International Economics Part I

Monetary Policy and Financial Policy

Balance sheet recession: financial recession that causes an economic recession.
The 2007 crisis started as a normal crisis (boom and bust) but just after a few months It was evident that the crisis
was far from normal. Is it even over?
Why didnt anybody notice? This is an unexpected story because it is explaining a Big Storm (Great Crisis) after a
Big Quiet (Great Moderation a very exceptional macroeconomic performance).

The Golden Age of Great Moderation

Alan Grenspan (nickname Maestro or Wizard)]: after the terrible 70s there was a large drop in inflation and in
unemployment.
US: increasing growth with stable inflation a Divine Coincidence (Blanchard)
Why?
Remember the Phillips curve unemployment on the horizontal axis, inflation on the vertical, and the standard
Phillips curve is downward sloping and it shows that there is a trade-off between the two: one country might
choose very low unemployment and combine it with high inflation; another might choose very low inflation but
high unemployment [Germany, The Netherlands, Finland] It is possible to go from either of the points to
arrive to a middle point, but again, there is a cost [to reduce inflation, increase unemployment and vice versa].
During the GM the Phillips Curve disappeared there was low unemployment and low inflation. The years before
the crisis were really particular: growth with low inflation.
Not just the US: In the UK after the terrible 80s the same happened; Italy as well (a non Anglo-Saxon example).
And STABILITY (important consumer can plan consumption better and firms/entrepreneurs also rely on stability
when it comes to planning). In macroeconomics the equilibrium variables are the level of output and level of price,
but that is not the real world the real world is about inflation and level of growth, all of which are highly
influenced by stability.

The gray lines represent Recessions (drop in GDP by a

quarter) and the closer we are to the 2000s, the less common
the recessions are. The purple line is the volatility of GDP
which stabilizes after the 80s.

Black is the inflation, gray is the volatility of inflation after the

80s both are low and stable and this is not only true for US.

Looking at 24 OECD countries in 80 - late 90s, they are more stable in both real and nominal terms, volatility keeps
decreasing, there are no jumps in volatility.
1. 11 drops in both GDP and inflation volatility
2. 20 drops in inflation volatility
3. No cases of jumps in both GDP and inflation volatility
The GM: Summing up
Before the GC, the GM was a period with stable macroeconomic performances and such stability is the
macroeconomic goal.
In terms of macroeconomic policies we dont need them. They are automatic results of good market structures.
What matters is the micro foundations: Good rules of the game.
-

Good institutions on one side and good rule of law on the other side. The better the rule of law, the more
likely all the markets are to be efficient, and the more micro markets are efficient, the better the macro
performance.

GM Economics: macro stability predictable and positive outcome of micro rational choices (like a well
functioning highway) and macro instability macro results can be unpredictable and negative outcome of micro
rational choices (like a traffic jam).
Are we wasting time speculating on this story? Is it relevant to speak about the crisis?

Recession: a fall in GDP in two successive quarters, at least.

Stagnation (secular): negligible or no economic growth.

Are we out of the crisis? For a part, yes. But it could be a double dip being out of the crisis, but falling in it again.
Where are we? Growth rate (optimal level is 2%, the one from the Great Moderation) is not back at the optimal
level. Optimal inflation rate is also 2% but we arent there either [2 is the magic number = optimal growth and
optimal inflation rate].
Per capita GDP in the crisis and before the countries move in the same direction. After the crisis they move in
different directions for some growth is higher than before, for some unchanged and for Italy, it is far below
(stagnation).
But even for the US the typical projected recovery path is smooth back on the track, but the real data is different.
The trend has changed, it is a lower one. But the same is true for other countries (UK, EU.) they are all
experiencing stagnation.
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There are some positive outliers: Canada, Australia, New Zealand For Canada the data is above the new lower
trend, but still there was a secular drop.
The data is telling us that this time it is different this is not a normal recession.

The need of rethinking macro

Before the crisis there was consensus that the models work. After the crisis, all knowledge on macro was basically
to be thrown in the trash and rethought.
After the explosion of the field (macro) in the 70, there has been enormous progress and substantial convergence.
() The state of macro is good. - Blanchard
-

Krugman said the efficient market idea was wrong, the intuition was reform and change.
Prof. Bernanke (FED before Yellen) finds that we do not need a reinvention of economics, we need to
understand what is going wrong and correct the strategy (not a revolution).

Recession or Stagnation: Which policies do we apply?

There are different views on how to address and fix the macroeconomic problems.
AGGREGATE DEMAND POLICIES
The idea is that we need Aggregate Demand Policies [Krugman and Summers], and to support the idea they used
the structure of trends in real interest rates [nominal interest rates adjusted to inflation]

Remember the Fisher equation nominal interest rate (i) = real interest rate (r) + inflation ()
Ex ante it is not easy to calculate

The dynamics of real interest rate: why are they so interesting and how can it be linked to the increase in aggregate
demand?
Remember macro: which markets depend on real interest rate?
The three different time horizons we look at:
Starting from the production function (Cobb-Douglass) in order to have output, you need labor and capital Y =

f (L ,K)
-

Long Run both labor and capital are variable (use growth model, i.e. Solow)
Medium Run capital is constant (usually) (use AS-AD model, aggregate supply, aggregate demand)
Short Run both capital and labor are constant (use IS LM model)

Our analysis focused on the Medium Run in general because we care about inflation, output growth and
unemployment, but to speak about real interest rates, we need to have Long Run analysis.
Which are the crucial drivers (demand and supply) of real interest rates?
-

The supply car is the saving car [higher real interest rates, higher level of savings positive slope].
The demand for saving has a negative slope (investment demand) [higher real interest rates, less incentive
for investing].

Why are 0 or negative real interest rates a bad thing? Why is it called stagnation?
Two perspectives on zero real rate:
1. Short term: no problem
2. Medium-Long Term: if Expected Rate = Effective Rate there will be distortions in labor, investment and
saving incentives
-

LR, it reduces the incentive of companies to invest [companies, borrowers, are happy that the r is 0 on the
short run, but the longer this is true, they will not invest], on top of that, savers have no incentive to save
at r = 0.

During the GM, there was an excess of saving (really high growth and saving rates), meaning an excess of supply
of savings (a trend towards lower interest rates). To address this problem, we have to increase consumption and
investment. Consumption is still weak everywhere, Investment is also low [all because of uncertainty; under
uncertainty between consumption and saving, you choose saving; between investment and accumulation you
choose accumulation; between real investment and finance you choose finance.
Aggregate Demand Disease:
Given the interest rate (long term) drivers, i.e. savings and investment growth
weakness depends on world lacking demand which produces an excess of saving
relative to opportunities for investment.

- Actors: private players, the State.

- Tools: fiscal and monetary policy indications and others.
Solution: Big government spending (and debt) financed by borrowing at low (zero)
interest rates.

Fiscal policy tools: public expenditures (G) and taxes (T); increase public spending (in case of demand deficit) and
lower taxation (means more income available for households). G (high) T (low) = DEFICIT (high) DEBT (high)

Monetary policy tools (i.e. interest rates): high or low interest rates? To sustain high deficit, we need low interest
rates.
The idea is to increase the role of the state.
-

When Yellen (US) increased interest rates, those who believe in this way were disappointed.

Is there consensus on this idea? NO.

AGGREGATE SUPPLY POLICIES
Aggregate Supply Policies [Spence, Lucas] completely different view, the idea is that the shortcomings are on
the supply side.
They have noted another phenomena looking at GM and real GDP, productivity and input there is a structural
problem. The real problem is the productivity of the overall economic system and not a problem of demand.
Output Growth Productivity relationship
Cobb Douglass Production Function such that
Growth = function (employment, capital stock) y = n + k
Where y = output growth; n = employment growth; k = capital growth and , = marginal productivities

In the Medium Run, capital is fixed, so the change

in output growth depends on change in
productivity. If labor is constant while output is
growing, the driver is productivity.

Coming back to the real interest rate market

Which is the supply side view? Aggregate Supply Disease
It is that the real crucial phenomenon is that the drop in demand
in capital (shift down of demand) is that also the real interest rate is
dropping [people dont invest, people dont work because of too much
state involvement in the economy]
If there is too much state in the economy, incentives to invest
and work are lower because more state means more public expenditure
(how to finance it?), higher taxes, the higher the taxes, the lower the
incentive to work and invest (less profits, more regulation and so on)

Growth weakness depends on world lacking productivity because big state intervention (high taxes)
discourages business confidence in the future

Solution Consequences in terms of fiscal and monetary policy and others:

-

Fiscal policy: low public expenditures, low taxes

Monetary policy: high interest rates (constraint to avoid deficit and public debt)

When Yellen increased interest rates, the supply side fans were also disappointed (too little, too late).
DEBT AND POLICIES APPROACH
The focus is on data on debt: not mentioned before because in the traditional view households are savers,
companies are borrowers; but households can be borrowers as well and are relevant in the real world.
What is the relationship between aggregate demand and debt? An increase in debt means lower or higher
demand?
Income over time should be increasing, and consumption is a fraction of income (so also stable and increasing,
but below it) and this is more true without uncertainty. If you dont know your future profile of income, then the
profile of consumption is also unknown. If there is debt, you can smooth your consumption: you will be borrower
when you are young and a lender when you are old. Therefore, the more it is true that there are no shocks, the
more it is true that more debt means more consumption provided that there are no shocks.
When the crisis came, the US families consumed less (problems with houses and work).
The relationship between AD and debt exists, but the sign can be different from time to time. The bottom
line is that debt is crucial.
Which is the implication for the real interest rates?
During the GM we accumulated too much debt, and we needed deleveraging
too much debt means there can be shocks on the capacity to invest and on
the capacity to supply [too much debt = default, no consumption]
Debt Disease:

Growth weakness depends on past debt excess because the debt burden
discourages both consumption and investment.
It agrees with believers of Aggregate Demand that there is an excess of supply;
and it agrees with friends of the supply that there is a drop in incentive to
invest, but the bottom line is that there is too much debt.

Solution Policy implications:

-

Fiscal policy: Government spending (too much debt, both public and private, so reduce spending to create
incentive to invest expansionary austerity, reduce debt to grow) and taxes (increase taxes to further
reduce deficit and debt) friends of the supply side
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Monetary policy: interest rates (lower, in order to reduce debt: debt restructuring) friends of the
demand side
Others: financial regulation

Drop in output drivers:

-

Secular stagnation: to fix stagnation we need to focus on aggregate demand policies bigger role on the
state Big government spending (and debt) financed by borrowing at low (zero) interest rates
Aggregate supply policies
Debt and policies debt deleveraging: low public spending, high taxation and low interest rates

WEALTH AND DISTRIBUTION AND POLICIES

Wealth Debt Both AD and AS
Consumption C = cY
(c) is the propensity to consume; if you are poor, it will be higher (you wont save), if you are wealthy, it will be
lower (and you will save more) so distribution of wealth matters! Investment I also depends on wealth.

We have Supply of Saving and Demand for Saving, i.e. investment which is
negatively correlated with the interest rate. The Equilibrium Condition
suggests that I = S
Inequality Disease:
Growth weakness depends on income and wealth inequality because
inequality discourages consumption and labor force participation.

Solution Consequences of this view on policies:

-

Fiscal Policy: Public spending (Big, to increase welfare and help the poor) and Taxation (redistributive)
Monetary Policy: Interest Rates (Low to facilitate debt and deficit)
Others: labor policies (not a so-called flexible market, more job security)

INSTITUTIONS AND POLICIES

Proposed it might depend on some non economic factors, such as institutions.
Example: data on public debt: in the 70s there were the oil shocks which led to an increase in public debt, which
continued to increase in the following period (very heterogeneous countries from an economic point of view with
one point in common divergent path in public debt); another group of countries, which suffered the same shocks
but reacted differently with the amount of debt convergence with one common economic feature.
Institutions: political [the first group were proportional regimes, majoritarian regimes political stability.
Rethinking the policy maker this doesnt exist in traditional macro:
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Player 1: Policy maker (traditional macro: benevolent player) - Before in our analysis we acted as the
rational player and not as the good player (focus on welfare); has a much longer time horizon than other
players, looks at maximization of public welfare for the future
Taking the consumer, a micro player, he is not a good player, but a rational player whose focus in on
maximizing utility given the budget constraint
Another player: Firms with the objective of profit and constrained by the production function/ Cobb
Douglas function; also a rational player
New Political Economy View: a policy maker who is a politician, not good or bad, but a rational player
and his objective is to obtain or remain in power (the more career concerned, the simpler the objective
function), win the election, and the constraint is the time horizon between t and t + 1; t being one election
and t +1 being the next (election, re election) which is a much shorter time horizon than that of a policy
maker (they are more short sighted).
Politicians goal is consensus maximization given the institutional setting. The institutional setting shapes
the political cost and benefit analysis, the economic policy choices, finally, the macro performances
economic policies as endogenous result

The policy maker is a long sight agent (complete political cost and benefit analysis), while the politician is a short
sight agent (partial political cost and benefit analysis)
Take public debt: [G T financed by money + debt, and assume that you cant just print money (take EU govs, they
cant print to finance debt)]
- Pros: More spending today (Gains today, costs tomorrow)
- Cons: More taxes tomorrow
Less political stability (weak institutions), shorter time horizon, more debt
A politician would want to gain today, but the shorter the time horizon, the more likely is that he wont care about
costs tomorrow because probability of being in charge is less than 1 and it is easier to increase public debt. This is
a political cost and benefit analysis with economic consequences. Consider the possibility that in some countries
the re-election date is uncertain.
To handle debt, dont change monetary or fiscal policies, but change institutions. Any kind of distortions are really
driven by the rules of the game and nothing else.
Institutional Disease:

Growth weakness depends on institutional weakness because with weak

institutions (low protection of property rights) peoples confidence in the future is
discouraged investment and consumption are discouraged; it can also mean a drop in
productivity (I down) as well as savings down.

Solution: dont change fiscal or monetary policies, just make sure to have strong
institutions

To go back to the five views, to use them, we need a compass essentially using two assumptions:
1. Path breaking point is the Great Crisis
2. There are two drivers to explain the crisis: monetary policy and financial policy
Course Motivation: Time Frame
We will analyze macro facts discovering and discussing alternative policy frameworks. We have three main
periods:
-

Before the Crisis: the Great Moderation and the Great Deviation
The Great Crisis
After the Crisis

Before the Crisis

Starting with FINANCIAL POLICY which is often overlooked in macroeconomic analysis [look at Cobb Douglass it
doesnt account for finance at all]
Finance is leverage production and distribution of leverage contracts (leverage contracts are on both sides of
the balance sheet in terms of loans and deposits)
Examples of Banking include Balance sheet
Assets
Loans (supply)
(free) Reserves
And for Money we refer to the CB Balance Sheet
Assets
Public Bonds

Liabilities and Net Worth

Deposits
Capital
Liabilities and Net Worth
Monetary Base
CAPITAL
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Making money means making profit, the value of money is by definition greater than the cost of producing it [a
10 euro note has value of 10 euros, but the cost of producing it is around 1 cent] and the difference between the
value and the cost is seigniorage.
Finance drivers: Technology + Rules and Creativity

Creativity + Technology and/or Rules = Financial Innovation

Any kind of innovation is the summing up of these three drivers [even in non-economic situations; take Monet, he
represents the creativity factor and he created a new way of painting (impressionism) with a technological
innovation: new brushes in order to break the rules (traditional painting styles)]

Financial Policy
Two different approaches financial policy:
1.
2.

Regulation = Rules Setting

Supervision = Rules Enforcement

BEFORE THE GM: STRUCTURAL REGULATION (Financial Repression Constraints on Competition)

Key assumptions: Bank and Financial Risks can be unpredictable

Take a banker and he is involved in different banking activities; are you able to calculate the risks in every
banking and financial activity? Avoid assuming too much risks. If you cannot calculate risk assumptions
you build up constraints; if you are adopting the structural regulation approach and the authority will start
introducing compulsory reserves (to compensate for risk, to reduce risk); On top of that you define ceilings
and bans on business and different bank activities, on prices and interest rat
regulation adopted after the Great Depression; then a new approach came

Therefore it is necessary to use bans in defining banking and financial businesses; in limiting the bank degree of
freedom in setting their business prices (interest rates) and/or their business products.
Examples: Compulsory Reserve Requirement, Ceiling on Loans, Ceilings on Interest Rates, Business Banning
DURING THE GM: PRUDENTIAL REGULATION

Key Assumptions: Bank and Financial Risks are ever predictable and measurable
Take a banker who is able to evaluate all risks, then it is sufficient to just define rules on firms/banks
(banking capital) (capital ratios, coefficients) in order to exploit the relationships between risk and capital
requirements; risks can be weighted and then capital ratios can be used for evaluation no banning, no
constraints, mandatory reserves very low, the only requirement is capital requirements.
How can it be so simple? Because we said we can calculate every risk distribution.

In this mindset a bank is just a sum of overall contracts and if we can calculate risk for every contract, we can
calculate and manage the overall risk of the bank; the banking system is the sum of all banks, so we can evaluate
the risk for the overall system and the system will be stable and efficient.
This is the approach used in the Basel Regulation regulation during the Great Moderation up to the crisis. Basel
II is the story of three pillars, but it is not true because there is only one pillar the minimum capital requirement,
the other two (market discipline and supervisory review process) are fictional and both turned towards the first
and dependent on it.
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To pass from financial regulation to prudential regulation financial deregulation was necessary (to remove
bans and constraints).
Bankers enjoy more degrees of freedom in setting their business prices (interest rates or fees) and/or their
business designs. Creativity, technological change and change of rules financial innovation
Creativity: Nobel prizes in finance: Fama, Hansen and Schiller - fathers of new ideas in finance and there was a
huge increase in use of technology of finance: the more you have more technology to manage information, the
more convenient it is in banking and finance; one more signal to this was the increase in patents in banking and
finance compared to other areas [why so many? What do you need to invent new derivatives? A pencil and paper
to write a formula, the first input is math, but a patent cannot be built on a math formula but it can on application
of the formula there was an explosion of new inventions coming from mathematicians and not economists.].
Deregulation produced three effects on finance:
1.
2.
3.

Dimension more finance

Complexity math + technology you can invent a lot, and there are many players
Interconnection in traditional finance there were barriers (national), but during GM there were
blurring effects (no barriers between countries), no barriers among banks, more interconnections
the system became a closely connected network [too big to fail substituted by too interconnected to
fail systematic risks] interconnection = complexity = uncertainty

Think of Lehman brothers: an investment bank, that was out of the traditional network, but they were deeply
interconnected with the commercial banks; one of those dots not just inside the banking system, but in the overall
financial industry; their collapse was the beginning of the domino effect one dot, one company . Take a CEO of
an Asset Management firm who sees the problem of Lehman brothers; hes sure there is no problem in his own
portfolio, but what about portfolios of his counterparts with whom he exchanges he doesnt know; so the
reaction is to sell, or even better, swap risky into non-risky assets (bonds) [US, German,] but the problem is that
all asset managers think the same and they all sell and they all buy and the market freezes, the prices of non-risky
bonds jump and interest rates drop to 0% or even negative interest rates on US and German bonds.
FINAL RESULT: SHADOW BANKING AND LEVERAGE ECONOMY
Shadow banking = non banking firms which perform banking activities
Banking + shadow banking = a big, complex and interconnected finance = leverage economy
-

MUNFI shadow-banking activity, financial activity that mimics banking activity without bank
involvement]

In traditional macro, leverage of households is 0, households are just savers, but in the real world that is not true.
Summing up
The Great Moderation = a NICE [Non inflationary consistently expansionary; stable growth with low inflation]
period; with high private debt a leveraged NICE period
Pros:
-

Leveraged economy was an intended economic consequence, a policy choice [deregulation means
leverage]; lasts around 3 decades [the political situation changed in the US over the course of those
decades it was a bipartisan policy] More debt, less volatility, more stability [macroeconomic
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consequence, smooths consumption, both parties could agree on it], increasing trend in consumption [but
the final point is lower than the initial point]
The great moderation was a normal time in terms
of finance and monetary policy we note there were
macroeconomic gains related to having high public
debts.
They noted an increase in housing prices (abnormal)
which is when one can wonder if there is a bubble (an
increase in prices, but there is no link between the
asset prices and the fundamental trends) but a
bubble can be discovered just after it has already
popped. Schiller also noted there was a credit driver
as well, which meant mortgage leverage was
increasing house purchasing. During the GM there was a roughly 40% deviation from the trend in house prices.
All investors thought they were smart and quick and that they could be out before the bubble would burst but
they all thought that and there was a crash.
In the US there had been another bubble quite recently before the crisis the dot com bubble, but it continued
growing after. They just thought a bubble is not going to make a change in the general macroeconomic system.

How the Economic System Works?

To discuss the monetary policy effects evolution, we have to know how the economic system works, to do so, we
need a benchmark, for which we will use a macroeconomic model: a modified AS-AD (Blanchard) to tell our story
in a systematic way it will be our standard model.
The Model

Parsimonious (efficient) macro description on how the economic system works (very few equations):
i.
Markets of goods and services
ii.
Labor markets
iii.
Monetary AND BANKING markets
iv.
With uncertainty and expectations
It is a modified AS-AD model in an open economy

Seven Key Assumptions

1. An open economic system with perfect capital mobility and perfect flexible exchange rates which is today
the setting in the advanced economies [all but ONE up to January 2015 Switzerland: there were no
perfect flexible exchange rates, they were pegged to the euro, but it has changed]
2. With uncertainty, also in order to capture the role of institutions (the better the institutions, the better
the stability, the better the performance, but uncertainty is the reality)
3. With the possibility to introduce different degrees of market imperfections and frictions (perfect markets
and perfect competition dont exist)
4. Including the banking and financial shocks in order to capture in the simplest way the role of the debt,
and in general of every kind of asset and wealth
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5. In a medium term perspective, i.e. the price level, the output and the employment can change, while
capital stock is fixed
6. Expectations matter
7. All the variables are flows, which are expressed as rates of change (positive or negative)
The traditional approach: Macro goals are GDP/Output level (Y on the X axis) and
the Price Level (P) defined by a downward sloping AD and an upward sloping AS
this is not the real world, the level of output is not relevant, it is always positive
what matters is the growth; thinking about price, no article talks about the level of
price, they talk about inflation and deflation.

Disinflation: situation in which inflation is still positive but falling, and when it becomes negative, it is
deflation.

Our new model will extend both the price now inflation both into positive and negative (on the Y axis) and the
output (growth) as well.

A normal time is when both inflation

and output growth are positive [bliss
point Great Moderation]. But times
are usually not normal

A country might have a very

high level of inflation with negative
output growth (recession) a
situation which is called stagflation
(during and after the oil shocks in the
70s) [very bad]

Another very bad situation is

recession combined with deflation
which is called stag-deflation
(happened for 2 decades in Japan)
There could also be special cases with growth and falling prices (deflation) which is called good deflation
because for consumers and households the income is increasing and the prices are negative real income
is growing (happened in US in period 1873-1893 and Switzerland in Oct 2015)

THE SUPPLY SIDE

The supply side the AS curve describes inflation.
What are the drivers? Looking at US, there is a correlation between inflation and wages

An inflation equation based on the ark up approach plus uncertainty

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Drivers:
1. The market of inputs, which means labor markets, given that capital is fixed
2. The market of outputs, considering the level of competition in the markets of goods and cervices
3. Uncertainty, i.e. randomness
Micro One: Prices depend on costs and competition
Consider a firm with marginal costs = labor costs; in two different and opposite markets:
1. Perfect competition: assume only marginal costs matter and the price is the market defined price
equilibrium is P = MC and the markup is minimum (=0)
2. Monopoly: given the same marginal costs, now that we know the demand for the output (as a monopoly)
we can calculate the marginal revenue Equilibrium is MC = MR to identify the Quantity and from that
Quantity we find the price by plugging it into the output demand and the markup is equal to the difference
between the cost for that quantity and the price charged is the markup (profit) at this level the markup
is at its maximum level.

On top of that, in the real world there is uncertainty: uncertainty, asymmetric information, rent seeking and price
setting the rationale is that it would lead to an increase in the markup
Inflation depends on three components: costs (wages only, capital is constant so we dont consider it); firm
market power; uncertainty
= inflation; = wage growth; Mi = mark up level in a given
year i; u = uncertainty, i.e. a random shock; which gives us
our first equation
u that can assume positive or negative values and it is normally distributed with zero average and unit variance.
Uncertainty produces more inflation.
Normalizing, we can assume that Mi 1 and during perfect competition M = 1 and for the sake of simplicity we
can write:

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: ratio of the mark up levels between two years, becoming an indicator of the degree of competition, i.e. the rent
factor. Note that when the markets are in condition of stable perfect competition it is true that (sufficient
condition; NOT NECESSARY): M(t-1) = Mt = = 1
Therefore:
= + ( 1) + u
Given the state of the competition which depends on the anti trust policies, ceteris parabus as well as the
uncertainty. Inflation will depend on the price of labor growth = wages.

Drivers of wages: higher employment growth (n) means higher wages; changes in employment produce
changes in wages if there is perfect flexibility, you have a perfect system a 2% increase in employment
means a 2% increase in wages which is perfect elasticity, where the changes are symmetrical. In the real
world they are not symmetrical, we need to introduce a factor b1 which determines how wages will
respond to changes in employment. Second thing to consider is whether were thinking of the price of
labor in real or nominal terms: it is in real terms (setting the wage for the future, so take into account
expected inflation)
In the labor market, the price of growth is associated with the growth of employment, given the role of
the institutional factors
w = bn
Where n is the employment growth; less frictions means a symmetric association between wages and
employment (stability); therefore b is bigger or equal to 1 and is the parameter which captures the role
of institutions, we call it rigidity factor; without frictions (perfect competition) b = 1, but inflation
expectations matter when the wage contracts are signed, therefore:
= e + bn
This is our second equation and our story
What about employment what are the drivers? Employment is an input and in order to pick out an
optimal number we need something to connect output with input a production function, which we
already know a standard Cobb-Douglass
Growth = function (employment, capital)
Y = n + k where alpha and beta represent productivity but since capital is fixed, growth of capital is k
= 0, meaning that Y = n and a>0 is the productivity index
Introducing an inefficiency factor opposite of labor productivity = 1/
n = Y which is our third equation

Note: Finance isnt an input!

By collecting all of the information substituting the 3 into the 2 equation and then substituting that into the first
we get our supply side.
The supply side equation defines the well-known relationship
between output and inflation, given expectations and
uncertainty.

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You are a firm and you wish to increase output. Given the
labor productivity, you need more workers. Getting more
workers means paying higher wages, which can mean
inflation given this crucial relationship, the other variable
is that there is negative association between
inflation and expected inflation given output.
Negative correlation between markup and output
growth more markup means less output. More
resilience means less output the higher b
(meaning paying your worker more) means less Y
I will pay more, but hire less workers and less
workers means less output. And finally, more
inefficiency less output.
THE DEMAND SIDE
The aggregate demand growth, i.e. the AD curve,
depends on:
1) exogenous changes in the demand for goods and services
2) demand changes due to movements in the interest rate
1 + 2 = IS LM model
3) banking and financial shocks
In general, the AD drivers are: Consumption C, private investment I, public expenditure G and trade balance NX (
export X import M).
And in each driver two components can be present:

The first component is the real component autonomous/exogenous

There is correlation between AD and interest rates dependent (on interest rate)/monetary component
Using which we will describe with the change in real money growth (difference between money supply
and inflation): higher money level, lower interest rates and inflation changes price levels (m ).
For example: I = I* - bi where I* is the autonomous component and bi the monetary component.
Note: in each driver endogenous component, i.e. associated with output growth, can be included without
altering our results, such as C = C* + cY where cY is the endogenous component.

Y = a + (m ) + l
The exogenous demand for goods and services a can be called the real component. The exogenous components
trigger the output growth.
On top of that there are AD components that can depend on the level of the interest rate (monetary components).
In an open economy there are two channels that the interest rate level can influence AD:
1. Relationship between private investment and interest rates
The demand of private investment is associated with the price of money, i.e. the nominal interest rate, i.
I = I(I*, i) and it has a negative relationship with interest rates, I* exogenous,
We know that I= I(I*, r) where r = I where r is the real interest rate
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2. Trade balance channel

We know that the trade balance nx export minus import is inversely associated with the real exchange
rate .
E=nominal exchange rates foreign currency units for one unit of
domestic currency and real ex rates have a positive relationship with
nominal exchange rates
= domestic inflation (higher internal inflation means appreciation in
real terms positive relationship)
* = foreign inflation (increase means depreciation in real terms negative relationship)
With perfect capital mobility and perfect flexible exchange rates the nominal exchange rate is positively associated
with the level of the interest rates nominal exchange rates are flexible and depend on capital movement (which
we assumed to be perfect) which depends on interest rates
Higher interest rates mean an inflow of capital and consequently the exchange rate
appreciates; the opposite is true with lower interest rates.
Change in interest rate change the demand for private investment and affect the trade balance (drive it up) an
increase in interest rates lowers investment, but can mean a reduction in trade balance and an inflow of capital.

Monetary component
Summing up, the two channels between interest rates and the aggregate demand drive the AD in the same
direction. For example, a monetary expansion, i.e. lower interest rates increases both the private investment
and the trade balance.
Which are the drivers of interest rates in an open economy?
-

There are two monetary policy strategies: quantitative policies and interest rate policies
The more stable the money demand, the more equal these two strategies are. Therefore the interest rate
level is associated with changes in the real money growth, which depends on changes in money supply
and inflation.
(m ) and it is a negative relationship higher level of money, lower interest rates [the more money the
CB holds, the less money exists in circulation]
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The money supply m depends on central bank monetary policies

and given the money supply the AD depends on real money growth (m ).
Our assumption is that money is an economic policy tool and is controlled by the central bank.
In an open economy the inflation rate can influence
the aggregate demand through two channels:
1) The real interest rate
2) The trade balance

Channels that inflation affects AD:

1. Changes in inflation influence the real money growth and therefore the real interest rates affect private
investments [I=I(I*,r)]
E.g. when inflation increases the money growth drops, the nominal interest increases (more than
proportionately), consequently also the real rate, and the aggregate demand decreases. The opposite is
true when inflation decreases.
2. Inflation triggers trade balance (inversely) it triggers real exchange rates which influence trade balance.
And therefore inversely affect the trade balance nx = nx(., )

E.g. when inflation increases, the exchange rate appreciates, the trade balance deteriorates and the AD
decreases. The opposite is true when inflation decreases.

So far we have:
y = a + (m )

The macro effects of banking, finance and wealth on aggregate demand can be time to time positive or negative.
We will suppose that uncertainty on aggregate demand will depend exclusively on banking and financial shocks
l, which can represent positive and/or negative shocks in leverage:

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The component L is the financial accelerator, it captures the role of banking and/or financial leverage
phenomenas effect on AD. We assume that the financial accelerator is a random shock component, that can
assume positive or negative values and it is normally distributed with zero average and finite variance. The final
result is the fourth equation:
On the AD side we find the usual negative association between AD and inflation.

y
Given the state of competition and
uncertainty, inflation is related to wages.
Wages are associated with employment
growth which can be more or less flexible
depending on institutions which are
reflected in parameter b (the rigidity
parameter) which is equal or greater
than 1 (=1 when there is perfect
flexibility, meaning a change in
employment growth produces the same
growth in wages). The less flexible the
market, the greater the b. Wages also depend on inflation expectations. Output growth depends on employment
growth and capital growth, depending on productivity of each component but since capital is fixed, change in
output growth depends on change in number of workers, taking into account productivity of labor. These three
equations give us the AS.
The AD again depends on three components. (a) which explains all exogenous components. Then (m ) which
summarizes all components depending on interest rates and the final component (l) that explains shocks from
banking and finance.
Aggregate Supply
Aggregate Demand
1. = + ( -1) + u
4. y = a + (m ) + l
2. = (exp) + bn
3. n = Y where =1/
And money is controlled by the CB, so it is a tool of economic policy m = m*

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Which are the possibilities to intervene as a policy maker?

Supply side policies: antitrust to control competition; institutions (if strong they reduce uncertainty - )
to control uncertainty; b is affected by labor policies and (the inverse of efficiency), enrapturing
productivity policies, is controlled through protection of property rights, institutional policies (u)
increasing efficiency of courts and the law the more the law protects and increases efficiency, the better
the macroeconomic performance.
Demand side policies: monetary policy (m) is a powerful tool, banking and financial policies (l) to influence
leverage shocks, FISCAL POLICY is the exchange in expenditure, an exogenous variable g = g* and where
is public spending in the equations? It is captured by the demand side policies in (a) which captures all
exogenous effects. The same goes for taxation.

EQUILIBRIUM AND EXPECTATIONS

In the standard model the equilibrium depends on how the expectations mechanism works.
We will distinguish between:
a) Constant (imperfect, exogenous) expectations
b) Rational (perfect, endogenous) expectations
Constant Expectations
With constant expectations:
1.
2.
3.
4.
5.

The wages are sticky

Inflation surprises are possible
It is possible to change employment and output growth without consistent changes in the real wage
The equilibrium is temporary (surprises are possible)
Changes in the AD produce real effects

1+2) Constant Expectations, Wages and Surprises

If the expectations are constant (exp) = *. In the labor market, the wages are sticky. Inflation surprises are
possible when w = * + bn. Therefore the changes between nominal wages, real wages and employment growth
can be inconsistent.
3) Consistency in the Labor Market
Consistency: nominal wages, real wages and employment growth are positively correlated: w = bn
In fact, we assume: w (exp) = bn but if > * nominal wages, real wages and employment growth become
inconsistent.
4) Constant Expectations and AS

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Temporary Equilibrium (surprises are possible)

Since there are no expectations in AD it remains the same, but
in AS the expectations exist and the graph line that intersects
AD is the Temporary equilibrium. If there are shocks in demand,
they can produce real effects. You work more for the same
wage (sticky, can be cheated) and you are affected by a nominal
illusion.

5) AD and real effects

AD changes produce output growth. Given an AD change, it is possible to increase the
output without increasing the real wages (nominal illusion)

Rational Expectations
With rational expectations:
1)
2)
3)
4)

The wages are flexible,

Inflation surprises are impossible and consequently
It is impossible to change employment and output growth without consistent changes in the real wage;
The equilibrium is permanent (surprises are impossible) and changes in the AD dont produce real effects.

1 + 2) Rational Expectations, Wages and Surprises

If expectations are rational (exp) = and in the labor market, the wages are flexible w = + bn. Inflation
surprises are impossible, therefore the changes between nominal wages, real wages and employment growth are
ever consistent.
3) Consistency in the Labor Market
Consistency: nominal wages, real wages and employment growth are positively correlated: w = bn, in fact we
assume w (exp) = bn and if (exp) = nominal wages, real wages and employment growth are ever consistent.
4) Rational Expectations and AS
When inflation is not exogenous, output no longer depends on inflation on the supply side (AS is vertical) and
output growth depends only on supply.
The AS is as follows:

and therefore:

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5) AD: No real effects

AD changes produce just inflation effects. Any AD change, Given the output growth,
triggers an inflation change.
The more you are rational, the higher your REAL wage is and there is no more nominal
illusion. Any change in AD doesnt produce any real effect, only inflation effects.

Monetary part: Outline

Period
Great Moderation
Great Crisis
After Crisis

Policy
Financial Policy
Monetary Policy

Tool
Standard Economic Model

Evaluating the US MP
Observing the interest rates Deregulation and Lax MP

In order to design and implement deregulation you have to finance it

In order to increase the overall leverage the interest rates have to be low and stable (easier to borrow,
more incentive)
Deregulation and monetary policy = two faces of the same coin
The neglected relationship: MP, leverage and house prices

John Taylor noted that interest rates before the crisis were likely to be too low (based on comparison between
actual interest rates and a simulation Taylor rule according to normal rules of monetary policy) why is this
dangerous? Because low interest rates mean high leverage, high amount of mortgage contracts, more demand for
housing, higher prices of housing.
The Great Moderation as a Good Disinflation Case
Notwithstanding the expansionary monetary policy and increasing leverage, the overall macroeconomic outcomes
were very good: stable demand, high growth
The US MP as a Great Deviation
The Taylor Critique: The US MP was a Great Deviation (from the normal stance) triggering the Great Crisis. This is
a neglected critique because notwithstanding the expansionary monetary policy and the increasing leverage, the
overall macroeconomic outcomes were very good: stable demand, high growth and low inflation. The GM as
an equilibrium, but which one?
The GM was a case of a mix of policies:
1. Financial deregulation and expansionary monetary policy with
2. Growth, disinflation, stable demand, high leverage
A case of good disinflation
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(From mock exam question) EQUILIBRIUM

We obtain the equilibrium level of both output and inflation:

Where

If you remember that a) financial deregulation increased efficiency (innovation) and b)

stabilized the demand (no real and financial shocks). More efficiency shifts the AD curve
to the right. Microeconomic consequences: 1) higher output growth and 2) lower
inflation

Summing up: GM as the Quiet before the Storm

Financial imbalances (leverage) and monetary imbalances
The Storm (GC) = Outcome of the GM Imbalances
The Great Crisis as a Balance Sheet Stagnation
The GC as a case of bad equilibrium The GC as the beginning of a balance sheet recession.
The GC as the beginning of a case of:
1) Low growth with 2) low inflation
The Great Crisis as a Balance Sheet Recession
A case of balance sheet recession debt excess recession
An explanation: A case of balance sheet recession (debt excess recession) too much debt stops being leverage
[this is not just a story of yesterday, some general features are appearing in China today high leverage and
problems with the financial market, wrapped up with a very aggressive monetary policy
Consider the Standard Economy {NOTE: Step by step in an exam question also requires an
interpretation of equations}
A negative drop in AD produces two effects: lower growth and lower inflation.
Todays situation: growth is still weak, interest rates are low, Japan gives negative yield bonds

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How to go ahead?
Two main views
AGGREGATE DEMAND VIEW

Extensively implemented in order to face the Great Recession

Bottom line: to end the great recession we need expansionary AD policies

Using the standard model:

Supply side: inflation associated with wage growth, competition and uncertainty (turn it around so that it gives
output y)
Labor market: In the ADV the expectations are constant and incorporated into sticky wages. Therefore in the labor
market the nominal wage is the equilibrium variable. The nominal wage growth depends on employment growth,
given the institutional setting: w = bn.
When n is the employment growth and the parameter b > 1 is the usual rigidity factor. The employment growth
is identified using the production function.

is the new version of equation (2).

is equation (1)
And the supply side equation defines the well known relationship between output and
inflation.
Demand side: The aggregate demand growth i.e. the AD curve, depends on three components:
1) Changes in the demand for goods and services
2) Changes in the real money growth
3) Banking and Financial shocks
We find out the standard relationship between AD and money supply.

EQUILIBRIUM

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AD and economic policies

In the AD approach it is assumed that the supply policies are sticky, therefore policies to implement in order to
address the recession are Fiscal and Monetary Policies. Fiscal policy is captured in (a) public demand for goods
and services and monetary policy is captured in (m) both a part of the AD equation.
In order to increase output growth now, I need to increase fiscal and monetary policy elements and if there is a
shock to one of these components, to match it, the output must increase which leads to need for more workers
(which leads to higher wages and given the markup, inflation will be higher) Increase in demand leads to higher
output and higher inflation.
The AD Policies: In the AD approach the AD policies are effective, paying a cost in terms of higher inflation.

Fiscal policy (a) produces real effects; it is effective. But it produces

inflation too: we face a trade off (sacrifice ratio).

The same is true for the monetary policy (m).

Fiscal Policy, Growth and Inflation
Increasing the public spending (or reducing taxation) we have the
equilibrium output multiplier (OM) and the inflation accelerator
(IA), where:

Monetary Policy, Growth and Inflation

In a symmetric way in the monetary side: implementing an expansionary monetary policy (increasing m)
consequences in terms of output growth: there is an equilibrium output multiplier (OM) which is positive and
equal to 1/gamma. In terms of inflation: a change in money will change inflation inflation accelerator (IA) =
(gamma -1)/gamma
Sacrifice Ratio
Having both the OM and the IA we can calculate the sacrifice ratio Sacrifice ratio (SR) = inflation costs to obtain
output gains.

It reflects how flexible the labor market is and how efficient the
production function is. The intuition: increase in output increase in
employment increase in inflation. If market is not efficient nor
flexible, supply will be relatively vertical.
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The SR depends on: flexibility (less flexibility in labor market means greater SR); productivity (less productivity
means greater SR). More flexible and efficient markets reduce the SR.
Assume this situation in country B and a normal
situation in A. If both have the same demand and the
same expansionary policy is implemented, macro
consequences are such that the new output in A will
be higher than before, while the change in inflation
will be small the sacrifice ratio is low. In country B
(less flexible) the situation has hardly changed in
terms of output, while inflation has increased a lot
the sacrifice ratio is very high.
To sum up the sacrifice ratio exists and depends on
the structure of the system: labor market and
production function flexible labor market and
effective production mean a low SR.
Two remarks on AD multipliers

Fiscal and monetary output multipliers are equal

The multipliers are greater than 1

Is the Multiplier positive and relevant and the Austerity Policy Wrong? YES
If the multiplier is positive, there are increases in public spending and/or decreases in taxation which trigger
output growth, therefore austerity is wrong.
Is the Multiplier Positive and relevant? NO; And the Austerity policy right? YES
If the multiplier is negative, there are increases in public spending and/or decreases in taxation, which trigger
recession therefore austerity is right.
Is the Multiplier Positive and Relevant?
Fiscal multipliers are typically defined as the ratio of a change in output to an exogenous and temporary change
in the fiscal deficit with respect to their respective baselines. In spite of an extensive literature, there is still no
consensus regarding the size of fiscal multipliers. Fore those studies government spending multipliers range
between 0 and 2.0 with a mean of 0.8 during the first year after fiscal measures are taken. Government revenue
multipliers range from about -1.5 to 1.4 with a mean of 0.3.
A literature review and empirical findings for state-dependent multipliers confirm that there is
considerable uncertainty surrounding the size of the short-term multiplier.
The Zero Money Multiplier
In the AD model the monetary multiplier is zero when the economy is in a Liquidity trap.
The monetary policy is completely ineffective = no real, no nominal effects. In a LT aggregate demand is
independent from the Monetary Policies. An increase in money supply doesnt make a difference in output
26

growth. It is possible that the liquidity preferences could become virtually absolute at a sufficient low interest
rate. In this event the monetary authority would have lost effective control over the rate of interest. It follows
that any increase in the money supply would be completely absorbed without producing any effect on output.
[Keynes]
Interest rates near 0 (like today) NO effect on investment.
For a bank, deposits are a private liability and cash is a public liability so increasing money supply means
increasing cash. A drop in the cash happens when there is increased innovation and more trust. When there is a
crisis, there is an increase in cash holdings.
Since monetary policy is completely ineffective, the only effective policy is the fiscal one.
Consider the ADV (AD view) with a Liquidity Trap, the supply and the demand curves and the equilibrium values
of output and inflation are:
AS: inflation depends on wages, competition and uncertainty
[1]; wages are associated with employment and the rigidity
factor[2]; employment is correlated with output through an
inefficiency factor [3].
AD: the standard view is that output depends on the real
component, monetary component and liquidity shocks, BUT in a
liquidity trap monetary policies dont affect output (money
doesnt matter) so y = a + l [4a] monetary policy is completely
ineffective, only the fiscal policy is effective.

This is a complete AD Economy AS is normal, while AD is vertical! An increase in efficiency would shift AS to the
right, but the same output would still be produced, but this time at lower prices. SUPPLY DOESNT MATTER HERE,
MONEY DOESNT MATTER. The only thing that can be done is increase the real component of AD.
A fiscal expansion triggers higher output growth and higher inflation AD shifts to the right, leading to a higher
output but also higher prices (inflation) its a trade-off.
AGGREGATE SUPPLY VIEW
It is based on the assumption that the households, firms and markets tend to be rational. With rational
expectations, changes in the AD are neutral no real effects.
Bottom line: to end the great Stagnation we need efficient AS policies.
Consider the ASV. The AS, AD and equilibrium values are:
Supply is derived the same way, BUT wages are set in real terms, not nominal. In the ASV the expectations are
rational, therefore the real wage is the equilibrium variable in the labor market. The real wage growth depends
on employment growth, given the institutional setting.
Equation (2)
Equation (1)
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Role of inflation disappears, so output growth depends on degree of competition,

uncertainty, degree of rigidity in the labor market and the degree of inefficiency in the
production function.
This supply is completely independent from inflation and graphically AS is vertical.
[Demand no news] and the graph is downward sloping (no change from normal) but monetary and fiscal policies
are inefficient in terms of output growth (no REAL EFFECTS) they are neutral and only inflation changes (only
NOMINAL EFFECTS).

ASV and Economic Policies

In the ASV approach which policies can be implemented to address a recession?
Supply Policies: Antitrust policies (), Labor policies (b), Productivity policies (), Institutional policies (u)
Monetary Part: Multiple Equilibriums
ONE SIZE DOESNT FIT ALL

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