Should value added in an open economy be defined as:
• the value added domestically (that is, within the country); or
• the value added by domestically owned factors of production?
The two definitions are not the same. Some domestic output may be produced by capital owned by foreigners, while some foreign output may be produced by capital owned by domestic residents.
The answer is that either definition is fine, and economists use both. Gross domestic product (GDP), the measure we have used so far,corresponds to value added domestically. Gross national product (GNP) corresponds to the value added by domestically owned factors of production, and is synonymous with gross national income (GNI), which is more commonly used now. GNP is equal to GDP plus net factor payments from the rest of the world (factor payments from the rest of the world minus factor payments to the rest of the world).While GDP is now the measure most commonly mentioned. GNP was widely used until thc early 1990s, and you will still often encounter it in newspapers and academic publications.
For most countries, the difference between GNP and GDP is typically small, because factor payments to and from the rest of the world roughly cancel each other out. For Australia in 2008, the difference between GDP and GNP was about 4.5 per cent of GDP. (This is a number that has gradually increased over the last forty years as Australia has become a larger net debtor country.)
There are a few exceptions. One is Kuwait. When oil was discovered in Kuwait, Kuwait's government decided that a portion of oil revenues would be saved and invested abroad rather than spent, to provide future Kuwaiti generations with investment income when oil revenues came to an end. Kuwait ran a large current account surplus, steadily accumulating foreign assets. As a result, it now has large holdings of foreign assets and receives substantial investment income from the rest of the world.Table I gives GDP. GNP and net factor payments for Kuwait from 1989 to 1994.
Note how much larger GNP is compared with GDP throughout the period. But note also how net factor payments decreased after 1989.This is because Kuwait had to pay its allies for part of the cost of the 1990-91 Gulf War and for reconstruction after the war. It did so by running a current account deficit—equivalently, by decreasing its net holdings of foreign assets. This in turn led to a decrease in the income from foreign assets and, by implication, to a decrease in net factor payments.
• II you want to learn more about international trade and international economics, a very good textbook is one by Paul Krugman and Maurice Obstfeld, International Economics, Theory and Policy, 8th edn (New York: Pearson, 2008).
I rom thc* information in panel (c) we can characterise the behaviour ol net exports—the difference between exports and imports (X - IM/e)—as a Iunction ol output. At output level V, for example, exports are given by the distance AC and imports by thc distance AB, so net exports are given by the distance ВС.
This relation between net exports and output is represented as the line ,VX (for net exports) in Figure 19.1, panel (d). Net exports arc a decreasing function of output. As output increases, imports increase and exports are unaffected, leading to lower net exports. Call Y/д (ТВ for trade balance the level ol output at which the value ol imports is just equal to exports, so that net exports are equal to zero. Levels of output above Y/ц lead to higher imports, leading to a trade deficit. Levels of output below Yjb lead to lower imports and a trade surplus.
19.2 EQUILIBRIUM OUTPUT AND THE TRADE BALANCE
The goods market is in equilibrium when domestic output equals the demand for domestic goods:
У = Z
Collecting the relations we derived lor the components ol the demand for domestic goods, Z:
У = CO' - T) + KY.r) + С - IM(Y,e)/e + X(Y*,e) (19.4)
The goods market is in equilibrium when production is equal to the demand for domestic goods. At the equilibrium level of output, the trade balance may show a deficit or a surplus.
An increase in government spendirg leads to an increase in output and to a trade deficit
• domestic demand for goods 430
• demand tor domestic goods, 430
• coordination, 438
Wc now have the elements we need to understand the movements ol output, the interest rate and the exchange rate.
C.oods-market equilibrium implies that output depends, among other lactors, on the interest rale and the exchange rate:
V = C(Y - T) + /(Y,i) + G + NX(Y, Y*,E)
The assumption of perfect capital substitutability is a fair approximation to what happens between countries with highly developed financial and goods markets and stable political and economic systems, such as Australia, the United States, the United Kingdom and Japan. For example, the government bonds issued by these countries have very similar risk characteristics, and the volatility of the exchange rate (which affects the comparison of their yields) is modest in size. This is why we assumed in the chapter that investors care only about the expected returns from investing in a portfolio of domestic and foreign bonds. Our investors weren't concerned about the default or currency risk of their portfolios.The two types of bonds are then perfect substitutes from the investor's point of view. This led us to the interest parity relation (20.4a), which played an important role in the Mundell-Fleming model:
1 + i, = (1 +
This relation is unsatisfactory when we are comparing portfolios of bonds from countries with a high default risk or with substantial currency volatility (or exchange rate risk).Then the bonds of the two countries are likely to be imperfect substitutes. When comparing the returns of bonds from two countries with these varying risk characteristics, investors will demand a relative risk premium on the return from the riskier country, if both
The aggregate supply shifts down over time, leading to a decrease in the price level, a real depreciation and an increase in output. The process ends when output has returned to the natural level of output.
output the aggregate supply shilts down. The reason: When output is below the natural level of output, the price level turns out to he lower than was expected. This leads wage setters to revise their expectation of the pricc level downward, leading to a lower price level at a given level ot output, and thus to a shift down of the aggregate supply curve.
So. starting Irom /1, the economy moves over time along the aggregate demand curve, until it reaches H. At B. output is equal to the natural level ol output, l he price level is lower than it was at A: by implication, the real exchange rate is lower than it was at A. In words: So long as output is below the natural level of output, the price level decreases. The decrease in the price level over time leads to Го summarise: In the medium run, despite the lact that the nominal exchange rale is lixed, the economy achieves the real depreciation needed to return output to iis natural level. This is an important qualification to the conclusions reached in the previous chapter, where we were focusing only on the short run:
• In the short run. a fixed nominal exchange rate implies a lixed real exchange rate.
Suppose a country is operating under a lixed exchange rate. Suppose financial investors start believing thai there may soon be an exchange rate adjustment—either a devaluation or a shilt to a flexible exchange rale regime accompanied by a depreciation.
We iust saw why this might be the case:
• The domestic currency may be overvalued. A real depreciation is called tor. While this could be achieved in the medium ain without a devaluation, financial investors may conclude that the government will take lhe quickest way out—and devalue.
Such an overvaluation often happens in countries ihai lix thc nominal exchange rate while having an inflation rate higher than the inflation rate in the country they are pegging to. Higher relative inflation implies a steadily increasing price of domestic goods relative to foreign goods, a steady real appreciation, and so a steady worsening of the trade position. As time passes, the need for an adjustment ol the real exchange rate increases, and linanciai investors become more and more nervous.
• September 5-6: The ministers of finance of the European Union meet in Bath, England. The official communique at the end of the meeting reaffirms their commitment to maintaining existing parities within the exchange rate mechanism (ERM) of the European Monetary System (EMS).
• September 8:The first attack.The attack comes not against one of the currencies in the EMS but against the currencies of Scandinavian countries, which are also pegged to the deutschmark (DM). The Finnish authorities give in and decide to let their currency, the markka, float—that is. be determined in the foreign-exchange market without central bank intervention. The markka depreciates by 13 per cent against the DM. Sweden decides to maintain its parity and increases its overnight interest rate to 24 per cent (at an annual rate).Two days later, it increases it further, to 75 per cent.
• September 10-1 I The second attack. The Bank of Italy intervenes heavily to maintain the parity of the lira, 'eading the bank to sustain large losses of foreign-exchange reserves. But on 13 September the lira is devalued by 7 per cent against the DM.
• September 16-17:The third attack. Speculation starts against the British pound, leading to large losses in fore gn-exchange reserves by the Bank of England.The Bank of England increases its overnight rate from 10 per cent to 15 per cent. However, speculation continues against both the pound and (despite the
An increase in the interest rate to last for five years leads to an immediate appreciation of the exchange rate today, followed by expected depreciation over the next five years.
Thc open economy IS-LM, AS-AD and interest parity relations arc depicted in Figure 21.6.
• In panel (a), the medium-run equilibrium ol the IS-LM model is shown at point Л„. The central bank has set the interest rate at i„ and output is at the natural level, Y„. The IS relation is the same as the one you saw in equation (20.6) except that the expected exchange rate is no longer assumed fixed. The LM relation is thc same as equation (20.7). The central bank now selects thc interest rate using a rule that depends on deviations of the price level Irom its target. P', and it is the same as the one we used in equation (7.4). Since the price level is equal to the target in medium-run equilibrium, the interest rate is set at its medium-run equilibrium value, i„.
• in panel (b), which gives the interest parity relation (21.6), the initial interest rate (i„) is associated at point Д, with the medium-run value of the nominal exchange rale, E,„ In medium-run equilibrium, thc current exchange rate will be constant and thus equal to the expected future exchange rate. From the interest parity relation, wc can then deduce that i„ = i*—the central bank must set the interest rate equal to the foreign interest rate in the medium run.
• Panel (c) shows the AS-AD model, and medium-run equilibrium at point A() has output at Y„ and the price level at the ccntral bank's initial target, P/,. Thc AS relation is exactly the same as the one we used in Chapter 7, equation (7.2). I he open cconomy AD relation extends the closed economy one (equation [7.5]) by adding a second effect of price level changes on output. The lirst eflcct is that a higher price level causcs thc ccntral bank to raise thc interest rate, which reduces investment (as in the closed economy), while thc second effect is that it leads to a real exchange rate appreciation (both directly through the higher price, and indirectly via the higher interest rate that increases thc nominal exchange rate), which reduces net exports and aggregate demand. Therefore, the open economy AD curve is Hatter than the closed economy one—a higher pricc level leads to a lall in investment ami net exports.
Let us do one experiment—a monetary policy contraction. We will leave our other favourite
experiments as exercises, but give you some hints at the end of this section.
In medium-run equilibrium, output is ot the natural level, the interest rate equals the foreign rate, and the price level equals the target
Monetary policy contraction—the medium run
The easiest to explain arc the medium-run effects. What will change from the initial to the final medium am alter a permanent monetary policy contraction? Just as you saw in the closed economy analysis of Chapter 7, the medium-run effects of monetary policy changes are neutral—real variables are unaffected in the medium ain. This means that output will return to Y„, and the real exchange rate will he back to its original value, €0.
From our monetary policy atle, a monetary policy contraction is a reduced price level target, which lalls Irom Pj, to P\. This is shown in Figure 21.7 in panel (c). In the medium run, the /IS and AD curves will have both shifted to go through A, at thc lower price level, and at thc original natural level of output. The AD curve shifts to ADt because at the unchanged natural level of output, the price level must fall to the lower targe; value P\ so that aggregate demand remains equal to Y„. The /IS curve shifts down because the expected price level decreases as the actual price approaches the lower price target.
A monetary policy contraction is a reduction in the price level target, which leads to a stronger nominal exchange rate but no real effects in the medium run.
When the pricc level reaches the lower target in the medium run, the interest rate set by the central hank returns to <„. With medium-run output unchanged at Y,„ and the real exchange rale unchanged ai Co, the IS and LM curvcs return to their original positions in panel a , and the new medium-run equilibrium is identical to the old one.
Since the real exchange rate is the same in ihe new medium run and the price level is now lower at Since t = EPiP'. * Pj, ihe nominal exchange rale must appreciate lo E, in the new medium-run equilibrium. The stronger if labelled IP0 to the flatter curvc IP, in panel (bi. Thus, the new medium-run equilibrium is at A,, where the interest rate again equals i„ ■ i*. and the nominal exchange rate equals E, - E'[.
A monetary policy contraction leads in the short run to an increase in the interest rate, о fall in output, a small fall in the price level, and an overshooting appreciation of the nominal exchange rate beyond the medium-run effect.
Lets go back to our analysis in Chapter 17, based on Figure 17.3. As a quick reminder, there were two key extensions to the basic IS-LM model of Chapter 5.
Let's go back to the argument we developed earlier about why output tends to return to its natural level in the medium run. The easiest way to present thc argument is in terms of the IS-LM graph in Figure 23.1, with the nominal interest rate on the vertical axis and output on the horizontal axis. The argument developed in Chaptcr 7, with a central bank fixing the money stock, went like this:
• Suppose that an adverse shock has led to a decrease in output, so the economy is at point A, with a ReC3"that the n3tural level of output, Y, below the natural level of output, Y„ in Figure 23.1. The nature of the shock isn't unemployment rate is
• The fact that output is below its natural level will lead, in turn, to a decrease in the price level over equal to the natural lime. Given the nominal money stock, the decrease in thc pricc level will increase the real money unemployment rate. See stock. This increase in the real money stock will shift thc LM curve down, leading to a lower interest Ciapter 6.
• Real money growth—nominal money growth minus inflation—is now equal to 5% - 3% = 2%. Equivalently, the real money stock increases by 2 per cent.
Suppose that this increase in thc real money stock leads to a decrease in the nominal interest rate from, say, 7 per cent to 6 per cent. This is the first effect you saw above: lower inflation leads to an increase in the real money stock and a lower nominal interest rate.
• Suppose that the decrease in inflation leads people to expect lhat inflation this year will be 2 per cent lower than it was last year, so expected inflation decreases from 5 per cent to 3 per cent.
This implies that, at any given nominal interest rate, the real interest rate increases bv 2 per cent. This is the second effect you saw earlier: at a given nominal interest rate, lower expected inflation leads to an increase in the real interest rate.
• Combining the two ellects, the nominal interest rate decreases from 7 per cent to 6 per cent. Expected inflation decreases from 5 percent to 3 percent. So, the real interest rate moves from 7% - 5% = 2% to 6% - 3% = 3%.
In words: The net effect of lower inflation is to increase the real interest rate, not to decrease it.
We have just looked at what happens at the start of the adjustment process. But it is easy to describe a scenario in which things go from bad to worse over time. The decrease in output from У to У" leads to a further decrease in inflation and a further decrease in expected inflation. This leads to a further increase in thc real interest rate, which leads to a further decrease in output, and so on. In other words, the initial recession can turn into a fully Hedged depression, with output continuing to decline rather than returning to its natural level. The stabilising mechanism described in earlier chapters simply breaks down.
In 1929 the LIS unemployment rate was 3.2 per cent. By 1933 it had increased to 24.9 per cent! Not until ten years later, in 1442, was it back down to 4.7 per cent. (Figure 23.7 shows the evolution of the unemployment rate from 1420 to 1950.) This Great Depression was worldwide: thc average unemployment rate from 1930 to 1938 was 18.2 per ccnt in Australia. 15.4 per cent in the United Kingdom, 10.2 per cent in France and 21.2 per cent in Germany. We will focus in the text only on what happened in thc United States, but further details on the Australian experience can be found in the tocus box The Great Depression in Australia'. We take up three questions:
1. What triggered the initial increase in unemployment?
2. What made thc depression last so long?
3. How did thc economy eventually reatrn to low unemployment?
Table 23.1 gives the evolution ol the US unemployment rate, the growth rate of output, the consumer pricc index and thc money stock from 1929 to 1942. Focusing only on unemployment and output for the moment, two (acts emerge from the data:
• For more on the Great Depression, Lester Chandler, America's Greatest Depression (New York: Harper & Row, 1970) gives the basic tacts. So docs lohn A. Garraty in The Great Depression (New York: Harcourt Brace Jovanovich, 1986).
• Peter Temin's Did Monetary Forces Cause the Great Depressioni New York: W.W. Norton, 1976) looks more specifically at the macroeconomic issues. So do the articles in a symposium on the Great Depression in thc Journal of Economic Perspectives, Spring 1993.
• For a look at the Great Depression in countries besides the United States, read Peter Tcmin. Lessons from the Great Depression Cambridge, MA: MIT Press, 1989>.
• For thc argument that the NIRA actually slowed down the recovery, read Harold Cole and Lee Ohanian, The Great Depression in the United States Irom a neoclassical perspective'. Federal Reserve Hank of Minneapolis Quarterly Review, Winter 1999.
• A description of thc Great Depression through the eyes of those who suffered through it is given in Studs Terkcls Hard Times: An Oral History of the Great Depression in America (New York: Pantheon Books, 1970).
• A good book on the Japanese economy, although a hit out ol date, is Takatoshi Ito's The lapancse Economy Cambridge, MA: MIT Press. 1992 .
• See also Adam Posen's Restoring Japan's Economic Growth (Washington, DC: Institute lor International Studies, 1998).
• An Empirical Assessment of Monetary Policy Alternatives at the Zero Bound i Brookings Papers on Economic Activity, 2004), by Ben Bernanke, Vincent Reinhart and Brian Sack, discusses what monetary policy can and cannot do when thc economy is in a liquidity trap.
We have derived two relations:
• A relation between seignorage, nominal money growth and real money balances (equation [24.2J).
• I here must be a liscal reform and a credible reduction of thc budget delicit. This reform must take place on both the expenditure side and the revenue side of the budget.
An underlying theme ol the core of this book was that, while output fluctuated around its natural level in the short run, it would tend to return to the natural level ol output in the medium run. And, if the adjustment was too slow, liscal and monetary policy could be used to help and shape thc adjustment. Most
SOURCES Tlie material in tins box draws largely from Jeffrey Sachs.'The Bolivian liyperinflation and stabilization*. NBER working paper. 1986 Sachs was one of thc architccts of the stabilisation program. See also Juan Antonio Morales. Thc transition from stabilization to sjstained growth in Bolivia', in Michael Bruno et al. (eds). Lessons of Economic Stabilization and hs Aftermath (Cambridge. MA- MIT Press. 1991).
Stabilisation
There were many attempts at stabilisation along the way. Stabilisation programs were launched in November 1982. November 1983, April 1984, August 1984 and February l985.The April 1984 package was an orthodox program involving a large devaluation, the announcement of a tax reform and an increase in public-sector prices. But the opposition of trade unions was too strong, and the program was abandoned.
After the election of a new president, yet another attempt at stabilisation was made in September 1985. This one proved successful.The stabilisation plan was organised around the elimination of the budget deficit. Its main features were:
• Fiscal policy. Public-sector prices were increased; food and energy prices were increased: public-sector wages were frozen: and a tax reform, aimed at re-establishing and broadening the tax base, was announced.
• Monetary policy. The official exchange rate of the peso was adjusted to what the black-market rate (the actual exchange rate at which one could exchange pesos for US dollars before the stabilisation program) had been pre-stabilisation.The exchange rate was set at I. I million pesos to the US dollar, up from 67.000 pesos to the dollar the month before (a 1,600 per cent devaluation). The exchange rate was then left to float, within limits.
• Re-establish international creditworthiness: Negotiations were started with international organisations and commercial banks to restructure the debt. An agreement with foreign creditors and the IMF was reached nine months later, in June 1986.
As in the previous attempt at stabilisation, the unions called a general strike. In response, the government declared a state of siege, and the strike was quickly disbanded. After so many failed attempts to end hyperinflation, public opinion was clearly in favour of stabilisation.
The effects on inflation were dramatic. By the second week of September the inflation rate was actually negative! Inflation didn't remain negative for very long, but the average monthly rate of inflation was below 2 per cent during 1986-89. As Table I shows, the budget deficit was drastically reduced in 1986, and the average deficit was below 5 per cent of GDP for the rest of the decade.
• For more on the German hyperinflation, read Sieven Webb, Hyperinflation and Stabilization in the Weimar Republic (New York: Oxford University Press, I989>.
• Two good reviews of what economists know and don't know about hyperinflation arc: Rudiger Dornbusch, Federico Sturzenegger and Holgcr Woll, Extreme inflation: Dynamics and stabili¬zation', Brookings Papers on Economic Activity, 1990 92, pp. l-84; and Pierre Richard Agcnor and Peter Montiel, Development Macroeconomics (Princeton. NJ: Princeton University Press, 1995) chapters 8 to II. Chapter 8 makes tor easy reading,- the other chapters are more difficult,
• The experience of Israel which went through high inflation and stabilisation in the 1980s, is described in Michael Bruno's Crisis, Stabilization and Economic Reform (New York: Oxford University Press 1993), especially chapters 2 lo 5. Michael Bruno was the head of Israel's central bank for most of lhat period.
• One of the classic articles oil how to end hyperinflations is The ends of lour big inflations by Thomas Sargent, in Robert Hall (ed.), Inflation: Causes and Effects (Chicago: NBFR and ihe University of Chicago, 1982», pp. 41-97. In that article, Sargent argues that a credible program can lead to stabilisation at little or no cost in terms ol activity.
• Rudiger Dornbusch and Stanley Fischer, Stopping hyperinflations, past and present'. Weltwirt- schaftlichers Archiv, 1986-1, pp. 1-47, gives a very readable description of the end ol hyper¬inflations in Germany, Austria and Poland in the 1920s, in Italy in 1947 and in Israel and Argentina in 1985.
T
т
7 9 II
Index of central bank independence
Less independent More independent
• Л leading proponent ol the view that governments misbehave and should be lightly restrained is lames Buchanan, from George Mason University, in the United Stales. Buchanan received the Nobel Prize in 1986 lor his work on public choice. Read his book, written with Richard Wagner, Democracy in Deficit: The Political Legacy of Lord Keynes ( New York: Academic Press, 1977).
• For a survey ol thc politics oi liscal policy, read Alberto Alesina and Roberio Perotti, Thc political economy ol budget deficits IMF Staff Papers 1995. Also look at lames Poterba. Do budget rules work?', in Alan Auerbach fed.1. Fiscal Policy. Lessons from Economic Research 'Cambridge, MA: MIT Press. 1997).
• For more on the politics of monetary policy, read Alberto Alesina and Lawrence Summers, 'Central bank independence and macroeconomic performance: Some comparative evidence', journal of Money, Credit and Banking, May 1993, pp. 289 97.
• The modern statement ol ihe Ricardian equivalence proposition is by Robert Barro. Are government bonds net wealth?'. Journal of Political Economy. December 1974, pp 1095—1 17.
• F.ach year, the Australian federal government presents its forthcoming budget ю parliament, and all
As we come to ihe end ol this brief history of macroeconomics, and to the end ol the book, let us restate thc basic set of propositions on which most macroeconomists agree:
• In the short rim, shilts in aggregate demand afleci output. Higher consumer confidence, a larger budget deficit, lower interest rates or faster growth of money arc all likely to increase output and to dccrcasc unemployment.
• In thc medium run. output returns lo its natural level. This natural level depends on thc natural rate ol unemployment which together with the size of the labour force, determines thc level ol employ¬ment on the capital stock and on ihe slate ol technology.
• In the long run. two main lactors determine the evolution of the level of output: capital accumula¬tion and technological progress.
• Monetary policy allects output in thc short run, but not in thc medium run or the long run, A higher rale of money growth eventually translates oric-for-one into a higher rate of inllation.
• Fiscal policy has short-run. medium-run and long-run effects on output. Higher budget deficits are likely to increase output in the short run. They leave output unalfccted in thc medium run. And they arc likely to dccrcasc capital accumulation and output in thc long run.
These propositions leave room for disagreements:
• One is about the length of the short run the period of time over which aggregate demand alfccts output. At one extreme, real business cvclc theorists start Irom ihe assumption that output is always at ihe natural level ol output: the short run is very short! Ai the other extreme, the study of slumps and depressions (which wc explored in Chapter 23) implies lhat the cffccts of demand may be extremely long-lasting, that the short run' may be very long.
• For more details on how the Australian Bureau ol Statistics compiles the national accounts, read Australian National Accounts: Concepts, Sources and Methods', ABS, cat. no. 5216.0 (available at the ABS website —go lo By Topic, then Concepts Classilication and Standards i.

Bonds differ in two basic dimensions-.
1. Default risk, the risk that the issuer of the bond (it could be a government or a company) won't pay back the lull amount promised by the bond.
2. Maturity, the length of time over which the bond promises to make payments to the holder of the bond. A bond that promises to make one payment of $1,000 in six months has a maturity of six months,- a bond that promises $100 per year for the next twenty years and a final payment of $1,000 at the end of those twenty years has a maturity of twenty years.
Maturity is the more important dimension lor our purposes here and we will focus on it in this chapter. However, default risk can be crucially important if it spreads across the financial system, leading to a financial crisis. We will discuss default risk in the context of financial crises in Chapter 22 in the 'Pathologies' extension to the book.
Bonds of different maturities have a price and an associated interest rate called the 'yield to maturity', or simply the yield. Yields on bonds with a short maturity, typically a year or less, are called short-term
We have so far focused on bonds But while governments finance themselves hy issuing bonds thc same isn't true of firms. Firms raise lunds in two ways: through debt finance (bonds and loans) and through equity finance (through issues ol stocks, or shares, as stocks are also called). Instead ot paying predetermined amounts as bonds do stocks pay dividends in an amount decided by the rirm. I )ividends arc paid from the lirms profits. They are typically less than prolits, as firms retain some of their profits to finance their investment. But dividends move with profits—when profits increase, so do dividends.
Our focus in this section is on thc determination of stock prices. As a way ol introducing the issues. Figure 15.5 shows the behaviour ol an index ol Australian stock prices, the Standard & Poor's ASX 200 Index (or the S&P Index, lor short Irom 1480 lo 2008. The S&P Index measures movements in the average stock price ol 200 large companies, representing about 90 percent ol the total value of the Australian market. Another popular Australian index is the All-Ordinaries Index, which has a slightly broader coverage than the S&P. The equivalent to the latter in the Llnited States is the S&P 500 Composite Index. A better known LIS index is the Dow Jones Industrial Index, an index ol stocks of industrial lirms only and there-lore less representative ol the average price of stocks than the S&P Index. Similar indexes exist for other countries. The Nikkei Index reflects movements in stock prices in Tokyo, and the FT, the CAC and the I lang Seng indexes reflect stock price movements in London Paris and
• There are many had books written about the stock market. A good one, and fun to read, is Burton Malkiel, /1 Random Walk Down Wall Street. 7th edn (New York: Norton, 2000).
• Peter Garber gives an account of historical bubbles in famous lirst bubbles', Journal of Lconomic Perspectives, Spring 1990, pp. 35-54.
The shaded columns represent recession periods. Relative movements in investment are much larger than relative movements in
consumption.
SOURCE: ABS. cat no. 5206.Table 54.
• Investment is much more volatile than consumption. Relative movements in investment range Irom -18 per cent to 22 per cent, while relative movements in consumption range from only -О. I per cent to 6 per cent. The standard deviation of investment growth is more than six times greater than that of consumption.
• Another way of stating the same fact is that, whereas the level of investment is much smaller than the level of consumption 'recall that business investment accounts lor 14 per cent of GDP. versus 60 per cent for consumption) changes in investment from one year to the next are typically of thc same magnitude as changes in consumption. Both components contribute roughly equally to fluctuations in output over time.
Consumption depends on both wealth and current income. Wealth is thc sum of non-human wealth i financial wealth and housing wealth) and human wealth (thc present value of expected after-tax labour income).
The response of consumption to changes in income depends on whether consumers perceive these changes as transitory or as permanent.
Consumption is likely to respond less than one-lor-one to movements in income, and consumption may move even if current income doesn't change.
Investment depends on both current prolit and thc present value ot expected future profits. Llnder the simplifying assumption that lirms expect profits and interest rates to be the same in the future as they are today, we can think of investment as depending on the ratio ot prolit to the user cost of capital, where the user cost is the sum of the real interest rate and the depreciation rate. Movements in profit arc closely related to movements in output. Hence, we can think of investment as depending indirectly on current and expected future output movements. Firms that anticipate a long output expansion, and thus a long sequence of high prolits, will invest. Movements in output that arc not expected to last will have a small effect on investment.
Investment is much more volatile than consumption. While business investment accounts only for 14 per cent ot Australian GDP today and consumption accounts for 60 per cent, movements in investment and consumption arc of roughly equal magnitude.
Let's start by reviewing what you have learned, and then discuss how we should modify the characterisation of goods and financial markets—the IS-LM model—we developed in The Core.
Expectations, consumption and investment decisions
The theme of Chaptcr 16 was lhal both consumption and investment decisions depend very much on expectations of future income and interest rates. The channels through which expectations aftcct consumption and investment spending are summarised in Figure 17.1.
Note the many channels through which expected future variables affect current decisions, both directly and through asset prices:
• An increase in current and expected future after-tax real labour income, or a decrease in current and expected future real interest rates increases human wealth (the expected present discounted value of after-tax real labour income), which in turn leads lo an increase in consumption.
• An increase in current and expected future real dividends, or a decrease in current expected future real interest rales, increases stock prices, which lead to an increase in non-human wealth and, in turn, to an increase in consumption.
Given expectations, a decrease in the real interest rate leads to a small increase in output the IS curve is steeply downward sloping. Increases in government spending, or in expected future output shift the IS curve to the right Increases in taxes, in expected future taxes or in the expected future real interest rale shift the IS curve to the left
large changes in spending. For example, lirms aren't likely to change their investment plans very much in response to a decrease in the current real interest rate il they don't expect luture real interest rates lo he lower as well.
• The multiplier is likely to he small. Recall that the size ol the multiplier depends on the size ol the effect of a change in current income (output) on spending. Bui a change in current income, given unchanged expectations of future income, is unlikely to have a large effect on spending. The reason: changes in income that aren't expected to last have only a limited effect on both consumption and investment. Consumers who expect their income to be higher only lor a year will increase con¬sumption, but by much less than the increase in income. Firms that expect sales to be higher only for a year arc unlikely to change their investment plans much, il at all.
Putting things together, a large decrease in the current real interest rate—from Г ; to Гц in Figure 17.2—leads to only a small increase in output, Irom Yл to The IS curve, which goes through points A and B, is steeply downward sloping.
Changes in all variables in equation (17.2) other than У and r shift the IS curve:
• Changes in current taxes (T) or in current government spending (G) shilt the IS curve. An increase in current government spending increases spending ai a given interest rate, shifting the IS curve to ihe right. An increase in taxes shifts the IS curve to the left. These shilts are represented in Figure 17.2.
In the basic IS-LM model we developed in Chapter 5, there was only one interest rate, i which entered both thc IS relation and the LM relation. When the RBA eased monetary policy, the' interest rate went down and spending increased. From the previous three chapters, you have learned that there are in fact many interest rates and that we must keep two distinctions in mind:
1. the distinction between the nominal interest rate and the real interest rate
2. the distinction between current and expected future interest rates.
The interest rate that enters the I.M relation, which is the interest rate that the RBA affects directly, is the currcnt nominal interest rate. In contrast, spending in the IS relation depends on both current and expected future real interest rates. Economists sometimes state this distinction even more starkly hy saying lhat, while the RBA controls the slwrt-term nominal interest rate, what matters lor spending and output is thc long-term real interest rate.
Let's look at this distinction more closely. Recall from Chaptcr 14 that the real interest rate is equal to thc nominal interest rate minus expected currcnt inflation:
r = i - 7T('
Similarly, the expected luture real interest rate is equal to the expected future nominal interest rate minus expected luture inflation.
r'e = i"r - тг'1'
The IS curve is steeply downward sloping. Other things being equal, a change in the current interest rate has a small effect on output The LM curve is upward sloping. The equilibrium is at the intersection of the IS and LM curves. We assume that the central bank fixes the current interest rate.
The effects of monetary policy on output depend very much on whether and how monetary policy affects expectations.
When account is taken of its effect on expectations, a decrease in government spending need not lead to a decrease in current output
smaller thc adverse effect on spending today. Note also that the larger the decrease in expected future government spending (G'c), the larger the eflect on expected future output and real interest rates,- thus, the larger the favourable effect on spending today. This suggests that backloading the delicil reduction program towards the future, with small cuts today and larger cuts in the luture, is more likely to lead to an increase in output
On the other hand, backloading raises other issues. Announcing the need for painful cuts in spending, and then leaving them to the luture, is likely to seriously decrease the program's credibility— thc perceived probability that the government will do what it has promised when the lime comes to do it. The government must play a delicate balancing act: enough cuts in the current period to show a commitment to deficit reduction, and enough cuts left to the future to reduce the adverse effects on the economy in thc short run.
More generally, our analysis suggests that anything in a deficit reduction program that improves expectations ol how the future will look is likely to make the short-run effects of deficit reduction less painful. Let's give two examples:
W
e have assumed so far that the economy was closed—that it didn't interact with the rest of the world. We had to start this way, to keep things simple and build up your intuition for the basic macroeconomic mechanisms.We are now ready to relax this assumption. Understanding the macroeconomic implications of openness will occupy us for this and the next three chapters.
Openness has three distinct dimensions:
1. Openness in goods markets—the ability of consumers and firms to choose between domestic goods and foreign goods.
In no country is this choice completely free of restrictions. Even the countries most committed to free trade have tariffs (taxes on imported goods) and quotas (restrictions on the quantity of goods that can be imported) on at least some foreign goods. At the same time, in most countries average tariffs are low and getting lower.
2. Openness in financial markets—the ability of financial investors to choose between domestic financial assets and foreign financial assets.
Until recendy, even some of the richest countries, such as France and Italy, had capital controls—restrictions on the foreign assets their domestic residents could hold as well as on the domestic assets foreigners could hold. These restrictions are rapidly disappearing. As a result, world financial markets are becoming more and more closely integrated.
3. Openness in factor markets—the ability of firms to choose where to locate production, and the ability of workers to choose where to work.
Here also trends are clear. Multinational companies operate plants in many countries and move their operations around the world to take advantage of low costs. Much of the debate about the North American Free Trade Agreement (NAFTA), signed in 1993 by the United States, Canada and Mexico, centred on its implications for the relocation of US firms to Mexico. And immigration from low-wage countries is a hot political issue in countries ranging from Germany through to Australia.
In the short run and in the medium run—the focus of this and the next three chapters—openness in factor markets plays much less of a role than openness in either goods markets or financial markets. Thus, we will ignore openness in factor markets, and focus on the implications of the first two dimensions of openness.
• Section 18.1 looks at openness in the goods market, the determinants of the choice between domestic goods and foreign goods, and the role of the real exchange rate.
• Section 18.2 looks at openness in financial markets, the determinants of the choice between domestic financial assets and foreign financial assets, and the role of interest rates and exchange rates.
• Section 18.3 gives the map to the next three chapters.
I I I I I I
1980 1985 1990 1995 2000 2005
Openness in financial markets allows financial investors to hold both domestic assets and loreign assets, to diversify their portfolios, and lo speculate on movements in foreign interest rates versus domestic interest rates, on movements in exchange rates, and so on.
Diversify and speculate they do. Given that buying or selling foreign assets implies buying or selling foreign currency—sometimes callcd foreign exchange the volume of transactions in foreign exchange markets gives a sense ol the importance of international financial transactions. "I he Bank of International Settlements (www.bis.orgi reported daily global volume of foreign-exchange transactions in 200/ equal to about LIS$3.2 trillion, ot which 86 per cent involved US dollars on one side of any transaction, and 37 per cent involved the euro. The LIS dollar/euro was the most traded pair, with 27 per cent of all transactions. The Australian foreign-exchange market was the seventh largest in the world, and the Australian dollar featured in 6.7 per cent of all transactions—about A$163 billion per day.
To get a sense of the magnitude ol these numbers, the sum of US exports and imports in 2007 totalled US$4 trillion lor the year, or about US$ I I billion a day. Suppose that the only US$ transactions in foreign-exchange markets had been on one side by LIS exporters selling their foreign currency earnings, and on the other side by LIS importers buying the foreign currency they needed to buy foreign goods. Then, the volume of transactions would have been US$11 billion a day, or a mere 0.3 1 per cent of the actual daily volume ol dollar transactions US$3.2 trillion) involving dollars in loreign-exchange markets. Doing a similar calculation (or Australia A$ transactions lor trade in goods and services in 2008 were about A$2 billion per day. or 1.2 per cent of all A$ transactions. These calculations tell us that most (actually about 40 per cent1 ol the foreign-exchange transactions arc associated not with trade but with purchases and sales ot financial assets. And much ol it is simply transactions between dealers and brokers on the global wholesale foreign-exchange market. The volume ol transactions in loreign-exchange markets is not only high but also rapidly increasing. The volume ol global foreign-exchange transactions in 2001 was double what it was in 1988 and increased by a huge 126 per ccnt Irom 2001 to 2007. Again, this activity rctlccts mostly an increase in financial transactions, rather than an increase in goods trade over the period. The lact that financial transactions dominate trade transactions by such a big margin indicates that exchange rates in the short term will be driven primarily by international portfolio considerations—in particular, by international parity relations, which we will discuss shortly.
I or a country as a whole, openness in financial markets has another important implication. It allows the country to run trade surpluses and trade deficits Recall that a country running a trade dclicit is buying more from the rest of the world than it is selling to the rest ol the world. In order to pay for the difference between what it buys and what it sells, the country must borrow from the rest of the world. It borrows by making it attractive for loreign linancial investors to increase their holdings ol domestic assets—in effect, to lend to the country.
Let's start by looking more closely at the relation between trade flows and financial flows. When this is done, wc will then be able to look at the determinants ol these financial flows.
The balance of payments
A country's transactions with the rest of the world, including both trade flows and financial Hows, arc summarised by a set ol accounts called the balance of payments. Table 18.3 presents the Australian balance ol payments for the year ending in June 2008. The table has two parts, separated by a line. Transactions are referred to cither as above the line or below the line
SOURCE ABS. cat. no. 5302.
The current account
Thc transactions above the line record payments to and Irom the rest ol the world. They are called current account transactions.
• Thc first two lines record the exports and imports ol merchandise' goods. Exports lead to payments from the rest ol the world imports to payments to the rest ot the world. In 2008. merchandise imports exceeded exports, leading to an Australian merchandise trade deficit of A$20.8 billion.
Note that the numbers lor exports and imports are slightly different from those in Table 18.2,- this is bccausc the numbers in Table 18.2 refer to the year ending August 2008.)
• Services such as insurance and shipping) are also imported and exported, and Australia had a net service trade surplus ol A$2.9 billion in 2008. Adding thc merchandise and service deficits, we get the trade balance tor Australia as a A$I7.C) billion deficit.
• Exports and imports arcn t thc only sources ot payments to and from thc rest ot thc world. Australian residents receive investment income on their holdings ol loreign assets, and foreign residents receive investment income on their holdings ol Australian assets. Also, Australia makes net transfers to foreign residents, largely through foreign aid. In 2008. net investment income and transfers which includes foreign aid paid to the rest ol the world was A$50.3 billion, this huge delicil reflects the fact that Australia is a net debtor country.
"I he sum of net payments to and from the rest of the world is called the current account balance. II net payments from thc rest ol the world are positive the country is running a current account surplus: ii they are negative the country is ninning a current account deficit. Adding all payments to and Irom the rest of the world net payments from Australia to the rest of the world in 2008 were equal to -A$I7.9 - A$50.3 -A$68.2 billion. Put another way, in 2008 Ausiralia ran a current account deficit ol $68.2 billion, a deficit equal to iust above 6 per cent ol its GDP.

The short run at a normal rate,and
Let's now turn to dynamics. Suppose that the economy is initially at its medium-run equilibrium: unemployment is at
unemployment is equal to the natural rate. Output growth is equal to the normal growth rate. The he naturr'1 rue of
. n . i . i i i i unemployment? To inflation rate is equal to the central banks target rate
answer, we need
Suppose, however, that the inllation rate and, by implication, the rate of nominal money growth are to discuss the costs of
high, and there is a consensus that inflation must be reduced. The central bank decides that the inflation inflation.We will do so
target must be lowered to 77"''. The question we now take up is what will happen along the way to the < in Chapters 24 ard 26. new medium-run equilibrium?
Just by looking at our three relations, we can tell the beginning of the story:
• Look at the dynamic aggregate demand relation: given the initial rate of inflation, a lower target " inflation rate leads to a higher interest rate, and thus to a decrease in output growth.
• Now look at Okun's law: output growth below normal leads to an increase in unemployment. 4 g. 1 => u
• Now look at the Phillips curve relation: unemployment above the natural rate leads to a decrease in % t =» n- i inflation.
So we have our first result. Tighter monetary policy (in the form of a lower inflation target) leads initially to lower output growth and lower inflation. If tight enough, it may lead to negative output growth and thus to a recession. What happens between this initial response after one year and the medium run (when unemployment returns to the natural rate)? The answer will depend on the path of monetary policy.
We can actually go a bit further in thinking about what happens to the economy over time:
• Look at the Phillips curve relation: so long as unemployment remains above the natural rate, inflation keeps decreasing. So, eventually, inflation approaches the lower inflation target, and as that
happens the central bank will be able to reduce the interest rate. * и > u„=> тг -l
You should remember three basic lacts about growth in rich countries since 1950:
• the large increase in the standard of living
• the decrease in growth since the mid-1970s
c. Suppose that the exchange rate is 0.1 (A$0.10 per kina i. Calculate PNG's consumption per capita in dollars.
d. Using the purchasing power parity method and Australian prices, calculate PNG consumption per capita in dollars.
4. Consider the production function Y = \ К \ К a. Calculate output when К - 49 and N = 81.
h. If both capital and labour double, what happens to output?
c. Is this production lunction characterised by constant returns to scale? Explain.
d. Write this production function as a relation between output per worker and capital per worker, c. Let K/N = 4. What s Y/W Now double K/N to 8. Does Y/N more than or less than double?
f. Does the relation between output per worker and capital per worker exhibit constant returns to scale?
g. Is your answer in (f) the same as your answer in i с)? Why or why not?
h. Plot the relation between output per worker and capital per worker. Does it have the same general shape as the relation in Figure 10.5? Explain.
Dig deeper
5. The growth rates of capital and output
Consider the production function given in problem 4. Assume that N is constant and equal to I. Note that if z = xa, then g. = a gx, where g- and gx are the growth rates of z and x.
a. Given the growth approximation here, derive the relation between the growth rate ol output and the growth rale of capital.
b. Suppose we want io achieve output growth equal to 2 per cent a year. What is the required rate of growth ol capital?
c. In (b), what happens to the ratio ol capital to output over time?
d. Is il possible to sustain output growth of 2 per ccnt lorever in this economy? Why or why not?
6. Between 1950 and 1973, Germany and japan experienced growth rates that were at least two percentage points higher than those in the United States. Yet the most important technological advances of that period were made in the United States. How can this be?
Explore further
7. In Table 10.1 we saw that the levels of output per capita in Australia, the United Kingdom, Germany, Trance, lapan and the United States were generally much closer to each other m 2004 than they were in 1950. llere we will examine convergence for another set of countries.
Go to the web address containing the Penn World Tables (see Table 10.1 and the focus box on the construction of PPP numbers) (http://pwt.econ.upenn.edu). Download the PW'I'6.2 bundle and
• Brad deLong, an economist at the Llniversity of California at Berkeley, has several fascinating articles on growth on his web page (www.j-bradford-delong.net). Read, in particular, Berkeley laculty lunch talk: Main themes ol twentieth century economic history, which covers many of the topics ol this chapter.
• A broad presentation ot tacts about growth is given by Angus Maddison in The World Economy. A Mill ennium Perspective Paris: OF.CD, 2001 ). The associated site, , has a large number of facts and data on growth over the last two millennia.
• Chapter 3 in Productivity and American Leadership, by William Baumol, Sue Anne Batev Blackman and Fdward Wolll (Cambridge. MA: MIT Press, 1989), gives a vivid description ot how life has been translormed by growth in the Llnited States since the mid- 1880s.
At the centre ol the determination of output in the long run are two relations between output and capital:
• The amount of capital determines the amount ol output being produced.
We have derived two relations:
• I ron the production side, equation (11.1) shows how capital determines output.
• I ron the saving side, equation (11.2) shows how output in turn determines capital accumulation.
When capital and output are low, investment exceeds depreciation and capital increases. When capital and output are high, investment is less than depreciation and capital decreases.
ol capital per worker, investment increases by less and less, while depreciation keeps increasing in pro¬portion to capital. For some level ol capital per worker, K*/N in Figure I 1.2, investment is iust enough to cover depreciation and so capital per worker remains constant. Го the left ot K*/N, investment exceeds depreciation and capital per worker increases. This is indicated by the arrows pointing to the right along the curve representing the production lunction. To the right ol K*/N, depreciation exceeds investment and capital per worker decreases. This is indicated by the arrows pointing to the left along the curve representing the production function.
Characterising the evolution ol capital per worker and output per worker over time is now easy. Consider an economy that starts with a low level ot capital per worker—say, KjN in Figure I 1.2. Because investment exceeds depreciation, capital per worker increases. And because output moves with capital, output per worker increases as well. Capital per worker eventually reaches К * / \ the level at which investment is equal to depreciation. Once the economy has reached the level ol capital per worker K*/S. output per worker and capital per worker remain constant at Y*/N and K*/N, their long- run equilibrium levels.
I hink tor example, ot a country that loses part ot its capital stock as a result ol bombing during a war. The mechanism we have iust seen suggests that if it has suffered much larger capital losses than population losses, it will come out ol the war with a low level ol capital per worker, so at a point to the left ol K*/S. The country will then experience a large increase in both capital per worker and output per worker for some lime. This appears to describe well what happened alter World War II to countries thai had proportionately larger destructions of capital than of human lives (see the locus box Capital accumulation and growth in France in the aftermath ot World War IF).
If a country starts instead from a high level ot capital per worker, from a point to the right ot K*/N, then depreciation will exceed investment and capital per worker and output per worker will decrease: the initial level ol capital per worker cannot he sustained given the saving rate. This decrease in capital per worker will continue until the economy again reaches the point where investment is equal to depreciation where capital per worker is equal to K*/N. From then on, capital per worker and output per worker will remain constant.
Steady-state capital and output
Lets look more closely at the levels ol output per worker and capital per worker to which the economy converges in the long run. I he state in which output per worker and capital per worker are no longer
1 in steady state hy definition, the change in capital per worker is zero thc steadv-state value ol capital per worker, K*/.X is given by
к*
(И.4)
Thc sleady-state value ot capital per worker is such that the amount of saving per worker (the left side) is just sullicieni to cover depreciation of the capital slock per worker (the right side1.
Given stcadv-siaic capital per worker (K*/N), the steady-state value ol output per worker (Y*/N > is given by the production function
• saving rate. 251
• steady state, 257
• golden-rule level ot capital. 261
• age pension, 262
• ageing population. 262
• pay-as-you-go social security system. 262
In 1928. Charles Cobb (a mathematician) and Paul Douglas (an economist, who went on to become a US senator) concluded that the following production function gave a very good description of the relation between output, physical capital and labour in the United States from 1899 to 1922:
Y = K" N]
with n being a number between zero and I.Their findings proved surprisingly robust. Even today, the production function (11 A.I), now known as the Cobb-Douglas production function, still gives a good description of the relation between output, capital and labour in the United States, and in many other countries, including Australia. And the Cobb-Douglas production function has become a standard tool in the economist's toolbox. (Verify for yourself that it satisfies the two properties discussed in the text: constant returns to scale, and decreasing returns to capital and to labour.)
The purpose of this appendix is to characterise the steady state of an economy when the production function is given by equation (I IA.I). (All you need to follow the steps is a knowledge of the properties of exponents.)
Recall that, in steady state, saving per worker must be equal to depreciation per worker. Let us see what this implies.
In an economy in which there is both capital accumulation and technological progress, at what rate will output grow? To answer this question, we need to extend the model developed in Chapter 11 to allow for technological progress. To introduce technological progress into the picture, wc must revisit ihe aggregate production function.
Technological progress and the production function
Technological progress has many dimensions:
• It may mean larger quantities of output for given quantities ol capital and labour. Think of a new type of lubricant that allows a machine to run at a higher speed and so produce more.
• It may mean better products. Think of the steady improvement in car safety and comfort over time.
• It may mean new products. Think ot the introduction of the CD player, the lax machine, mobile phones, llai screen monitors, the ifod.
Capitol per effective worker and output per effective worker converge to constant values in the long run.
• The relation between output per effective worker and capital per effective worker was derived in Figure 12.1. The relation is repeated in Figure 12.2. Output per effective worker increases with capital per effective worker, but at a decreasing rate.
• for more on growth, both theory and evidence, read Clharles Jones Introduction to Economic Growth New York: Norton. 2002, 2nd edn). Jones's web page. , is a useful portal to the research on growth.
• For more on patents, see the Economist survey on Patents and Technology. 20 October 2005
• For an evaluation ot thc contribution of IT to the growth in thc standard ol living 'compared with other great inventions in the past see Robert Cordon, Does the "New Economy" measure up to the great inventions ol the past? , journal of Economic Perspectives. Fall 2000.
• For an in-depth analysis of the role ol R&D lor growth in Australia, read the 2008 Cutler report Venturous Australia .
Readings on two issues we have not explored in the text:
We have looked so lar at the short-run effects of a change in productivity on output, employment and unemployment. In thc medium mn, we know the economy returns to the natural level of output—the level ol output consistent with the natural rate ol unemployment. Now we must ask: Is the natural rate of unemployment itself allectcd by changes in productivity?
Recall Irom Chapter 6 that the natural rate of unemployment is determined hy two relations, the price-setting relation and the wage-setting relation. Our first step must be to think about how changes in productivity allcct each of these two relations.
Price setting and wage setting revisited
Consider price setting first.
• From equation 13.1), each worker produces A units ol output; equivalently, producing I unit of output requires \IA workers.
• If thc nominal wage is equal to IV, thc nominal cost of producing 1 unit of output is therefore equal
to (1/A)W= W/A.
• If firms set their pricc equal lo I + fx times cosl (where /л is lhe markup), lhe price level is given by:
W
P = (j + fJLV
Thc only diflcrcncc between this equation and equation (6.3) is lhe presence ol the productivity term, A (which we had implicitly set to I in Chapter 6). An increase in productivity decreases cost which decreases lhe price level given the nominal wage.
Turn to wage setting. The evidence suggests that, other things being equal wages are typically set to rcllect lhe increase in productivity over time. It productivity has been growing at 3 per cent a year on average lor some time, then wage contracts will build in a wage increase of 3 per cent a year. This suggests thc lollowing extension ol our earlier wage-setting equation:
W = A'PTiu.z)
Look at the three terms on the right side of equation (1 3.4).
• Two of them, P1' and T:u,z), are familiar Irom equation (6.1). Wages depend (negatively) on the unemployment rate, u, and on institutional factors captured by the variable z. And workers care about real wages, not nominal wages, so wages depend on the expected) price level, P1'.
• Thc new term is A''—wages now also depend on the expected level of productivity, A'\ If workers and firms both expect productivity to increase, they will incorporate those expectations into the wages set in bargaining.
The natural rate of unemployment
We can now characterise the natural rate of unemployment. Rccall that the natural rate of unemploy¬ment is determined by the price-selling and wage-setting relations, and the additional condition that expectations be correct. In this case, this condition requires lhat expectations of both prices and productivity be correct, so P1' = P and A' - A.
• For more on the process of reallocation that characterises modern economies, read The Churn: The Paradox of Progress, a report by the Federal Reserve Bank of Dallas, 1993.
• For a fascinating account ol how computers arc transforming labour markets, read Frank Levy and Richard Murnane, The New Division of Labour: How Computers are Creating the Next lob Market (Princeton, NJ: Princeton University Press, 2004).
• For the role of institutions in growth, read Abhijit Banerjee and Esther Duflo, Growth theory through the lens of development economics', in Handbook of Economic Growth (Amsterdam: North Holland, 2005) (read sections 1 to 4 of Chapter 7).
• For more on institutions and growth, read Daron Acemoglu, Llnderstanding institutions', Lionel Robbins Lectures, 2004, .
• For a detailed analysis of growth in China, read the OF.CD's Economic Survey of China, published in 2005, .
I .et's now turn to the second key concept introduced in this chapter that of expected present discounted value.
To gain an understanding of this concept, let's return to the example of the manager considering whether to buy a new machine. On the one hand, buying and installing the machine involves a cost today. On thc other, the machine allows lor higher production, higher sales, and thus higher prolits in the future. The question lacing the manager is whether the value of these expected profits is higher than the cost ot buying and installing the machine. This is where the concept ot expected present discounted value comes in handv. The expected present discounted value ot a sequence ot future payments is the value today ol this expected sequence ol payments. Once the manager has calculated the expected present discounted value ot the sequence ot profits, her problem becomes simple. Il this value exceeds the initial cost, she should go ahead and buy the machine. Il it doesn't she should not.
As in the case ot the real interest rate in Section 14.1 thc practical problem is that expected present discounted values aren t directly observable. They must he constructed Irom inlormation on the sequence ot expected payments and expected interest rates. Let's first look at the mechanics of construction.
Calculating expected present discounted values
If the one-year nominal interest rate is ;',, lending one dollar this year yields I + i, dollars next year. Equivalently, borrowing one dollar this year implies paying back I + i, dollars next year. In that sense, one do.lar this year is worth I + t dollars next year. I his relation is represented graphically in the first line of Figure 14.3.
Turn the argument around and ask: One dollar next year is worth how many dollars this year? The answer, shown in the second line ol Figure 14.3, is 1/(1 + i',) dollars. Think of it this way: if you lend 1/(1+ i,) dollars this year, you will receive l/( I + /,} times (I + t,) - I dollar next year. Equivalentlv il you borrow l/( I + i, dollars this year you will have to repay exactly one dollar next year. So, one dollar next year is worth 1/(1 • /,) dollars this year.
More formally, we say that l/( I + i.) is the present discounted value ot one dollar next year.
The word present comes from the fact lhat we are looking at the value ol a payment next year in terms of dollars today.
The word discounted comes Irom the fact lhat the value next year is discounted, with l/l 1 + /,) being the discount factor. (The one-year nominal interest rate, /',, is sometimes called the discount rate.)
Because the nominal interest rate is always positive, the discount factor is always less than I: a dollar next year is worth less than a dollar today. The higher the nominal interest rate, the lower the value
today ot a dollar next year. It i 5 per cent, the value this year of a dollar next year is l/l .05 «= 05 cents. II i - 10 per cent, the value today of a dollar next year is 1/1.10 = 91 cents.
Now apply the same logic to the value today ol a dollar two years Irom now. For the moment, assume that current and future one-year nominal interest rates arc known with certainty. Let i, be the nominal one-year interest rate lor this year, and he the one-year nominal interest rate next year.
Il today, you lend one dollar tor two years, you will get • I + i,)( 1 + /,.,) dollars two years from now. Put another way, one dollar today is worth (I + /, м I •/,,,) dollars two years Irani now. This relation is represented in the third line ol Figure 1-13.
What is one dollar two years from now worth today? I!y the same logic as before, the answer is l/( 1 + I. I + /,. | dollars: it you lend l/( 1 + /,)( I + i,_, dollars this year, you will get exactly one dollar in two years. So. the present discounted value of a dollar two years from today is equal to I/(1 + /,) I +/'..,) dollars. T his relation is shown in the fourth line of Figure 14.3. II, for example, the one-year nominal interest rate is the same this year and next, and equal to 5 per cent, so i, - /,., = 5 per cent, then the present discounted value ol a dollar in two years is equal to I I .05)-, or about 91 cents, today.
A general formula
I laving gone through these steps, it is easy to derive the present discounted value for the general case.
Consider a sequence ol payments in dollars, starting next year and continuing into the future. Assume tor the moment that these future payments arc known with certainty. Denote the lirst year's payment by the payment the next year by $z,.lf the payment three years from today by and so on.
The present discounted value ol this sequence ol payments that is the value in today's dollars ol
the sequence ot payments which wc will call $V't, is given by

1 + /', ~ (I + /,)(1 + iM)
Each payment in the future is multiplied by its respective discount factor. The more distant the payment, the smaller the discount factor and thus the smaller today's value of that distant payment. In other words, future payments are discounted more heavily, so their present discounted value is lower.
We have assumed so far that future payments and future interest rates were known with certainty. Actual decisions, however, have to be based on expectations of future payments rather than on actual values for these payments. In our earlier example, the manager cannot be sure of how much profit the new machine will actually bring.- nor can she be sure what interest rates will be in the future. The best she can do is get the most accurate forecasts she can. and then calculate the expected present discounted value ot prolits, based on these forecasts.
How do wc calculatc the expectcd present discounted value when future payments or interest rates arc uncertain? This is done in basically the same way as before, but replacing the known future payments and known interest rates by expected future payments and expected interest rates. Formally, denote expected payments next year by expected payments two years from now by and so on.
Similarly, denote the expected one-year nominal interest rate next year by /',',,, and so on. The one-year
I
Ж - $=h—r + 7ГТ
l + t
We will spend the next three chapters using the tools we have iust developed. In the rest ot the chaptcr we take a first step, introducing thc distinction between real and nominal interest rates in the IS-LM model and then exploring the relation between money growth, inflation, and real and nominal interest rates.
In the IS-LM model we developed in The Core i Chapter 5), the interest rale entered in two places: it allecied investment in the IS relation, and ii allecled the choice between money and bonds in the LM relation. Which interest rate—nominal or real—were we talking about in each ease"
The RBAs decision to allow for easier monetary conditions is the main lactor behind the decline in interest rates in the last six months' Imaginary quote, circa carlv 2002).

The inflation rates calculated using either the CPI or the CDP deflator are largely similar. SOURCES: ABS. cat no. 6401 (col. J): RBA Bu/ferm.Table G11 (cols L and W).
Take another example—1995. CPI inflation was almost three percentage points higher than CDP deflator inflation. During this year, commodity prices fell, which was partly responsible for the exchange rate depreciating to a historically low point. This meant that imports were much more expensive, and so the CPI increased much more than the CDP deflator.
In what follows, we will typically assume that the two indexes move together, so we don't need to distinguish between them. We will simply talk about the price level and denote it by Pt, without indicating whether we have the CPI or the GDP deflator in mind.
Why do economists care about inflation?
If a higher inflation rale meant just a laster proportional increase in all prices and wages—a case called pure inflation—inllation would be only a minor inconvenience. Relative prices wouldn't be allected by inflation.
Take, for example, the workers' real wage—the wage measured in terms ol goods rather than in dollars. In the economy with 10 per cent inllation prices would increase by 10 per cent a year. Bui so would wages—and real wages would remain the same. Inllation wouldn't be entirely irrelevant,- people would have to keep track ol the increase in prices and wages when making decisions. But this would be a small burden, hardly justifying making control ot the inflation rate one ot the main goals ot macroeconomic policy.
So, why do economists care about inflation? They care because there is no such thing as pure inflation:
• In the medium run—say, a decade—the second answer is the right one. Over the medium run, the economy tends to return to the level ol output determined by supply factors—the capital stock the level ol technology and the size of the labour force. And, over a decade or so, these factors don't move so much that it is a mistake to take them as given.
• In the long run—say, a half-century or more—the third answer is the right one. To understand why japan grew so much taster than, say, the United Slates lor the lorly years following World War II we must look at why both capital and the level ol technology increased so much faster in lapan than in the United Stales. We must lake into account factors such as the education system, the saving rate and the role of the government.
This way of thinking about the determinants of output underlies both macroeconomics and the
organisation of this book.
Equation 3.8) implies that the government, by choosing the level of spending, G, or the level of taxes, /. can choose the level of output it wants. Il it wants output to be higher by, say, $l billion, all it needs to do is to increase С by $ I — r, i billion this increase in government spending, in theory, will lead to an output increase of $ I -c() billion times the multiplier I/O — c,), thus $l billion.
Can governments really choose the level of output thev want? Obviously not. There are many aspects ol reality that we haven't yet incorporated in our model, and all complicate the government's task. We will incorporate them in due time. But it is useful to list them briefly here:
• Changing government spending or taxes may be far from easy. Getting the Australian House ol Representatives and the Senate to pass bills always takes time, and can often turn into a Treasurer's nightmare, especially when the two houses arc controlled by different parties (Chapters 25 and 27).
• We have focused on the behaviour of consumption. But investment is also likely to respond—and so arc imports, as some of the increased demand by consumers and firms lalls not on domestic goods but on foreign goods. All these responses are hard to assess with much certainty, and are likely to come with complex dynamic effects (Chapters 5. 18 and I9i.
• Anticipations are likely to matter, for example, the reaction ol consumers to a tax cut is likely to depend very much on whether they think ol the lax cut as transitory or permanent. The more they perceive ihe lax cut as permanent, the larger their consumption response will be (Chapters 16 and 17).
• Achieving a given level of output may come with unpleasant side-effects. Trying to achieve too high a level ol output may, for example, lead to increasing inflation and tor that reason, may become unsustainable in the medium run (Chapters 7 and 8i.
• Cutting taxes or increasing government spending may lead to large budget def icits and an accumula¬tion of public debt. Such debt may have adverse implications in the long run (Chapters 1 I and 27). In short the proposition that, by using fiscal policy, the government can affect demand and output
in the short run is an important one and a correct one. But. as we refine our analysis we will see that
The interest rate must be such that the supply of money Iwhich is independent of the interest rateI is equal to the demand for money (which does depend on the interest ratei.
implies a lower demand lor money. The supply ol money is drawn as the vertical line denoted АГ: the money supply equals .VI, and is independent ol the interest rate. Equilibrium is at point A, with interest rate /.
With this characterisation ol the equilibrium, we can look at the effects of changes in nominal income or in the money stock on the equilibrium interest rate.
• Figure 4.3 shows the effects of an increase in nominal income on the interest rate. The figure replicates Figure 4.2, so the initial equilibrium is at point A. An increase in nominal income from $Y to $V increases the level ol transactions, which increases the demand tor money at any interest rate. The money demand curve shifts to the right, from Л I-' to XV1'. The equilibrium moves from Л up to A'; the equilibrium interest rate increases Irom i to »".
In words: An increase in nominal income leads to an increase in the interest rate. The reason is that at the initial interest rate the demand for money exceeds the unchanged supply ol money. An increase in the interest rate is needed to decrease the amount of money people want to hold and re-establish equilibrium.
• Figure 4.4 shows the ellccts ot an increase in the money supply on the interest rate. The initial equilibrium is at point A. with interest rate i. An increase in the money supply, Irom JV1s = M to M"' = M', leads to a shilt of the money supply curve to the right, from M" to Ms'. The equilibrium moves from Л down to A': the interest rate decreases Irom i to i".
!n words: An increase in the supply of money leads to a decrease in the interest rate. The decrease in the interest rate increases the demand lor money so it equals the larger money supply.
Monetary policy and open-market operations
We can get a better feel for the results in Figures 4.3 and 4.4 by looking more closely at how the central bank actually changes the money supply, and what happens when it docs so.
To understand what determines the interest rate in an economy with both currency and bank current account deposits, we must first look at what banks do.
What banks do
Modern economies arc characterised by the existence of many types ol financial intermediaries, institutions that receive funds Irom people and lirms, and use these lunds to buy bonds or stocks or to make loans to other people and lirms. Their liabilities are what they owe to the people and firms from whom they have received funds. Their assets arc the stocks and bonds they own and the loans they have made.
Banks are one type ol linanciai intermediary. What makes banks special—and the reason we focus on hanks here, rather than financial intermediaries in general—is that their liabilities arc money. People can pay :or transactions by writing cheques or using FHTPOS up to the amount of their bank account balance. Let's look more closely at what they do.
Banks receive lunds Irom depositors. They keep some ol these funds as reserves and use the rest to make loans and to purchase bonds. Their balance sheet is shown in Figure 4.6, panel (h). Their liabilities consist ot currcnt account deposits, the lunds deposited by people and firms. (We are ignoring term deposits oi other non-transaction accounts. ) Their assets consist ol reserves, loans and bonds.
• Banks receive funds from people and lirms who either deposit lunds or have funds sent directly to their account (their salaries, lor example). At any point in lime, people and firms can write cheques or use EFTPOS or withdraw up to the lull amount of their account balance. Thus, the liabilities of the banks arc equal to the value of currcnt account deposits.
Lets lirst summarise what we learned in Chapter 3:
• Equilibrium in the goods market was characterised as the condition that production, Y, be equal to the demand for goods, 2. We called this condition the IS relation.
We have looked so lar at liscal policy and at a particular monetary policy in isolation. Our purpose was to show how each policy worked. In practicc, the two are often used together. The combination ol monetary and fiscal policies is known as the monetary-fiscal policy mix, or simply, thc policy mix. In this section, we will examine various policy mixes lo help understand recent macroeconomic episodes But to do that, we first need to introduce a slightly different type of monetary policy. From ihis, you will see an example ol why the policy mix matters.
Lip until now, we have assumed that the central hank chose the nominal money supply, M, and stuck with it. In the case ol fiscal policy changes in Section 5.3, we assumed lhat Л1 remained constant. In the case of monetary policy in Section 5.3 also, we assumed that the central bank changed the nominal money supply from M to M' and left it there.
But, often, the central bank decides not to keep M constant, but rather the interest rate constant (or more precisely, the interest rate equal to some short-term target, f(t). We will see why and how in is chosen, later on in the book (for example, in Chapters 7, 9 and 26i. but, for many countries today (including Australiai, this is a good description ol what the central bank does: pick a value /„, and try to keep / close to it.
Can the central bank do this? Yes. How?
• Take a change in output, Y, which leads to an increase in money demand M''. As you saw in Figure 4.1 in Chapter 4, il the nominal money stock is kept constant, the interest rate would have to rise to achieve financial market equilibrium. But if the central bank wanted to keep the interest rate unchanged at /',,. all it has to do is increase the nominal money stock by the appropriate amount. It achieves this through open-market operations involving bond purchases.
SOURCE- beginning of 2008. It is sure to deteriorate in 2009 as the new administration under President Obama responds to the serious decline in US economic activity arising from the global financial crisis.)
The effects of the initial decrease in investment demand and the monetary and fiscal responses in 2001 can be represented using the IS-LM model. In Figure 3. assume that the equilibrium at the end of 2000 is represented by point A, at the intersection of the initial IS and the initial LM curves. What happened in 2001 was the following:
• The decrease in investment demand led to a sharp shift of the IS curve to the left, from IS to IS'. In the absence of policy reactions, the economy would have been at point A', with output Y'.
• The easing of monetary policy led to a downward shift of the LM curve, from LM to LM'. An increased money supply was associated with lower interest rates.
• The decrease in tax rates and the increase in spending both led to a shift of the IS curve to the right, from IS" to IS'.
We have so far ignored dynamics. For example when looking at the effects ot an increase in taxes in Figure 5.9 ! or Figure 5.11)—or the effects of a monetary' policy expansion in Figure 5.10—it looks as il the economy moved instantaneously Irom A to A' as if output went instantaneously from У to У. This is clearly not realistic—the adjustment of output clearly takes some time. To capture this time dimension, we need to reintroduce dynamics.
Introducing dynamics tormally would be difficult. But, as in Chapter 3, we can describe the basic mechanisms in words. Some of thc mechanisms are familiar from Chapter 3, while some arc new:
• Consumers are likely to take some time to adjust their consumption to a change in disposable income.
• Firms are likely to take some time to adjust investment spending following a change in their sales.
• Firms arc likely to lake some time to adjust investment spending following a change in the interest rate.
• Firms arc likely to take some lime to adjust production following a change in their sales.
So, in response lo, say, an increase in taxes, it is likely to take some time for consumption spending to decrease in response to the change in disposable income, lor production to decrease in response to thc decrease in consumption spending, for investment to decrease in response to lower sales, lor consumption to decrease in response to the decrease in income, and so on.
In response to, say, a monetary policy expansion, it is likely to take some time lor investment spend¬ing lo increase in response lo the decrease in lhe interest rate lor production to increase in response to the increase in investment spending, for consumption and investment lo increase in response to the induced change in output, and so on.
i i ii i i i II i i i
4 8
Time (quarters)
• IS curve, %
• LM curve, 100
• tiscal contraction, liscal consolidation 102
• liscal expansion, 102
• monetary expansion, 105
• Vulgar Keynesians . by Paul Krugman. discusses the role ol monetary policy in the IIS economy. Read it and try lo see it you can restate his arguments in terms ol the IS-LM model. Internet address: .)
• Another interesting web page is by Brad DeLong, an economist at the University of California at Berkeley Internet address: ). For more information on delicit reduction and the Clinton Greenspan policy mix, read his article The Budget Deficit'.
When unemployment rises, the ratio of the long-term unemployed to total unemployed also increases, usually with a log of a year.
unemployment rate began its descent. Thus, the two series in Figure 6.2 are positively related, with a lag. In other words, il you can imagine the long-term ratio line shifted to the left by one year, the two curves would match closely. In 2008, Australia's 14 per cent proportion of long-term unemployed is well below the OECD average ol 29 per cent, but it is above the United States' at Ю per cent. Long-term unemployment affects thc individuals suffering it. hut it also can have an impact on the performance ol the macroeconomy. As we will see later in the chapter, unemployment affects wage setters. However, the longer someone remains unemployed, the smaller their impact on wage bargaining. We will discuss this pathological issue 'also known as hysteresis in Chapter 13 when we discuss European unemployment problems, and in Chapter 23 when we examine the Great Depression.
• Thc Hows in and out ol the Australian labour lorce are also surprisingly large. Going back to figure 6.1. you can see that in each month in 2007-08, 314,000 workers dropped out ol the labour force (232,000 + 92,000), and a roughly equal number joined the labour force (217,000 + 108,000). Each ot these (lows was about 7 per cent ol those out ot the labour force.
You might have expected these two flows to be small, thinking they comprised, on one side, those finishing school and entering the labour lorce lor the first time, and on the other side workers entering retirement. But both ot these groups actually represent a small fraction ol the total flows seen in Figure 6.1.
What this fact implies is that many ol those classified as out ot the labour force arc in tact willing to work and move back and forth between participation and non-participation. To understand this, it is important to appreciate that 61 per cent ol people out of the labour force are women. Among the 4.5 million Australians classilied as out ol the labour force, about a million today report that, although they weren't looking, they 'wanted a job. What they mean exactly is unclear, but the evidence is lhat many do lake jobs when ottered one.
This tact also has an important implication. The sharp focus on the unemployment rate hy economists, policy-makers and news media is partly misdirected. Some of the people classified as 'out of ihe labour force are thought ol as hidden unemployed', very much like the unemployed; they are in ellect discouraged workers and, while they are not actively looking for work, they will take ii il they lind it. This is why economists sometimes locus on the non-employment rate, the ratio ol population minus employment to population, rather than thc unemployment rate. Further, there is the important distinction between part-time and full-time employment. Many part-timers would like to work more hours, il they could only get the work. The unemployment rate should
Having looked at the nature ol unemployment, lets turn to wage determination, and to the relation between wages and unemployment.
Wages are set in a number ol ways. In Australia, they are set in collective bargains, in legal awards and in individual agreements.
• Collective bargaining is bargaining between one or more firms and trade unions. In 2006, 41 per cent of workers in Ausiralia had their wages set in collective bargaining agreements. Negotiations may take place at the level ol the firm or enterprise), at the level of industry, or at the national level. Sometimes contract agreements apply only to firms that have signed the agreement.- sometimes they arc automatically extended ю ail lirms and all workers in the sector or the economy. One of the major reforms of thc Keating l abor government from 1991 to l')<)6 was to encourage enterprise bargaining—lhat is, bargaining between an individual lirm I or enterprise and unions.
We have just seen how equilibrium in the labour market determines the rate of unemployment (we have called this equilibrium rate ol unemployment the natural rate of unemployment), which in turn determines the level of output iwe have called this level of output the natural level of output).
So, you may ask, what did we do in the previous three chapters? If equilibrium in the labour market determines the unemployment rate and, by implication, the level of output, why did we spend so much time looking at the goods and linanciai markets? What about our earlier conclusions that the level of output was determined by (actors such as monetary policy fiscal policy, consumer confidence, and so on—all factors that don't enter equation (6.8) and therefore don't affect thc natural level of output? The key to the answers is simple, yet important.
• We have derived the natural rate ol unemployment, and the associated levels of employment and output, under two assumptions, l irst, we have assumed equilibrium in the labour market. Second, we have assumed that the price level was equal to the expected price level, which is a feature of thc medium run.
• There is no reason for thc second assumption to be true in thc short run. Thc price level may well turn out to be different from what was expected by wage setters when nominal wages were set. Hence, in the short run there is no reason for unemployment to be equal to the natural rate, or lor output to he equal to its natural level.
As we will see in the next chapter, the factors that determine movements in output in the short run are indeed the factors we focused on in the preceding three chapters: monetary policy, fiscal policy, and so on. Your time (and ours) wasn't wasted.
• But expectations are unlikely to be systematically wrong (say, always too high or always too low) forever. That is why, in the medium run. unemployment tends to return to the natural rate, and output lends to return to the natural level.
In the medium run, thc lactors that determine unemployment and output arc the factors that appear in equations (6.7) and (6.8).
These, in short, are the answers you might be looking lor. Developing these answers in detail will be our task in the next three chapters.
SUMMARY
• Thc labour force is composed of those who are working (employed) or looking for work (unemployed). The unemployment rate is equal to thc ratio of thc number of unemployed to the number in thc labour force. The participation rate is equal to the ratio ot the labour force to thc population of working age.
• 1 he Australian labour market is characterised by large llows between employment, unemployment and 'out ol tile labour force. Each month, on average, about 40 per cent of the unemployed move out of unemployment, either to take a job or to drop out of the labour force.
• Unemployment is high in recessions, low in expansions. During periods ol high unemployment, the probability of losing a job increases, and the probability of finding a job il unemployed decreases.
• A further discussion of unemployment along the lines of this chapter is given by Richard Fayard, Stephen Nickell and Richard Jackman in The Unemployment Crisis (Oxford: Oxlord University Press, 1994).
• A related hut alternative treatment ol many ot the issues in this chapter is given by Ian Macdonald in Macroeconomics. 2nd edn (Brisbane: John Wiley & Sons. 1996).
• The ABS is an excellent resource for details about the Australian labour market. Go to . l.ook under the link Themes-People , then Labour'. Read ABS6I04 lor a good summary view ot the Australian market in 2008.
An increase in government spending increases output at a given price level, shifting the aggregate demand curve to the right A monetary contraction shifts the aggregate demand curve to the left
To summarise:
• Starting from the equilibrium conditions for the goods and financial markets, we have derived the aggregate demand relation.
• This relation implies that the level ot output is a decreasing function of thc price level. It is represented by a downward-sloping curve, called the aggregate demand curve.
• Changes in monetary or fiscal policy—or more generally in any variable, other than the price level that shifts the IS or the LM curves—shift the aggregate demand curve.
Deriving the AD curve with an interest rate rule
We have derived the aggregate demand relation for the case where the central bank keeps the money stock lixed. allowing the interest rate to be determined by market equilibrium conditions. But. as you saw in Chapter 5 Section 5.4, most central banks in developed countries don t keep the money stock fixed. Rather, they conduct their monetary policy by choosing the interest rate. Let's see what that means lor the AD curve.
Suppose the monetary authority decides to have an interest rate i = i,„ but now the value they choose for thc interest rate depends on the value ol thc price level. P. Why do we introduce this new feature? It is important because central banks do set interest rates in response to what is happening in the economy. Most central banks are concerned with what is happening to prices, since one ol their main goals is to ensure that domestic money retains its purchasing power. Therelore, they will typically respond when they see prices rising. When prices go up, they will usually raise thc interest rate lo slow down demand.
Let's assume that the central bank has a particular price level target, P1, which ii aims to achieve in the medium run. It adjusts the interest rate whenever the current price level is diftereni from its target price level. (In Chapter У, we develop the analysis tor a central bank with an inflation target, 77 ".) So, if P - P' > 0, the current price level is too high and the sensible response will be to raise the interest rate. II P — P1 < 0, the current price level is too low and the central bank will lower the interest rale. In medium-run equilibrium, the price will reach a constant value with P = P!. and then lhe interest rate will also be ai its constant medium-nin value, which we call i„. Thus, the central bank's interest rate rule can be written as:
Interest rate rule: i = i„ + a(P - P')
There were two sharp increases in the nominal price of oil :n the 1970s. followed by a decrease in the 1980s and the 1990s. There was a short-lived spike during the first Gulf War in the early 1990s, and a general rise from mid-1999 to prior to the second war in Iraq in 2003. The relative price of oil index (nominal price/US PPI) varied much less, and apart from 1974-84 remained little changed.The nominal price and the relative price of oil spiked dramatically in 2007-08 but fell precipitously after mid-2008.
SOURCE; ; US Department of Labor: Bureau of Labor Statistics.