.
Figure 7-7 extends Figure 7-6 to add aggregate expenditure surface RSTU (red) in panel (a). Its functional
specification is
(2) AE1 = f ( Y, P | r, ...),
which has two principal independent variables, Y and P, all others assumed constant. The RSTU surface is represented as being linear, but it could in reality be concave downward if the consumption function is concave downard as depicted in Figure 4-2, or if a progressive income tax is imposed. Aggregate expenditure surface RSTU slopes upward along the 0Y axis because increasing income enables greater expenditures, but it slopes downward along the 0P axis since, as the price level increases relative to any particular income level, real expenditures must fall.
It can now be seen in panel (a) of Figure 7-7 that aggregate expenditure path FJ' (red) is a vertical slice through the aggregate expenditure surface parallel to the 0Y axis at price level P1. Suppose that long run aggregate supply increases from Y1 to Y2. The new intersection of aggregate supply with aggregate demand is along path KK' (blue). The ensuing adjustment process (described below) causes the price level to fall to P2, and a new slice through the aggregate expenditure surface along path GK'. When viewed from the perspective of axis 0Y as illustrated in panel (b) of Figure 7-7, it is apparent that AE2 lies above AE1. The conclusion is that any increase of aggregate supply which decreases the price level will cause the AE schedule to shift upward. Likewise, a decrease of aggregate supply which increases the price level will cause the AE schedule to shift downward.
Figure 7-8 illustrates the effect of an increase of aggregate demand. In panel (a) the aggregate demand surface shifts outward from the origin to new locus A'B'C'D' (darker blue). The intersection of the new aggregate demand surface with the unchanged aggregate supply is along path LL'. The ensuing adjustment process (described below) causes the price level to rise to P3, and another new slice through the aggregate expenditure surface along path HL'. This time, in panel (b) the new aggregate expenditure schedule, AE3, lies below the original aggregate expenditure schedule at AE1. The conclusion is that an increase of aggregate demand which causes the price level to rise will cause the AE schedule to shift downward. It also follows that a decrease of aggregate demand which decreases the price level will cause the AE schedule to shift upward.
In Figure 8-1, if the demand for loanable funds were to increase from D1 to D2, the nominal interest rate would rise from i1 to i2. The interest rate can be expected to fall from i1 to i3 in response to a decrease in the demand for loanable funds from D1 to D3.
In Figure 8-2, if the supply of loanable funds should increase from S1 to S2, the nominal interest rate would fall from i1 to i2. A decrease in the supply of loanable funds from S1 to S3 would induce the nominal interest rate to rise from i1 to i3. Since the demand for loanable funds is a derived demand, it must be a function of the demand for the final goods and services which can be produced with the real capital financed by the loanable funds. Nominal interest rates on long-term riskless instruments therefore cannot diverge significantly or for long from the true interest rate specified in regard to the scarcity of real capital.
Another source of demand for loanable funds is government. When governments at any level run budgetary deficits or otherwise mount capital spending programs which require borrowed funds, the resulting increase in the demand for loanable funds can be expected to put upward pressure on the interest rate in the loanable funds market (other things remaining the same). Decreasing budget deficits will decrease the demand for loanable funds, and budgetary surpluses may even add to the supply of loanable funds. In either case, the interest rate will tend downward.
Consumers may also add to the demand for funds in the loanable funds market. Because "big ticket items" such as homes and motor vehicles usually cannot be purchased out of the normal flow of income, purchasers must resort to credit markets to finance them. Consumer interest rates often are higher than interest rates on funds lent for investment purposes since consumers have to bid funds away from investment uses. An increase in consumer demand for credit can thus be expected to raise interest rates in the loanable funds market.
The demand for money is hypothesized to be an inverse function of the interest rate due to the opportunity cost of income from financial instruments not held in order to hold money which yields little or no
interest. The supply of money is usually represented as perfectly inelastic with respect to the interest rate and is presumed to be determined by the central bank of the region. In reality, commercial bankers and borrowers play some role so as to render the money supply a direct (though still highly inelastic) function of the interest rate.
As illustrated in Figure 8-3, an increase of the price level or the real income level causes the demand for money to increase (shift to the right) from D1 to D2. At interest rate i1, the quantity demanded, M2, exceeds the quantity supplied by the amount represented by line segment AB. Assuming that the money supply has not changed, the interest rate rises from i1 to i2 so that the new equilibrium is at point C. At the higher interest rate, the quantity of money demanded has decreased to M1, the amount which is in circulation.
A decrease of either the price level or the real income level would cause the demand for money to decrease from D1 to D3 in Figure 8-3. There is now more money in circulation than people want to hold as represented by line segment AF. This puts downward pressure on the interest rate to fall from i1 to i3. The new equilibrium is at point E. At the lower interest rate, people are pleased to hold the amount of money in circulation, M1.
Figure 8-4 illustrates an easier (or looser) monetary policy implemented through open market purchases of bonds which shifts the vertical money supply from S1 to S2. At interest rate 1, there is more money in circulation than people want to hold in the amount represented by line segment AB. Assuming that the demand for money has not changed, this induces the interest rate to fall to i2, so that the new equilibrium is at point C.
A tighter monetary policy (implemented by open market purchases of bonds by the central bank) is illustrated in Figure 8-4 by the decrease of the money supply from S1 to S3. At interest rate i1, there is now less money in circulation than people wish to hold in the amount represented by line segment AF. This induces the interest rate to rise to i3. The new equilibrium is at point E. At the higher interest rate, people are pleased to hold the amount of money in circulation, M1.
There is only one interest rate that can equilibrate the demand for money with the supply of money. Any interest rate above the equilibrium level results in an excess supply of money relative to the amount which people want to hold at that interest rate. By the same token, any interest rate below the equilibrium level results in an excess demand for money to hold relative to the amount in circulation. However, the money demand-supply relationship does not contain within itself a mechanism to cause the interest rate to change or to achieve equilibrium. A connection to the bond market must be made for this purpose.
The yield rates or rates of return on financial instruments, euphemistically designated as "bonds," vary inversely with the prices of those instruments. The bond yield rates are implicitly the interest rates on the bonds. Although there are numerous formulas for computing yields on bonds given their prices, examples using the "effective yield" formula reveal most simply the inverse relationship between the price
of a bond and its yield rate:
effective yield = (face value at maturity - current price) / current price
Suppose that a bond has a $1000 maturity face value, provides no coupon interest payments, and is sold and traded at some price which is discounted from face value. At a current market price of $900, the effect yield is ($1000 - $900) / $900, or approximately 11.1 percent. If the market price should rise to $910, the effective yield, ($1000 - $910) / $910, would fall to approximately 9.9 percent.
In the bond market, demand and supply are presumed to be normally sloped relative to the prices of the bonds as illustrated in Figures 8-5 and 8-6.
Since financial instruments exhibit a wide range of denominations, the "quantity of bonds" on the horizontal axis should be understood not in terms of a number of such financial instruments, but rather as an amount of financing demanded or supplied by such instruments. For purpose of exposition, a standard bond of fixed denomination, e.g., $1 million, might be assumed so that the horizontal axis units can be understood as the number of such bonds. An increase in the demand for bonds from D1 to D2 in Figure 8-5, other things remaining the same relative to the supply of bonds, results in an increase in the price of bonds from P1 to P2, and a corresponding fall in their yield rates. If the demand for bonds should decrease from D1 to D3, the price of bonds would fall to P3 and the yield rates would rise.
Similarly, in Figure 8-6 an increase in the supply of bonds from S1 to S2, other things the same for the supply of bonds, results in a decrease in the price of bonds from P1 to P2, with corresponding rise in the yield rate. A decrease in the supply of bonds to S3 would elicit an increase in the price of bonds to P3 and a fall in their yield rate.
This last relationship provides the needed explanation in the money market
for why the interest rate changes when the demand or supply of money changes. In Figure 8-3, line segment AF represents an excess supply of money relative to the amount which people want to hold after the demand for money decreases.
In attempting to rid themselves of their excess money balances, they can purchase goods and services in those markets, or they can purchase financial instruments in the "bond" market. To the extent that they do the latter, the demand for bonds increases in Figure 8-5, pushing bond prices higher and yield rates lower. This is why the interest rate in Figure 8-3 falls from i1 to i3 when the demand for money increases. A similar explanation of the interest rate decrease in Figure 8-4 follows upon the illustrated increase in the supply of money.
When the demand for money increases in Figure 8-3 or the supply of money decreases in Figure 8-4, line segment AB (in either diagram) represents an excess of demand for money to hold relative to the amount in circulation. In their efforts to get more money to hold, people can cut back on their purchases of goods and services relative to their continuing income flows, or they can sell financial instruments in the bond markets. To the extent that they do the latter, the supply of bonds increases in Figure 8-6, pushing bond prices lower and yield rates higher. This is why the interest rates in Figures 8-3 and 8-4 rise when the demand for money increases or the supply of money decreases, respectively.
A cautionary note is warranted at this point. Efforts by a central bank to increase interest rates by decreasing the supply of money (or reducing the rate of increase of it) may not have the intended effect if people choose to get more money to hold by cutting back on their purchases of goods and services rather than by selling financial instruments. Likewise, central bank efforts to cause interest rates to fall by expanding the money supply may not be effective if people use their excess money balances to purchase goods and services rather than buy financial instruments. In both cases, the impacts may be more upon the price level than upon interest rates, but this may have been the ultimate objective of central bank policy anyway.
One (but not the only) source of an increase in the demand for bonds results from an excess supply of money when the demand for money decreases or the central bank increases the supply of money. Likewise, a source (but not the only one) of an increase in the supply of bonds results from an excess demand for money to hold consequent upon an increase in the demand for money or a decrease in the supply of money. In addition to the money demand-supply relationship, the supply of bonds may also be affected by the desires of businesses to finance capital investments, the needs of governments to finance deficits or dispose of surpluses, and the intent of the central bank to execute monetary policy. Changing interest rate differentials between domestic and foreign
locales may also induce bond demand or supply shifts. It is the market forces of demand and supply in the bond market which serve as the vehicle for interest rate change in the money market as noted above.
Changes in the prices of bonds (and thus their yield rates) become transmitted to the prices (and yields) of other types of financial instruments via the process of arbitrage, i.e., the simultaneous purchase and sale of different types of financial instruments. Arbitrageurs are successful if they are able to operate by the criterion of "buy low,
sell high." If they are successful, they will both capture profits and precipitate convergence of prices (and yields) across the markets. Unsuccessful arbitrageurs will suffer losses and tend to destabilize markets, and they may cause interest rates on different types of financial
instruments to diverge.
Recent experience in several European countries and Japan is with declining populations. Population decline can be expected to shift the long run aggregate supply curve to the left (or slow its rightward shift), carrying with it the short-run aggregate supply curve.
The SRAS may be shallowly upward-sloped if people generally do not expect inflation and are surprised when it occurs. If inflation is an on-going phenomenon which is fully anticipated by the majority of people, the SRAS curve will be steeply upward-sloped, and may converge with the vertical LRAS curve. The equilibrium path which the economy follows depends critically upon whether the aggregate demand curve, AD, also shifts in the same direction and at some rate greater than, approximately equal to, or less that the rate of growth of aggregate supply and the normal operating capacity of the economy.
Figure 9-1 illustrates positive growth as a discrete rightward shift of the long-run aggregate supply curve from LRAS1 to LRAS2 as the natural rate of real output increases from N1 to N2.
The short-run aggregate supply shifts along with the LRAS curve to SRAS2. This shift should be understood to be a "snapshot" of an on-going growth process. Suppose that aggregate demand grows at a relatively slow pace represented by the small shift from AD1 to AD2, which intersects SRAS2 at E2. This leaves output at Y3, well below the new natural rate of real output at N2, and unemployment correspondingly above the natural rate of unemployment. Deflation ensues as the price level falls from P1 to P2. As expectations begin to catch up with the falling price level, suppliers of resources may begin to accept lower prices and wages (in order to avert unemployment) so that costs of production fall. When this happens, it causes SRAS to shift even further to the right (not shown) toward the intersection of AD2 with LRAS2. As prices continue to fall, output may gradually approach the natural rate of real output at N2. If AD continues to shift in such a fashion relative to the AS shifts in subsequent periods, there will be a tendency in the economy toward chronic deflation and a lagging of output behind the expanding capacity. This is a phenomenon which economists refer to as a "growth recession" if it is perceived to be a temporary phenomenon, or "secular stagnation" if it appears to be a permanent condition.
Alternately, if in Figure 9-1 aggregate demand growth results in a much larger shift from AD1to AD3, the price level rises from P1 toward P3 and output increases, at least temporarily, toward Y4. As output increases above the natural rate of real output N2, the actual rate of unemployment falls below the natural rate of unemployment. If AD continues to shift in such a fashion relative to the LRAS shifts in subsequent periods, there will be a tendency for chronic inflation as the economy attempts to sustain production in excess of its normal operating capacity. The equilibrium path is along the upward-sloping dashed line from E1 toward E3 in Figure 9-1. As resource owners gradually become aware of the rising output prices (i.e., their costs of living) and begin to push up their own prices and wage rates, production costs rise. The initial demand-pull inflation thus induces further cost-push inflation as the SRAS curve slows its rate of rightward advance and may even begin to shift upward (not shown) toward the intersection of AD3 with LRAS2. In this scenario aggregate demand is increasing at a rate faster than short-run aggregate supply (which may actually be decreasing). A possible consequence is a slowing of the growth rate of output due to the resulting cost-push inflation.
As can be seen in Figure 9-1, an equilibrium path which avoids both inflationary and deflationary pressures requires that aggregate demand continue to increase at approximately the same rate as long-run aggregate supply. This is illustrated as the shift from AD1 to AD4, with horizontal equilibrium path from E1 to E4. Under such growth conditions, the economy may enjoy relative price stability, not unlike that experienced by the U.S. economy during the late-1990s.
Roy Harrod's analysis of growth in the context of the "Keynesian cross" diagram from panel (b) of Figure 4-1 suggests that there is an appropriate, or "warranted," rate of growth of the economy to allow sustained growth of output without inflation.
Suppose, as illustrated in Figure 9-2a, the economy is presently in equilibrium at point A and operating at output level Y1, which is below the full-employment output level, Yf.
An increase of investment spending from I1 to I2, which also shifts aggregate expenditure upward from AE1 to AE2 as illustrated in Figure 9-2b, results in inventory depletion represented by line segment AB.
This sets in motion a process of expansion in the economy until it reaches a new equilibrium at point H with output level at Y2 which coincides with the former full employment output level. However, the additional investment spending has created additional productive capacity by adding to the stock of productive capital in the economy, thereby increasing the full-employment output level to Yg. At Yg, even more investment in the amount from J to K is needed in order to achieve the new full employment level of output at K. The additional investment creates additional capacity and the economy continues to suffer unemployment.
Because the marginal propensity to consume is less than 100 percent, the slope of the consumption function is less than 45 degrees, forming a "wedge" between the consumption function and the 45-degree path, represented by AJK if Figure 9-2a. This wedge represents a difference between consumption spending and income i.e., saving, which must be absorbed or "filled up" with various types of injections, including investment spending, in order to keep the economy growing and at full employment. Because the saving wedge expands as income rises, Harrod concluded that investment must increase again in the next period, and keep on increasing period after period to keep the economy growing and prevent rising unemployment. The conclusion may be generalized to the sum of all types of injections, including export spending and government purchases as well as investment.
The problem of the wedge of saving may be exacerbated if progressive income taxation or some other phenomenon tends to make the consumption function flatten out at higher income levels (become concave downward) as illustrated in Figure 9-3. In this case, the wedge will become an ever-widening funnel which must filled up with injections of spending.
Harrod's analysis concludes that the right or "warranted" rate of output growth can be estimated by computing the ratio of the marginal propensity to save (ΔS/ΔY) to the marginal capital-output ratio (ΔK/ΔQ). The required injection growth rate then depends upon the value of the effective multiplier. Any output growth rate in excess of the warranted rate will result in chronic inflationary pressures; any output growth rate less than the warranted rate will produce chronic recession and deflationary pressures (i.e., growth recession or secular stagnation).
Is there any apriori reason to expect either aggregate demand or aggregate expenditures to increase at just the right rates? Aggregate demand can be counted upon to shift to the right when population grows simply because there are more mouths to feed. This same phenomenon will cause the AE schedule to shift upward because one of its components, consumption spending, increases. And if per capita incomes are increasing due to productivity advances, there will be an additional impetus for rightward shifts of aggregate demand and upward shifts of the consumption function and the AE schedule. Also, it is not unreasonable to expect investment spending to increase in some proportion to the growth of the economy, simply to increase capacity by enough to meet the requirements of population growth and income increase. These three factors might be expected to yield a continuing demand increase which paces or outruns the rightward shift of the aggregate supply function.
Continuing government deficits further shift the AD function to the right and the AE schedule upward. Should governments succeed in balancing their budgets, this source of AD increase will disappear. Governmental budget surpluses which are not used to retire public debt would siphon purchasing power from the economy and thus constitute a drag on the rightward pace of AD. But as long as governments are prone to running budget deficits, there seems to be little basis for the fear that there will be inadequate additional spending to fill up the widening saving wedge. Economists are more often concerned that the increasing spending will be excessive and produce chronic inflationary pressures. Whether these pressures become actualities will depend in large measure upon the central bank's implementation of monetary policy.
The starting-point of the analysis is equilibrium at E1 where AD1 and SRAS1 intersect. The scenario is that one of the determinants of aggregate demand changes (a newly-enacted government program is one possibility) to shift aggregate demand to AD2, setting in motion an adjustment process upward along SRAS1 toward E2. This is illustrated in time-sequence graph of Figure 10-1 as a macroeconomic expansion between time t0 and time t1. This results in some unanticipated demand-pull inflation which sets in motion a cost-pushing shift of the aggregate supply curve from SRAS1 toward SRAS2. This adjustment along AD2 from E2 toward E3 is illustrated in the time-sequence graph as a macroeconomic contraction from time t1 to t2 when the economy returns to its sustainable normal operating capacity. As we noted in Chapter 2, after this adjustment is completed, no permanent real change has occurred in the economy, but the rate of price inflation is now permanently higher.
The adjustment process may come to an end after the adjustment just illustrated, but we may carry the scenario forward in either of a couple of plausible directions. Let us suppose that the increase of aggregate demand resulted from a one-time "spurt" of additional spending in the economy which was not sustained. In this case the aggregate demand curve might well return to near its former position at AD1, tracing out an adjustment path from E3 toward E4 en route back toward E1, illustrated in the time-sequence graph as a further macroeconomic contraction between times t2 and t3, followed by an expansion between t3 and t4. As is now apparent, a complete cyclical process has now been illustrated in the time-sequence graph.
An alternative scenario, and one which seems even more plausible, is that
equilibrium E3 is difficult to recognize so that during the cost-push adjustment there is an overreaction of business and labor decision makers. This results in a further shift of aggregate supply to SRAS3 with movement along AD2 toward E5. When the overreaction is finally recognized, aggregate supply returns to SRAS2 where it again intersects AD2 at the normal operating capacity of the economy. But this little episode of overreaction has in panel (b) also resulted in another possible explanation of the cyclical contraction followed by expansion from period t2 through t3 to t4.
Other shifts of aggregate demand and aggregate supply may likewise set
in motion adjustment processes which, when examined in time sequence, reveal what appears to be cyclical behavior. The reader is invited to reexamine Figure 7-5 which illustrates an initial upward shift of aggregate supply (possibly a result of a so-called "supply shock") and the ensuing shifts of aggregate demand and supply. The construction of a time sequence graph for Figure 7-5 would also yield the appearance of cyclical behavior.
An exchange rate is the price of one currency expressed in terms of another
currency. During part of the twentieth century, the exchange rates of many
countries' currencies were relatively stable during some periods, but more
volatile during other periods. What causes exchange rates to change, and how do
changing exchange rates affect macroeconomies?
Under a fixed exchange regime, exchange rates are
determined by government fiat. Exchange values are fixed or stabilized either
by intervention of a government agency in exchange markets, or by exercise of
the police power of the state to dictate official rates and punish transactions
at rates other than the official rates. Under a flexible exchange regime,
exchange rates are determined in foreign exchange ("forex") markets
by interaction of suppliers and demanders. Exchange rates vary in response to
changes of demand for and supply of foreign exchange (i.e., shifts of demand
and supply curves). We shall first examine the macroeconomic implications of
market determination of exchange rates. Later in the chapter we shall return to
the implications of governmental determination of exchange rates.
Although any exchange rate can be expressed as either the foreign currency
price of the domestic currency (e.g., the euro price of a dollar, e/$) or its
reciprocal, the domestic currency price of the foreign currency (e.g., the
dollar price of a euro, $/e), the former should be used in order to make sense
of appreciation and depreciation of the domestic currency. Figure 13-1 is a
hypothetical illustration of the foreign exchange (forex) market for dollars
priced in euros at e0.85 per dollar ($1.17 per euro) at the inception of the
euro in January, 1999. In following discussion, the subscript U refers to the
U.S. and the subscript E refers to Europe.
In Figure 13-1, the demand for the domestic currency on the forex
market varies inversely with price, e/$, as its principal determinant.
The demand for the domestic currency derives from two sources, citizens of the
nation and foreigners. Citizens of the nation may demand their own currency on
the forex market if they have acquired foreign currencies in trade, as earnings
on investments, or as gifts. The foreign demand for the domestic currency is
equivalent to the foreign supply of the foreign currency. Foreigners may supply
their own currencies to purchase the nation's domestic currency on the forex
market in order to make gifts to citizens of the nation, import goods and
services from the nation, or invest in the nation. The principal non-price determinants of the total demand (domestic and
foreign) for the domestic currency on the forex market are foreign incomes, YE,
foreign preferences, prefE, relative rates of inflation, PE/PU,
comparative interest rates, (iU - iE), and domestic trade
barriers, TariffsU, and non-tariff barriers, NTBU. This
may be expressed in functional format as (1) D$ = f ( e/$ | YE,
prefE, PE/PU, (iU - iE),
TariffsU, NTBU), where e/$ is the euro price of a dollar. All of the non-price determinants
of demand are assumed constant (ceteris paribus) in order to specify the
locus of the demand curve illustrated in Figure 13-1. A change of any of the
non-price determinants of demand shifts the demand curve. The demand for
dollars on the forex market might increase from D1 to D2
in Figure 13-2 if European incomes rise, European preferences for American
goods improve, European price levels rise relative to the U.S. price level, or
U.S. interest rates rise relative to European interest rates. The forex demand
for dollars might also increase if U.S. trade barriers were to decrease.
Assuming that the supply of dollars does not change, the increased demand
for dollars on the forex market induces the price of the dollar to rise. This
means that the dollar appreciates relative to the value of the euro, or
the euro depreciates relative to the value of the dollar. A change in
any of the non-price determinants of demand in the opposite directions to those
specified above would decrease the forex demand for dollars. Again, assuming
that the supply of dollars does not change, the demand decrease would induce
the euro price of the dollar to fall. This means that the dollar depreciates
relative to the euro, or the euro appreciates relative to the dollar. The assumption that the supply of dollars does not change is unnecessarily
stringent. The same conclusion obtains in each case if the supply of dollars
changes in the same direction as the demand for dollars, but by a smaller
amount, or if the supply of dollars changes in the opposite direction to the
change in the demand for dollars. In Figure 13-1, the supply of the domestic currency on the forex
market varies directly with price, e/$, as its principal determinant.
The principal non-price determinants of the domestic supply of the
domestic currency to the forex market (i.e., the domestic demand for the
foreign currency) are domestic incomes, YU, domestic preferences,
prefU, relative rates of inflation, PU/PE,
comparative interest rates, (iE - iU), and foreign trade
barriers, TariffsE, and non-tariff barriers, NTBE. This may
be expressed in functional format as (2) S$ = g ( e/$ | YU,
prefU, PU/PE, (iE - iU),
TariffsE, NTBE, A change of any of the non-price determinants of supply would shift the
supply curve. The supply of dollars to the forex market might increase, i.e.,
shift to the right, if U.S. incomes increase, U.S. preferences for European
goods improve, the U.S. price level rises relative to European price levels, or
European interest rates rise relative to U.S. interest rates. Decreases of
European trade barriers also might increase the supply of dollars to the forex
market. If any of these non-price determinants of supply should change in the
opposite direction to those specified above, the supply of dollars to the forex
market would decrease. The supply shift in Figure 13-3 illustrates dollar
depreciation from e1.20 toward e1.00 per dollar (i.e., from $0.83 per euro
toward $1.00 per euro).
It is important to note that the demand for exchange on the forex market is not coincident with the demand for money. Nor is the supply of exchange on the forex market coincident with a nation's supply of money. Only a part of the global quantity of the money supply denominated in units of a nation's currency will be offered on the global forex market at any one point in time, and only a portion of the money supply denominated in units of the nation's currency will be demanded for international transactions purposes. However, during any particular forex trading period (such as a trading day), the total volume of transactions denominated in units of a particular national currency may exceed the nominal amount of the of the nation's money supply by virtue of the fact that the same quantities may be traded many times over during the trading period.
While the demand for and supply of a nation's money are not coincident, respectively, with the demand for and supply of the domestic currency on the global forex market, they are linked by what eighteenth century economist David Hume called the price-specie flow mechanism. Hume was concerned with inflows and outflows of gold and silver (specie) from a nation. Modern money supplies are more diverse, consisting not only of coin and paper currencies but also of balances on deposit at financial institutions. These balances, though physically resident as liability accounting entries "on the books" of financial institutions within the nation, may be owned by foreigners as well as by citizens of the nation.
This section describes the process of adjustment to a Current Account deficit (i.e., a Capital Account surplus). An emerging or growing Current Account deficit is likely to increase the supply of domestic money to the forex market (i.e., increase the demand for the foreign currency). Assuming that the demand for domestic money has not changed, the resulting excess supply likely will induce depreciation of the domestic currency on the forex market. The depreciation of the domestic currency makes the nation's exportables look cheaper to foreigners and imports from abroad appear more expensive to citizens, thereby alleviating the Current Account deficit.
Following is an illustration with graphic models of a scenario which, starting from an initial equilibrium, eventually result in a balance of payments deficit.
Panel (a) of Figure 13-4 illustrates a scenario in which the initiating
change occurs in the private sector rather than by macropolicy. Starting from a situation of equilibrium in all markets, assume that the demand for money to hold decreases as illustrated in panel (a) by the leftward shift of the money demand schedule from MD to MD'. The horizontal bracket indicates an excess supply of money in the sense that at interest rate i1 there is more money in circulation than people wish to hold.
A similar scenario, but one for which the initiating factor occurs as a
matter of macropolicy, is illustrated in panel (aa) of Figure 13-5. Here the central bank, in an effort to implement an expansionary (or “loose”) monetary policy, increases the money supply from MS to MS’ by conducting open market purchases of treasury bonds. As in panel (a), the horizontal bracket in panel (aa) represents an excess supply of money at interest rate i1.
Panel (b) in Figure 13-4 illustrates the Keynesian conclusion that people can rid themselves of their excess money balances by buying “bonds” (a Keynesian euphemism for all kinds of financial instruments) to hold in their portfolios of assets. This is illustrated in panel (b) as the rightward shift of the bond demand curve from DB to DB’. Other things remaining the same, bond prices will rise above PB, causing bond yields to fall below i1 in panel (a) or in panel (aa).
Monetarists suggest that the bond market is not the only place where people can rid themselves of excess money balances. They may do so by increasing their consumption spending relative to the flow of their incomes so as to decrease their saving. Panel (c) illustrates that when people increase their consumption spending the aggregate demand curve shifts right (increases) from AD to AD’. Other things remaining the same for aggregate supply, AS, the increased spending will induce output (and income) to rise above Y1, and the price level to rise above P1 as illustrated in panel (c).
In a closed economy, the adjustment to an excess supply of money will be
played out completely in the bond and real markets. When the economy is open to international transactions, both current account (goods and services) and capital account (short term instruments like bank account balances and currencies as well as portfolio investments and direct investments) responses may result as well. Panel (d) illustrates that when there is an excess supply of money as illustrated in panel (a) or in panel (aa), the supply of dollars to the foreign exchange market may increase from S$ to S$’. This shift results in an excess supply of dollars on the foreign exchange market at exchange rate e1. This excess supply may be interpreted as a Balance of Payments (BoP) deficit because the supply of dollars to buy “things” (merchandise, services, dollar-denominated bank balances, treasury bonds, stock shares, plant and equipment, etc.) from foreign sources exceeds the demand for dollars to purchase “things” domestically. The same result might have been illustrated in panel (d) as a decrease (leftward shift) of the D$ schedule as people attempt to exchange less of the foreign currencies (i.e., to acquire fewer dollars) in the effort to eliminate the excess supply of money.
If exchange rate flexibility is permitted, a BoP deficit causes the foreign currency ("euro" as illustrated) price of the local currency ("dollar" as illustrated) to fall, i.e., the dollar depreciates (or the euro appreciates). The adjustment process plays out in the form of rising domestic output and price level (panel (c)), increasing bond prices (panel (b)), and falling interest rates (panel (a) or panel (aa)). The domestic adjustment process occurs just as it would in a closed economy. In a cleanly floating exchange rate system, there are no international flows of reserves or changes of the domestic money supply. But suppose that the government resolves to prevent depreciation of its currency on the forex market. One way in which to do this is to specify an official exchange rate at euro1, and then to employ the police power of the state to punish transactions at any exchange rate other than euro1. Under this type of fixed exchange regime, a BoP deficit will persist. Imports (M) of “things” (any type, current or capital account) exceed exports (X) of “things” with the result that the (X - M) deficit has to be paid for by an outflow of money. In David Hume’s 19th century discussion of the price-specie flow mechanism, gold would flow out in payment for the imports. In the 21st century, this outflow of money takes the form of foreigners acquiring ownership of domestic currency denominated bank account balances. The money outflow thus decreases the account balances of local citizens and the reserves of their commercial banks. This outflow of money and reserves has the effect of shifting the money supply curve to the left of MS in panel (a), or to the left of MS’ toward MS in panel (aa). This diminishes the excess supply of money in panel (a) or in panel (aa) and prevents the interest rate from falling below i1. If the outflow of money and reserves is sufficient to eliminate the excess supply of money, bond prices won’t rise (panel (b)), interest rates won’t fall (panel (a) or panel(aa)), output won’t increase (panel (c)), and the price level won’t rise (panel (c)). This implies that in the case of a fixed exchange rate regime (like the 19th century gold standard or the 20th century Bretton Woods regime) the BoP deficit will persist and there is no effective mechanism to relieve international disequilibria. An alternative implementation of a fixed exchange rate regime is that a
designated government agency (central bank or treasury department) enters the open market for foreign exchange when the exchange rate departs too far from the official rate (i.e., above or below specified boundaries on either side of the official rate). The exchange control authority purchases or sells foreign exchange by selling or purchasing the domestic currency. In the foreign exchange market illustrated in panel (d) the excess supply of dollars can be eliminated by a central bank purchase of dollars by selling euros. This amounts to an open market sale in the foreign exchange market, the side effect of which is to destroy money and bank reserves. This has the effect of shifting the MS schedule in panel (a) to the left to eliminate the excess supply of money caused by the leftward shift of MD. The effect in panel (aa) is to shift the money supply schedule leftward from MS’ toward its original locus at MS. If the central bank keeps the local currency from depreciating by selling foreign currency, no domestic changes will occur to domestic bond prices, interest rates, the output level, or the price level. The BoP deficit persists and there is no effective mechanism to alleviate international disequilibria. Since domestic monetary policy has been dedicated to fixing the exchange rate, the central bank cannot use it to address domestic macroeconomic issues such as inflation or unemployment. Although there is no technical limit to the ability of a central bank to
supply its own currency in an effort to relieve a BoP surplus and prevent
appreciation of its own currency, the opposite possibility is severely limited.
Suppose that a BoP deficit emerges for non-monetary reasons and the prospect is
for the currency to depreciate. The central bank can prevent depreciation only
as long as it is able to supply the foreign currency to the foreign exchange
market in buying back its own currency (thereby reducing the domestic money
supply and the reserves of domestic commercial banks). Once the central bank
stocks out of the foreign currency, it can no longer prevent depreciation of
its currency. Depreciation ensues until the BoP deficit is alleviated.
Experience during the post-Bretton Woods era (since 1972) suggests that central
banks, singly or in coordination with other central banks, rarely have the will
or enough foreign exchange reserves to fully alleviate BoP deficits. A nominally flexible exchange rate regime has been in place since the early
1970s. Under a flexible exchange regime international adjustment to changing
international circumstances is automatic (though not necessarily immediate as
claimed by some writers). The exchange rate falls until an emerging BoP deficit
is eliminated. This means that the domestic adjustment to an incipient BoP
deficit is increase of domestic output, prices, and employment, just as would
occur in a closed economy. Of course, these increases may be prevented by
exercise of contractionary macropolicy. Unlike a fixed exchange rate regime in
which monetary policy must be dedicated to keeping the exchange rate fixed,
under a flexible exchange rate regime monetary policy is free to be applied to
domestic macropolicy problems.
The possible causes of an emerging or growing Current Account surplus of
a nation are the same items which cause appreciation of its domestic currency.
Three of the most prominent causes are domestic incomes decreasing or
increasing at a slower pace than foreign incomes, foreign inflation at a
faster pace than the domestic inflation rate, and domestic interest rates
which are higher than foreign interest rates. An emerging or growing Current Account surplus is likely to increase
the demand for domestic money in the forex market (i.e., increase the supply
of the foreign currency). Assuming that the supply of the domestic currency to
the forex market does not change, the resulting excess demand for the domestic
currency likely induces appreciation of the domestic currency. The appreciation
of the domestic currency makes the nation's exportables look more expensive to
foreigners and imports from abroad appear cheaper to citizens, thereby
alleviating the Current Account surplus.
A major source of the increasing demand for the domestic currency on the
forex market is foreigners who wish to import goods and services from domestic
producers, invest in the nation, or make unilateral transfers (gifts) to
citizens of the nation. Another source of the increasing demand for the
domestic currency is citizens of the nation attempting to convert quantities of
the foreign currencies into the domestic currency in order to repatriate export
earnings or foreign investment income. As the foreign currencies are exchanged
for the domestic currency in the forex market, the relevant domestic money
supply (that which motivates the behavior of citizens of the nation) increases
by the amount not involving citizen-to-citizen or foreigner-to-foreigner
transactions. As described in Chapters 6 and 8, assuming that the domestic money demand
does not change, the domestic money supply increase likely results in rising
domestic prices, falling domestic interest rates, and increasing domestic
employment. The rising domestic prices of tradeables tend to reduce the volume
of exports and increase the volume of imports. The falling domestic interest
rates tend to increase the volume of investment by citizens in other countries
and decrease the volume of investment by foreigners in the nation. The
increasing domestic employment increases incomes and thus stimulates imports.
These three phenomena supplement the appreciation of the domestic currency in
alleviating the Current Account surplus. The burden of adjustment borne by
domestic prices, interest rates, and employment is lessened to the extent that
currency appreciation occurs. If appreciation of the domestic currency is
prevented by government authorities, the full burden of adjustment to the
Current Account surplus will descend upon domestic prices, interest rates,
employment, and incomes.
Chapter 20 illustrates the effects of macroeconomic phenomena
which culminate in balance of payments deficits. The graphic models and
exposition of this chapter are revisions to illustrate the effects of
macroeconomic phenomena which culminate in balance of payments
surpluses.
Panel (a) of Figure 13a-1 illustrates a scenario in which the initiating
change occurs in the private sector rather than by macropolicy. Starting from a
situation of equilibrium in all markets, assume that the demand for money to
hold increases as illustrated in panel (a) by the rightward shift of the money
demand schedule from MD to MD'. The horizontal bracket
indicates an excess demand for money in the sense that at interest rate i1
people would like to hold more money than is in circulation, MS. A similar scenario, but one for which the initiating factor occurs as a
matter of macropolicy, is illustrated in panel (aa) of Figure 13a-1. Here the
central bank, in an effort (for whatever unspecified reason) to implement a
contractionary (or “tight”) monetary policy, reduces the money supply from MS
to MS’ by conducting open market sales of treasury bonds. As in
panel (a), the horizontal bracket in panel (aa) represents an excess demand for
money at interest rate i1. Panel (b) in Figure 13a-1 illustrates the Keynesian conclusion that people
can get more money to hold by selling some of the “bonds” (a Keynesian
euphemism for all kinds of financial instruments) that they hold in their
portfolios of assets. This is illustrated in panel (b) as the rightward shift
in the bond supply curve from SB to SB’. Other things
remaining the same, bond prices will fall below PB, causing bond
yields to rise above i1 in panel (a) or in panel (aa). Monetarists suggest that the bond market is not the only place where people
can get more money to hold. They may do so by decreasing their consumption
spending relative to the flow of their incomes so as to increase their saving,
and they may then hold their savings in the form of idle money balances to
satisfy their excess demand for money to hold. Panel (c) illustrates that when
people decrease their consumption spending the aggregate demand curve shifts
left (decreases) from AD to AD’. Other things remaining the same for aggregate
supply, AS, the increased saving will induce output (and income) to fall below
Y1, and the price level to fall below P1 as illustrated
in panel (c). In a closed economy, the adjustment to an excess demand for money will be
played out completely in the bond and real markets. When the economy is open to
international transactions, both current account (goods and services) and
capital account (short term instruments like bank account balances and
currencies as well as portfolio investments and direct investments) responses
may result as well. Panel (d) illustrates that when there is an excess demand
for money as illustrated in panel (a) or in panel (aa), the supply of dollars
to the foreign exchange market may decrease from S$ to S$’.
This shift results in an excess demand for dollars on the foreign exchange
market. This excess demand may be interpreted as a Balance of Payments (BoP)
surplus because the demand for dollars to buy “things” (merchandise, services,
dollar-denominated bank balances, treasury bonds, stock shares, plant and
equipment, etc.) domestically exceeds the supply of dollars to the foreign
exchange market to purchase “things” from foreign sources. The same result
might have been illustrated in panel (d) as an increase (rightward shift) of
the D$ schedule as people attempt to acquire more dollars on the
foreign exchange market to meet the excess demand for money to hold illustrated
in panel (a) or in panel (aa). If exchange rate flexibility is permitted, a BoP surplus causes the foreign
currency ("euro" as illustrated) price of the local currency
("dollar" as illustrated) to rise, i.e., the dollar appreciates (or
the euro depreciates). The adjustment process plays out in the form of falling
domestic output and price level (panel (c)), falling bond prices (panel (b)),
and rising interest rates (panel (a) or panel (aa)). The domestic adjustment
process occurs just as it would in a closed economy. In a cleanly floating exchange rate system, there are no
international flows of reserves or changes of the domestic money supply. One way in which to impose fixed exchange rates is to employ the police
power of the state to specify an official exchange rate at euro1,
and then to punish transactions at any exchange rate other than euro1.
Under this type of fixed exchange regime, a BoP surplus will persist. Exports
(X) of “things” (any type, current or capital account) exceed imports (M) of
“things” with the result that the (X - M) surplus has to be paid for by an
inflow of money. (In David Hume’s 19th century discussion of the price-specie
flow mechanism, gold would flow in to pay for the exports.) The inflow of money
adds to the account balances of local citizens and the reserves of their
commercial banks. This inflow of money and reserves has the effect of shifting
the money supply curve to the right of MS in panel (a), or to the
right of MS’ toward MS in panel (aa). This shift meets the
excess demand for money to hold and prevents the interest rate from rising
above i1. If the inflow of money and reserves is sufficient to meet
the excess demand for money to hold, bond prices won’t fall (panel (b)),
interest rates won’t rise (panel (a) or panel (aa)), output won’t fall (panel
(c)), and the price level won’t fall (panel (c)). This implies that in the case
of a fixed exchange rate regime (like the 19th century gold standard or the
20th century Bretton Woods regime) the BoP surplus will persist and there is no
effective mechanism to relieve international disequilibria. An alternative implementation of a fixed exchange rate regime is that a
designated government agency (central bank or treasury department) commits to
enter the open market for foreign exchange if the exchange rate departs too far
from the official rate (i.e., above or below specified boundaries on either
side of the official rate) to purchase or sell foreign exchange by selling or
purchasing the local currency. In the foreign exchange market illustrated in
panel (d) the excess demand for dollars can be met by a central bank sale of
dollars to purchase euros. This amounts to an open market purchase in the
foreign exchange market, the side effect of which is to create money and bank
reserves. This newly created money has the effect of shifting the MS
schedule in panel (a) to the right to meet the excess demand for money to hold
caused by the rightward shift of MD. The effect in panel (aa) is to
shift the money supply schedule rightward from MS’ back toward its
original locus at MS. If the central bank keeps the local currency
from appreciating by buying the foreign currency, no domestic changes will
occur to domestic bond prices, interest rates, the output level, or the price
level. The BoP surplus persists and there is no effective mechanism to
alleviate international disequilibria. Since domestic monetary policy has been
dedicated to fixing the exchange rate, the central bank cannot use it to
address domestic macroeconomic issues such as inflation or unemployment. Under a flexible exchange regime, international adjustment to changing
international circumstances is automatic (though not necessarily immediate as
claimed by some writers). The exchange rate rises until an emerging BoP surplus
is eliminated. This means that adjustment to an incipient BoP surplus is
decline of domestic output, prices, and employment, just as would occur in a
closed economy. Of course, these declines may be prevented by exercise of
stimulative macropolicy. Unlike a fixed exchange rate regime in which monetary
policy must be dedicated to keeping the exchange rate fixed, under a flexible
exchange rate regime monetary policy is free to be applied to domestic
macropolicy problems. In the modern era of nominally floating exchange rates, governments may act
singly or in concert with governments of other nations (often in a “group of
seven”) to try to prevent change of exchange rates in a direction perceived as
undesirable, or to precipitate change of exchange rates in a direction thought
to be desirable. Such an exchange regime has been called a “dirty float.”
Suppose that the central bank or treasury department can supply some, though
not enough, of the appreciating currency to the foreign exchange market (i.e.,
it can buy some but not enough of the foreign currency). In panel (d) of
Figures 13-4 , the excess demand gap for dollars may be partially filled with
sales of dollars to purchase euros, thereby slowing but not entirely preventing
the appreciation of the dollar. The dollar cannot appreciate far enough to
eliminate the BoP surplus, i.e., the increase in the supply of money in panel
(a) or panel (aa) is not sufficient to fully satisfy the excess demand for
money to hold. Bond prices will fall some in panel (b), the interest rate will
rise some in panel (a) or in panel (aa), output will fall some below Y1
in panel (c), and the price level will fall some below P1 in panel
(c). Technically, there is no limit to the ability of a central bank to supply
its own currency to the foreign exchange market (i.e., engage in open market
purchases of a foreign currency) since in a debt-money using world a central
bank can create any amount of its own money in simply buying things from open
markets. This means that if the central bank of the dollar-issuing nation
illustrated in panel (a) and in panel (aa) wished to do so, it could purchase
enough euros (i.e., supply enough dollars) to more than fill the BoP surplus
gap and precipitate depreciation of its own currency by fostering a BoP
deficit. This would have the effect in panel (a) or in panel (aa) of increasing
the domestic money supply to the right beyond MS to create an excess
supply of money at interest rate i1. Forcing depreciation in this
manner causes the bond supply schedule to decrease (shift left) from SB,
precipitating an increase of bond prices in panel (b) and a decrease of
domestic interest rates in panel (a) or in panel (aa). The ensuing rightward
shift of aggregate demand beyond AD in panel (c) would induce output to
increase beyond Y1 (limited by full employment constraints) and the
price level to rise above P1.
Can exchange rate flexibility insulate the domestic economy from international disturbances? Suppose that there has occurred an externally-sourced (foreign) decrease of demand for domestically produced "things" (anything, including merchandise, services, financial instruments, direct investments, etc.). If this decreased demand impacts primarily the current account (merchandise and services), the result is a decrease of exports (X). Panel (d) of Figure 13-5 illustrates the resulting decrease of the demand for dollars on the foreign exchange market to purchase such things, precipitating an incipient balance of payments (BoP) deficit and portending a depreciation of the exchange rate.
While our objective is to consider the insulating properties of exchange rate flexibility relative to foreign disturbances, we should note that in panel (dd), the same incipient BoP deficit and exchange rate depreciation pressure would results from an internally-sourced increase of the demand for foreign made things which shifts the supply schedule for dollars to the forex market to the right. If the increased demand for foreign things impacts primarily the current account, the result is an increase of imports (M).
In either case illustrated in panels (d) or (dd), net exports (X - M) decreases, causing a decrease of aggregate demand illustrated as a leftward shift of the AD curve in panel (c). To the extent that AD decreases, real output (Y) falls and unemployment rises.
Under a flexible exchange rate regime, if depreciation occurs concurrently with the decreased demand for exports or increased demand for imports, the lower foreign price of the domestic currency makes domestic goods appear cheaper to foreigners and foreign-made goods appear more expensive to domestic consumers. Both effects offset the leftward shift of AD in panel (c), and ideally will prevent any net leftward shift. In this best-case scenario, the exchange rate depreciation serves to insulate the domestic
economy completely from the effects of decreased demand for domestically produced things or the effects of increased domestic demand for foreign-made things. Output doesn't fall and unemployment doesn't rise.
Exchange rates respond to a variety of influences other than what is happening in the current account (X - M), and they often respond sluggishly to changing international conditions. If the exchange rate falls too slowly or doesn't fall far enough to prevent a net leftward shift of AD, output and employment may fall, at least temporarily. In such less-than-ideal scenarios, exchange rate flexibility may not be sufficient to completely insulate the domestic economy from foreign
disturbances.
In contrast, under a fixed exchange rate regime there is virtual certainty that international disturbances will impact the domestic economy. How they do so depends critically upon the strengths of secondary effects. One way in which exchange rates may be fixed is to specify an official exchange rate at euro1, and then to employ the police power of the state to punish transactions at any exchange rate other than euro1. With an overvalued currency which cannot depreciate,
increasing imports or decreasing exports cause a growing current account (X - M) deficit that decreases aggregate demand, shifting the AD curve to the left toward AD'. Output and income falls and unemployment rises.
Secondary effects may ameliorate the contraction. Consequent upon the falling incomes, the demand for money decreases, illustrated as a shift in panel (a) from MD to MD', causing an excess supply of money at interest rate i1. In the Keynesian transmission mechanism, the excess supply of money causes the demand for bonds to increase from DB toward D'B in panel (b), raising bond prices and depressing
interest rates in panel (a) below i1. As interest rates fall, interest-sensitive consumer and business investment spending increase. In the monetarist transmission mechanism, some to the excess money supply goes directly to consumption spending, irrespective of interest rates. In either case, the increased spending causes aggregate demand to recover from AD' back toward AD, thereby ameliorating the initial contraction.
But other secondary effects may dampen the amelioration. The emerging BoP deficit has to be paid for by an outflow of money, represented by the excess supply of dollars to the forex market at euro1 in panel (d). In David Hume’s 19th century discussion of the price-specie flow mechanism, gold would flow out in payment for the imports. In the 21st century, the money outflow usually is accomplished by foreigners acquiring ownership of dollar-denominated bank balances in payment for the excess of imports over exports. The money outflow decreases the account balances of local citizens and the reserves of their commercial banks. This outflow of money and reserves has the effect of shifting the money supply curve to the left of MS in panel (a). This diminishes the excess supply of money in panel (a) and may prevent the interest rate from falling below i1. If the outflow of money and reserves is sufficient to eliminate the excess supply of money, bond prices won’t rise (panel (b)), interest rates won’t fall (panel (a)), output won’t increase (panel (c)), and the price level won’t rise (panel (c)). This implies that when exchange rates are fixed an international disturbance is likely to have adverse impact on the domestic economy when all of the secondary effects are taken into account. This also implies that in the case of a fixed exchange rate regime like the 19th century gold standard or the 20th century Bretton Woods regime, the BoP deficit will persist and there is no effective mechanism to relieve international disequilibria.
In the more liberal (market oriented) implementation of a fixed exchange rate regime, a designated government agency (central bank or treasury department) enters the open market for foreign exchange when the exchange rate departs too far from the official rate (i.e., above or below specified boundaries on either side of the official rate). The exchange control authority purchases or sells foreign exchange by selling or purchasing the domestic currency. The decreased net exports decreases aggregate demand, illustrated as the leftward shift toward AD' in panel (c). Output and income falls, and unemployment rises. As income falls, the demand for money decreases, illustrated as the shift to MD' in panel (a). In the foreign exchange market the excess supply of dollars illustrated in panel (d) can be eliminated by a central bank purchase of dollars by selling euros. This amounts to an open market sale in the foreign exchange market, the side effect of which is to destroy money and bank reserves. This has the effect of shifting the MS curve in panel (a) to the left to eliminate the excess supply of money caused by the leftward shift of MD. If the central bank keeps the local currency from depreciating by selling foreign currency, the domestic economy is likely to be impacted adversely by the external disturbance. As long as the BoP deficit persists, there is no effective mechanism to alleviate international disequilibria. And, since domestic monetary policy has been dedicated to fixing the exchange rate, the central bank cannot use it to address domestic macroeconomic issues such as inflation or unemployment.
There is a severe limit to the ability of a central bank to prevent
depreciation of its own currency. It can prevent depreciation only as long as it is able to supply the foreign currency to the foreign exchange market in buying back its own currency (thereby reducing the domestic money supply and the reserves of domestic commercial banks). Once the central bank stocks out of the foreign currency, it can no longer prevent depreciation of its currency. Depreciation ensues until the BoP deficit is alleviated. Experience during the post-Bretton Woods era (since 1972) suggests that central banks, singly or in coordination with other central banks, rarely have the will or enough foreign exchange reserves to fully alleviate BoP deficits.
When the economy experiences either an increase
or a decrease of aggregate demand or a decrease of aggregate supply, there
is a natural tendency for the adjustment process to return the economy
to its normal operating capacity, although there may be lasting effects
upon the rate of price inflation. However, the natural adjustment process
takes time, perhaps extending beyond a few quarters and to several years.
Belated responses or overreactions by business decision makers may set
in motion cyclical oscillations which are felt with dampening effects for
years, especially if managers attempt to control inventories within narrow
limits.
The rationale for bringing the offices of government to bear upon the stability of the economy is based upon the view that market economies are naturally unstable, that the degree of instability is intolerable, and that some force must be applied to counteract the natural instability of the market economy. The only entity in the economy that can possibly bring enough force to bear upon the problem of instability is the government.
The government's best hope of eliminating or diminishing instability lies in influencing the components of aggregate demand and aggregate supply. The means by which the government can influence aggregate demand and supply is through the government's monetary and fiscal policies.
Monetary policy, the control of the money supply and interest rates, affects interest-sensitive business and consumer purchases and any consumer spending tat is motivated by financial liquidity (i.e., a "real balance effect"). Fiscal policy is implemented by changing the government's purchases from the private sector, or the taxes and other fees which businesses and income recipients pay to the government.
If government officials could perfectly predict private sector changes of
aggregate demand or supply, they could devise offsetting changes of the
government's budget which would neutralize the private sector shifts. For
example, suppose that in Figure 14-1 a decrease of aggregate demand from
AD1 to AD2 is sourced in the private sector (a collapse of investment or consumption spending) and can be perfectly predicted.
In order to prevent output from falling to Y2 with an attendant increase of unemployment, the government could increase its own purchases by the same amount as the decrease of aggregate demand. Or it might reduce tax collections by enough to stimulate a corresponding increase of consumption spending. The effect would be to return aggregate demand from AD2 to AD1 or perhaps even to prevent it from falling away from AD1.
A private-sector sourced increase of aggregate demand, if perfectly predicted, could be neutralized by a same-magnitude decrease of government purchases or an increase of tax collections which would reduce consumption purchases by the required amount. With such perfect offsets of spending changes in the private and public sectors, inventories would not change and the macroeconomy would be stabilized.
Monetary policy might be used to effect off-setting changes of aggregate demand. In order to counter a predicted aggregate demand decrease, the monetary authority would have to pursue an expansionary monetary policy by lowering bank reserve requirements, lowering the short-term bank rate, or buying bonds or other financial instruments from banks or parties in the private sector. The resulting monetary expansion, if it is not otherwise offset, results in falling interest rates to stimulate interest-sensitive expenditures and increased liquidity to stimulate liquidity-sensitive consumption purchases.
A predicted aggregate demand increase might be offset by implementing a restrictive monetary policy, i.e., by raising bank reserve requirements, increasing the discount rate, or selling financial instruments. The ensuing monetary contraction, if it is not otherwise neutralized, will result in rising interest rates and diminishing liquidity to elicit the desired offset to the increase of aggregate demand.
Shifts of aggregate supply in a market economy are even more difficult
for government to offset by manipulating its own budget since it has no
direct control over production capacity or cost conditions. It may be able to exert some influence over aggregate demand in the long run by taking actions to make markets work more efficiently, to remove market imperfections which impede the mobility or availability of resources, to diminish reporting or compliance costs, or to remove disincentives to work or assume risks.
It may be possible to implement a fiscal policy stimulus which will counter an adverse aggregate supply shift. Suppose that a supply shock causes the aggregate supply curve to shift from AS1 to AS2 as illustrated in Figure 14-2.
The ensuing consequence is a fall of real output to Y2 below the normal operating capacity, N, accompanied by rising unemployment and cost-push inflation from P1 to P2.
If the government can be patient, it is possible that the aggregate supply
curve will recover to its earlier position after the shock has abated, so
that output can return to the normal operating capacity and the rate of
inflation diminish. However, if this does not happen, or if it takes
too long to happen, the government may implement a fiscal stimulus (i.e.,
increasing purchases or cutting taxes) to shift the aggregate demand curve
from AD1 toward AD2. While this may hasten the return of real output to the normal operating capacity of the economy and relieve unemployment, it will likely also result in some more inflation, this time demand-pull, from P2 to P3.
Unfortunately, the world does not work like this in many respects. For
one, changes of government purchases or tax collections have impacts on
the government's budget. If an expansionary fiscal policy causes the budget to go into deficit (i.e., expenditures in excess of revenue), the deficit must be financed. This can be done in only two ways, either by creating money or by borrowing from private sector capital markets. The former will likely cause inflationary pressures, while the latter will result in rising interest rates which may crowd-out some private sector investment, thereby offsetting the fiscal stimulus. In Figure 14-3, the intent of government was to implement a fiscal stimulus sufficient to shift aggregate demand from AD1 to AD2 and return output from Y2 to Y1.
However, rising interest rates consequent upon deficit financing
the public sector fiscal stimulus crowded out some private sector investment, allowing aggregate demand to increase only as far as Y2'. The crowding-out effect "snubbed" the fiscal stimulus so that there was only a partial recovery.
Even if it were possible to accurately predict the magnitude of an autonomous aggregate demand or supply shift, with our present knowledge and limited ability to control fiscal variables, it is highly unlikely that the right fiscal change can be implemented with any degree of precision. Thus, the fiscal measure taken would likely be either inadequate or excessive relative to the amount of autonomous change to be offset. Suppose in Figure 14-2 that the government "over does it" by precipitating an excessive aggregate demand shift even beyond AD2 and there is no significant crowding-out effect. The economy may attempt to produce above its normal operating capacity with even more demand pull inflation.
It is even more difficult to use monetary policy as a means of attempting
to offset private-sector changes of aggregate demand because the linkages
between money-supply changes and spending are only indirect and imprecise.
The monetary policy transmission mechanism works either through changing
interest rates which affect interest-sensitive purchases, or through the
so-called real-balance effect of a change in liquidity which induces
consumer spending changes. At this stage of our understanding, it is not
possible with any degree of precision to effect the right change of any
monetary aggregate which will elicit just the appropriate offsetting change of aggregate demand.
Finally, we should note the distinct possibility that domestic macroeconomic stabilization may not be the highest priority of the government, or at least not until the economy becomes seriously destabilized by excessive inflation or unemployment or both. Under more normal circumstances, particularly in democratic societies, the government's agenda may require it to become oriented mainly to program needs rather than economic stability. Program needs may include social, military, or infrastructure projects. The dominant fiscal motivation of a democratically elected government may be financing the expenditures to which it has become committed, irrespective of the fiscal requirements of economic stability. When the needs of fiscal finance dominate public policy, the government loses its capacity to manipulate its budget in the pursuit of economic stability.
Figure 6-1 can be used to examine the demand for investment spending:
The macroeconomic model depicted in Figure 6-1 is mathematically indeterminate, i.e., too much must be known in order to find the solution. This follows from the fact that there are fewer equations (represented by graphed functions) than there are variables in the model. This problem can be remedied by introducing enough additional equations.
In the long run, the economy's normal operating capacity, N, tends to increase with economic growth, that is, as population grows and productivity increases with technological advance and capital investment. Recent experience in Western market economies indicates that N increases on average between 2 and 3 percent per annum, but varies signifiantly with cyclical or irregular macroeconomic fluctuations. Long-run growth and short-run fluctuations may be depicted by rightward or leftward shifts of the vertical LRAS curve.
The aggregate expenditure and aggregate demand schedules do not occupy the same two-dimensional graphic plane even though they share a common axis. Assuming a linear consumption function and that the short run aggregate supply curve does not diverge from the long run aggregate supply curve, the relationship between AE and AD may be illustrated in the three-dimensional panel (a) of Figure 7-6.
In a financial sense, interest may be defined as the price for the use of a dollar’s (or other local currency unit's) worth of credit for a year. The nominal interest rate is determined by the interaction between forces of demand and supply in the loanable funds market as illustrated in Figures 8-1 and 8-2.
Interest is construed as the return to financial instruments other than money. Figures 8-3 and 8-4 illustrate the determination of the interest rate by the interaction of the forces of demand for and supply of money.
Population growth and productivity advance tend to cause the normal operating capacity of the economy to increase at some rate. This rate has ranged from 1 to 3 percent per annum in Western market economies during the early years of the twenty-first century. This growth of the normal operating capacity of the economy can be expected to shift the long run aggregate supply curve, LRAS in Figure 7-1, to the right at the same rate, carrying with it a short-run aggregate supply curve, SRAS.
Although the aggregate demand-supply model is intended to provide only short-run analysis of the macroeconomy, it can be shifted into a "comparative static" mode (i.e., superimposed successive shifts of curves over a long-enough time period) to demonstrate the possibility
of cyclical behavior. To illustrate this possibility, we reproduce Figure
7-3 in Figure 10-1 and add a time sequence graph below it to demonstrate cyclical behavior.
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