Transcript Introduction

INTERNATIONAL MONETARY
AND
FINANCIAL ECONOMICS
Chapter 13
Third Edition
The Price Level,
Real Output,
and Economic
Policymaking
Joseph P. Daniels
David D. VanHoose
Copyright © South-Western, a division of Thomson Learning. All rights reserved.
Deriving the Aggregate Demand Schedule
Panel (a) shows that a rise in the price level induces an increase in the
equilibrium nominal interest rate through the real balance effect, as the
LM schedule shifts back along the IS schedule from point A to point B.
Because equilibrium real income falls as the price level increases, the
aggregate demand schedule containing real income–price level
combinations A and B slopes downward in panel (b).
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The Effect of an Increase in the Money stock on
Aggregate Demand in a Closed Economy
With an unchanged price level, an increase in the nominal quantity of
money in circulation causes an increase in the amount of real money
balances and shifts the LM schedule downward and to the right along
the IS schedule in panel (a). Because the resulting real income level at
point B in panel (b) corresponds to the same price level, this new
equilibrium real income–price level combination lies on a new aggregate
demand schedule to the right of the real income–price level combination
at point A on the original aggregate demand schedule. Thus, an increase
in the nominal money stock causes an increase in aggregate demand.
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The Effect of an Increase in the Money Stock
with a Fixed Exchange Rate
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The Effect of an Increase in the Money Stock
with a Fixed Exchange Rate
In all three pairs of panels, an increase in the money stock
causes the LM schedule to shift downward and to the
right. The induced increase in real income causes import
spending to rise, and the induced decline in the nominal
interest rate results in capital outflows, and these effects
together lead to a balance-of-payments deficit.
If the central bank sterilizes its interventions to maintain a
fixed exchange rate, then the money stock remains at its
higher level, M2, and the aggregate demand schedule
shifts fully to the position yd(M2). With unsterilized
interventions, however, the money stock falls back
toward its original level of M1. Consequently, the
aggregate demand ultimately returns to its original
position.
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The Effect of an Increase in the Money Stock
with a Floating Exchange Rate
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The Effect of an Increase in the Money Stock
with a Floating Exchange Rate
In all three pairs of panels, an increase in the
money stock causes the LM schedule to shift
rightward, resulting in a balance-of-payments
deficit, which, in turn, causes a domestic
currency depreciation. The rise in the exchange
rate stimulates greater net export expenditures
and raises equilibrium real income.
With higher capital mobility, the extent of capital
outflow and, consequently, the size of the
resulting depreciation and real income effect,
rise. Hence, higher capital mobility enhances the
amount of the expansion in aggregate demand
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induced by a rise in the money stock.
The Effect of An Increase in Government Spending on Aggregate
Demand in a Closed Economy
With an unchanged price level, an increase in government spending shifts the IS
schedule rightward along the LM schedule from point A to point B in panel (a). The
resulting real income level at point B in panel (b) corresponds to the same price
level, and this new equilibrium real income–price level combination is located on a
new aggregate demand schedule to the right of the real income–price level
combination at point A on the original aggregate demand schedule. Consequently,
an increase in government spending causes an increase in aggregate demand.
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The Effect of Government Spending with a
Fixed Exchange Rate
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The Effect of Government Spending with a
Fixed Exchange Rate
•In all three pairs of panels, an increase in government
expenditures causes the IS schedule to shift rightward,
inducing initial increases in the equilibrium nominal
interest rate from R1 to Rand in the level of equilibrium
real income from y1 to y.
•Panel (a1) shows that with low capital mobility, there is a
balance-of-payments deficit which requires the central
bank to sell foreign exchange reserves, thereby resulting
in a final equilibrium at point C in panel (a2). Panels (b)
and (c) show that with higher or perfect capital mobility, a
rise in government spending causes a balance-ofpayments surplus at point B. To keep the exchange rate
from declining in both cases, the central bank must
purchase foreign exchange reserves, which leads to a 10
final equilibrium at point C and larger increases in
The Effect of Government Spending with a
Floating Exchange Rate
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The Effect of Government Spending with a
Floating Exchange Rate
• In all three pairs of panels, an increase in government
expenditures causes the IS schedule to shift rightward,
inducing initial increases in the equilibrium nominal interest
rate from R1 to R and in the level of equilibrium real
income from y1 to y .
• Panel (a1) depicts a situation of low capital mobility, which
the rise in government spending causes a balance-ofpayments deficit at point B, which induces a currency
depreciation and an additional rightward shift in the IS
schedule. With high or perfect capital mobility an increase in
government spending causes a balance-of-payments
surplus, a currency appreciation, and a partially or fully
offsetting leftward shift in the IS schedule.
• Thus, the aggregate demand effect of a rise in government 12
expenditures is mitigated by higher capital mobility.
The Aggregate Production Function
and the MPN Schedule
Given a fixed stock of capital and a current state of technology, higher levels of
labor employment are necessary to achieve increased production of real output.
The bowed, or concave, shape of the production function in panel (a) reflects the
law of diminishing returns, which states that total output increases at a
decreasing rate for each additional one-unit rise in employment of labor.
Consequently, as shown in panel (b), the marginal product of labor declines as
employment rises.
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The Demand for Labor
A profit-maximizing firm employs labor to the point at which the value of
labor’s marginal product is equal to the nominal wage. Thus, a rise in the
nominal wage reduces the quantity of labor demanded by a firm.
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Employment and Output Determination with
Fixed versus Flexible Nominal Wages
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Employment and Output Determination with
Fixed versus Flexible Nominal Wages
• Panels (a) show that if wages are inflexible, then the
overall level of nominal wages Wf does not vary with a
change in the position of the VMPN schedule resulting
from a rise in the price level.
• Consequently, employment rises from N1 at point A to
N2 at point B, as the value of workers’ marginal product
increases, inducing firms to demand more labor. The
resulting increase in employment cause a movement
from point A to point B along the aggregate production
function, so that aggregate real output increases from y1
to y2.
• Hence, the aggregate supply schedule slopes upward
with fixed nominal wages.
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Employment and Output Determination with
Fixed versus Flexible Nominal Wages
• In contrast, panels (b) show that if Wb is
an initial, base level of wages, then
automatic contractual adjustment of wages
in response to an increase in the price
level, to Wb +(P2 – P1), results in no
change in employment or output.
• Hence, with complete wage adjustment to
price changes, the aggregate supply
schedule is vertical.
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The Short-Run and Long-Run
Aggregate Supply Schedule
Over the short run, when
nominal wages are fixed and
do not adjust to changes in the
price level, the aggregate
supply schedule, ys (Wf)
slopes upward. In the long run,
which is a sufficiently lengthy
interval during which the wage
determination process can
account for an increase in the
price level, the aggregate
supply schedule is vertical, as
illustrated by the schedule
denoted ys LR.
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Determination of the Equilibrium Price
Level and Equilibrium Real Output
The equilibrium price level and the
equilibrium level of real output arise at
the intersection of the aggregate
demand and aggregate supply
schedules. This point, denoted E, is
on the aggregate demand schedule
and corresponds to a point of IS–LM
equilibrium. At the same time, this
point is on the aggregate supply
schedule. If the price level happened
to equal P2, then the level of
aggregate desired expenditures is
consistent with an output level equal
to y3, but the aggregate output level
that firms produce is equal to y2.
Thus, the equilibrium price level must
rise to P1.
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The Effects of a Policy-Induced
Increase in Aggregate Demand
An expansionary monetary,
exchange rate, or fiscal policy
action causes the aggregate
demand schedule to shift to
the right along the short-run
aggregate supply schedule.
This results in a rise in the
equilibrium price level and an
increase in equilibrium real
output.
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Nominal Wages and Employment
under Rational Expectations
At the initial points labeled A, workers and firms have established an initial base
wage given their expectation of the price level and their anticipation of the value
of the marginal product of labor. If workers and firms form expectations rationally
and recognize that a policy action is likely to raise the price level, then they will
raise their price expectation to and negotiate a higher base nominal wage. As a
result, equilibrium real output will remain unchanged in panel (b), so that the
aggregate supply schedule will shift upward by the amount of the anticipated
increase in the price level, from point A to point B in panel (c).
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Inflation in Selected Nations
Since the mid-1980s, consumer price inflation rates in the United States,
Germany, and Japan have been well below those in most other nations.
Nevertheless, all nations typically have experienced positive inflation in nearly
every year.
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The Inflation Bias of Discretionary
Policymaking
If the current equilibrium for the economy is point A,
and if the policymaker’s goals are to raise output
toward the capacity output level yT but to keep
inflation low, then the policymaker’s temptation is to
split the difference between these conflicting
objectives by inducing a rise in aggregate demand, to
point B. But if workers realize that the policymaker
has an incentive to permit prices to rise, then they will
bargain for higher contract wages, thereby shifting the
aggregate supply schedule leftward. This means that
if the policymaker ignores the temptation to induce a
rise in aggregate demand, the result will be higher
prices and lower real output at point D. To avoid this,
the policymaker must raise aggregate demand as
workers expect. The final equilibrium in the absence
of policymaker credibility not to increase inflation,
therefore, is at point C. The increase in the price level
caused by a movement from point A to point C is an
inflation bias resulting from discretionary
policymaking.
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Central Bank Independence, Average
Inflation, and Inflation Variability
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