Macroeconomics Final

1. Introduction to Macroeconomics
1. Drawing a line between macro and microeconomics

In macroeconomics, we typically assume that most details of resource allocation and income
distribution are of secondary importance to the study of the overall rates of inflation and
unemployment.

Macroeconomics → Changes in aggregates

Microeconomics → Individual decision making

Aggregation & Macroeconomics

An economic aggregate is nothing but an abstraction that people use to

describe some important feature of economic life, such as total domestic
product or inflation.

Foundations of Aggregation

The composition of supply & demand in various markets is of little consequence for the
economy-wide issues of growth, inflation and unemployment.

During economic fluctuations, markets tend to move up or down together.

2. Supply & Demand in Macroeconomics

Moving to Macroeconomic Aggregates

Aggregate supply and aggregate demand relate domestic product (”GDP” or “Y” → On the
horizontal axis) to the price level (”P” on the vertical axis).

Aggregate demand (AD) = quantity of domestic product that is demanded at each possible
price level.

Aggregate supply (AS) = quantity of domestic product that is supplied at each possible price
level.

Macroeconomics Final 1
 An economy slipping
Economic Growth →
into a recession
2 Interpretations of a Shift in the Demand Curve Usually both supply &
demand increase which
means an increase in
price & quantity (however
q usually has a faster
increase than p)

3. Gross Domestic Product

Money as the Measuring Rod : Real vs Nominal GDP

GDP → The sum of money values of all final

goods and services produced in the domestic
country within the year.
GDP calculation :
y = C + I + G + ( X - IM )

Nominal GDP (GDP in current euros) → values each good and service at
the price at which it was actually sold during the year.

⚠ Beware of the difference between final goods & intermediate goods !

For example : if a computer produced in France and bought by EDHEC to resell as an
education service, it’s an intermediate good, which should not be counted twice in the
GDP !)

What Gets Counted in the GDP ?

📌 Only final goods & services produced within the year produced within the
geographic boundaries of the Eurozone (or the country considered)

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 Limitations of the GDP : What it is Not

It only includes market activities (”declared transactions” excluding black market, private
transactions, illegal ones)

It places no value on leisure

It counts “bads” as well as “goods” (bad actions such as killing animals for example)

It does not deduct ecological costs of economic activity (for example cutting down a park
increases GDP because of the workers needed, and then if you put a parking lot instead for
example, it increases your GDP once again).

Drawbacks of the Nominal GDP

It changes when the price changes even if

there is no change in the actual production.

The solution is to calculate real GDP or GDP in

constant euros.
→ Price Index as the weighed average
(for ex in France 0,20 x price of baguette
+ 0.30 x price of oil + etc)

4. The Goal of Economic Growth

Potential GDP : The Real GDP that the economy could produce if the
labour force and other resources were fully employed.

⚠ Be cautious about the meaning of “fully employed” here! Employment rate → NAIRU
(Non Accelerating Inflation Rate of Unemployment) does not cause raise of salaries
meaning inflation.

📌 Macroeconmic policy aims to raise the potential GDP and to minimise the output gap
→ that is the difference between potential & nominal GDP.
*Output Gap : the difference between what an economy actually produces and what it
would produce in an ideal world

→ When the GDP is too high, there is a waste of materials and then there is a big drop, growing
too fast is essentially a waste. What is wanted is growth of potential GDP not real GDP.

Macroeconomics Final 3
 5. The Capacity to Produce : Potential GDP

The growth rate of potential GDP depends on :

The growth rate of the labour force ( ⚠ could mean immigration, but also labour force ≠
population, as children and retired people for example don’t work).

The growth rate of the nation’s capital stock ( ⚠production tools needed to work
efficiently, don’t confuse with money)

The rate of technical progress

6. The Goal of Low Unemployment

Unemployment Rate : the number of unemployed people, expressed as a

% of the labour force.

→ Unemployment entails a loss in output for the society as a whole, a loss that can never be
recovered.

7. Types of Unemployment

Frictional Unemployment → the normal movement of workers from one

job to another.

Structural Unemployment → exists when workers’ characteristics do not

fit with employers’ requirements.
→ Made of people who are unfit for the labour markets (which is bad). Can
be helped by governments or firms that offer training.

Cyclical Unemployment → occurs when the level of economic activity

declines (like for example a health crisis)

8. How much Unemployment is “Full Employment” ?

It was once thought that 4% was a good target in the US. In several EU countries, full
employment is assumed to be reached when the unemployment rate is around 8%.

In any case, “Full Employment” is actually a moving target.

NAIRU → Non Accelerating Inflation Rate of Unemployment.

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 📌 Macroeconomics policy aims to make the unemployment rate as close as possible to
the NAIRU and to reduce the NAIRU.

9. Inflation : The Myth & The Reality

The costs of inflation are less obvious than those of unemployment, yet people certainly fear
it.

Inflation and Real Wages → Inflation does not typically erode real wages, because in
nominal wages compensate for the rising prices.
*Real Wages : income expressed in terms of purchasing power as opposed to actual money
received.
*Nominal Wages : wages measured in money as distinct from actual purchasing power.

10. Inflation as a Re-distributor of Income & Wealth

Because inflation does not proceed evenly, it redistributes income & wealth in arbitrary,
unfair ways.

It systematically discriminates against people on fixed incomes, and it may favour borrowers
at the expense of lender.

→ To understand this point, consider the interest rate :

11. Real vs Nominal Interest Rates

Inflation that is accurately anticipated (π^e) needs not redistribute wealth between borrowers
and lenders.

The nominal interest rate will include an adequate inflation premium, above the real
interest rate.

Nut, if the actual inflation rate turns out to be different from the expected rate anticipated, then
redistribution will occur.

12. Other Costs of Inflation

The uncertainty created by inflation may inhibit long-term contracts.

Inflation may impose real costs on shoppers, whose level of information about relative
prices deteriorates.

13. The Costs of Low vs High Inflation

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 Inflation creates fewer social problems if :

It is low rather than high

It is steady (and therefore relatively predictable) rather than variable.

📌 Macroeconomic policy aims at a low and predictable inflation rate.

14. Phillips Curve

The Phillips curve demonstrates the inverse relationship between the

rate of unemployment and the rate of inflation. To resume, a lower rate
of unemployment will lead to a more important inflation rate in the economy.
When the output gap is lower, there is more unemployment when AD shoots
up, output increases and GDP shoots up which leads to 2 changes :
unemployment comes down and prices rise which consequently translates
into an upward movement on the Phillips curve.

2. The Aggregate Demand Curve

1. AD, Domestic Product & National Income

Aggregate Demand (AD)

The total amount that all customers, business firms, and government
agencies are willing to spend on final goods & services.

📌 AD = C (Y - T) + I + G + X - IM
*C → Consumption
*(Y - T) → Net income / Disposable income
*I → Investment
*G → Government expenditure
*X → Exports
*IM → Imports

Consumer Expenditure (C)

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 The total amount spent by consumers on newly produced goods and
services (excluding purchases of new homes, which are considered
investment goods)
⚠ Second hand & reselling does not count, because the house can be built
before that year.

Investment Spending (I)

The sum of the expenditures of business firms on new plant and equipment
and households on new homes. Financial “investments” are not included,
nor are resales of existing physical assets.

Government Purchases (G)

The goods and services purchased by all levels of government.

Net Exports (X-IM)

The difference between the country’s exports and imports. It indicates the
difference between what we sell to foreigners and what we buy from them.

Consumption Spending & Disposable Income

→ Same data as previous graph, but shows the
relationship of disposable income and total
consumption (a linear relationship shows that they are
both increasing).

2. Consumption Function

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 When the data is converted into a consumption function (linear function) diagram - with
income on 1 axis and consumption on the other - the relationship between real consumer
spending and real disposable income is almost linear, here with a slope of about 0.7.

This slope is called the Marginal Propensity to Consume (MPC)

→ This equation can replace the C (Y - T) of the AD equation.

Marginal Propensity to Consume is the proportion of an

increase in income that gets spent on consumption.
MPC varies by income level.

Factors that Shift the Consumption Function

Δ Disposable Income → movement along a consumption

function.

Δ Any other variable that affects consumption → shift in

the entire consumption function.

→ Can shift or rotate based on external variables such as wars

or pandemics.

The consumption function gets shifted by changes in :

Wealth (an accumulation of investments, income, material things)

Price level (price increases but doesn’t change income → lower consumption)

Real interest rate (a rise in interest rates → shift down)

Expectations of future income (income lowers but price stays the same → lower
consumptions)

3. Equilibrium GDP

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 The equilibrium level of GDP on the demand side is the one at which total
spending = production.
In such situations, firms find their inventories remaining at desired levels, so
there is no incentive to change output or prices.
Equilibrium = producing as much as we consume.

Construction of the Expenditure Schedule Income-Expenditure Diagram

4. The Mechanics of Income Determination

The “income-expenditure” diagram or “45 degree line” diagram show the equilibrium level of
GDP.

All other levels of GDP are disequilibrium points, at which GDP will move in the direction of the
equilibrium.

Changes on the Demand Side : Multiplier Analysis

Multiplier = ratio of the change in equilibrium GDP (Y) divided by the

original change in spending that caused the change in GDP.

Demystifying the Multiplier : How it Works

The multiplier is greater than 1 because one person’s spending is another person’s
income → when you buy something, you give them your income, which in return becomes
their income.

Macroeconomics Final 9
 An increase in spending = an increase in income

A portion of the increase in income is spent on consumption, creating more income, which
in turn creates more consumption spending, and so on.

Algebraic Statement of the Multiplier

📌 Multiplier = 1 / (1 - MPC)

If the MPC = 0.7, then the multiplier is equal to 3.33

In the real world, the multiplier is much smaller, because of :

International trade

Inflation

Income taxation

5. The Aggregate Demand Curve

An increase in price level = A decrease in consumption (shift down).

Therefore, an increase in price level = a decrease in total expenditures and a decrease in

equilibrium GDP.

Therefore, an increase in price level = a decrease level of real aggregate quantity demanded.

The Aggregate Demand Curve

The effect of the price level on equilibrium GDP

The negatively-sloped AD curve shows all the equilibria of price levels and GDP.

💡 Remember that any income-expenditure diagram is drawn for a specific price level.

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 6. The Multiplier & the AD Curve

Δ Autonomous spending → horizontal shift of the AD curve by an amount given by the

oversimplified multiplier formula.

3. The Aggregate Supply Curve

1. The Aggregate Supply Curve

The AS curve shows the relationship

between the price level & the quantity of real
GDP supplied, holding all other
determinants of quantity supplied constant.

Why the AS Curve Slopes Upward

Firms normally can purchase labour and other inputs at prices that are fixed for some period
of time.

Therefore, higher prices mean higher profits and more

incentive to produce.

*CT = total costs

Shifts of the AS Curve

Costs of production are constant along the AS curve.

Change in costs of production = shifts in the AS curve (towards the left if there is an
increase of costs & towards the right if there is a decrease of costs).

The money wage rate

Prices of other inputs (for example rent or gas prices increase)

Technology & productivity

Available supplies of labour and capital.

Higher cost of production = inward shift

of the AS curve

Money wage rate

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 Interest rate

Material prices

Shift of the AS Curve

Lower costs of production = outward shift of the AS curve

Improvements in technology

Increases in productivity

Increases in supplies of labour & capital

2. Equilibrium of AD and AS

Price level adjustments bring the AS-AD

equilibrium

Imbalance between AS and AD → changes in

inventories → changes in prices → movement
along AS and AD towards the equilibrium.

Equilibrium of Real GDP & The Price Level

3. Recessionary and Inflationary Gaps Revisited

Short run : AS-AD equilibrium may or may not equal to full employment GDP

Recessionary gap : Equilibrium GDP < Potential GDP

A recessionary gap occurs when a country's real GDP is lower than its GDP if the
economy was operating at full employment.

Inflationary gap : Equilibrium GDP > Potential GDP

An inflationary gap exists when the demand for goods and services exceeds
production due to factors such as higher levels of overall employment, increased trade
activities, or elevated government expenditure.

In the long-run, market forces make the

Macroeconomics Final 12
 Equilibrium GDP = Potential GDP.

Adjusting to a Recessionary Gap

When unemployment exists, if money wages

fall :

The aggregate supply curve will shift

outward

Full employment will be attained eventually

Elimination of a Recessionary Gap
Wage reductions are slow and uncertain in the
real world.

There are several possible reasons why wages are so sticky in the downward direction :

Institutional rigidies

Psychological resistance

Reduced severity of business cycles

Competition for the best workers

With sticky wages, cyclical unemployment may last a long time.

Does the economy have a self-correcting mechanism ?

The economy will self-adjust eventually

A decrease in wages = higher demand for labour

A decrease in prices = larger demand for goods & services

But many people believe that government intervention should help speed up the process.

Adjusting to an Inflationary Gap

When GDP > Full employment

Price level rises

Labour is in short supply

Both forces increase money wages

AS curve shifts inward

Employment falls

Eventually eliminates the inflationary gap Elimination of an Inflationary Gap

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 *Money Wages are the amount of money that
someone is paid for work they have done, without
considering the amount of goods it can buy

During this process, both prices and unemployment are increasing.

Stagflation : inflation that occurs while the economy is growing slowly or

having a recession.

Demand Inflation & Stagflation

In an inflationary gap, prices and wages rise because of excess demand.

Rising wages are a symptom, not a cause, of the underlying problem.

*Wages : the payment for work agreed between an employee and his or her employer
under the contract of employment

A period of stagflation is part of the normal aftermath of a period of excessive AD.

The stagflation that follows a period of excessive AD is comparatively benign ; output is falling,
but it is still above potential GDP.

Independent shifts inward of the supply curve are another source of stagflation.
*Stagflation : persistent high inflation combined with
high unemployment and stagnant demand in a country's economy.

4. Inflation & the Multiplier

Inflation reduces the size of the

multiplier

As long as the AS curve is upward sloping,

a higher AD curve means a higher price
level.

This, in turn, drains off some of the higher

real demand.

Lower purchasing power of consumer

wealth

Lower net exports (X - IM) Inflation & the Multiplier

5. A Role for Stabilisation Policy

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 Since the economy’s self-correcting mechanism sometimes works slowly, there is room for
government stabilisation policy to improve the workings of the free market.

4. Fiscal Policy

Fiscal policy refers to the use of government spending and tax policies
to influence economic conditions, especially macroeconomic conditions.
These include aggregate demand for goods and services, employment,
inflation, and economic growth.

→ During a recession, the government may lower tax rates or increase spending to encourage
demand and spur economic activity. Conversely, to combat inflation, it may raise rates or cut
spending to cool down the economy.
→ Fiscal policy is often contrasted with monetary policy, which is enacted by central bankers and
not elected government officials.

1. Income Taxes & the Consumption Schedule

Higher taxes → lower consumption & lower AD

Fixed taxes (= taxes that do not vary with GDP) → implies a parallel shift down in the
consumption function
→ Fixed taxes : when increase or decrease there is a shift up and down

Variable taxes (= taxes that vary with GDP) → flatten the consumption schedule

→ Variable taxes : when increase or decrease there is a rotation of the slope (flatter or
steeper)

How Tax Policy Shifts the Consumption Schedule

Macroeconomics Final 15
 Larger government purchases of goods and
services = higher total spending directly through
the G component of C + I + G + (X - IM).

Higher taxes = decrease in total spending

indirectly by lowering disposable income and,
this, reducing the C component of C + I + G + (X
- IM).
The Multiplier in the Presence of an Income Tax
On balance, the government’s actions may raise
or lower equilibrium GDP, depending on how
much spending and taxing it does.

Note that variable income tax reduces the multiplier, because it flattens the expenditure line on
the expenditure schedule.

2. The Multiplier Revisited

Automatic stabilisers

Automatic stabilisers are features of the economy that reduce its

sensitivity to shocks.

Personal income tax

Unemployment insurance

Multipliers for Tax Policy

Multiplier for change in T < Multiplier for change in G

G affects AD directly

T changes only disposable income

Resulting change in consumption < change in disposable income

If G & T increase by the same amount, the effects do not cancel out.

Higher G = Higher GDP

Higher T = Lower GDP

Because G’s multiplier is larger, the net effect will be an increase in GDP

Moral : fiscal policies that keep the deficit (G - T) constant do not keep AD constant.

If spending increases are financed by tax increases, the economy will expand.

If tax cuts are financed by spending cuts, the economy will contract.

Macroeconomics Final 16
 Government transfer payments

Transfers are payments to individuals that do not compensate them

for any direct contribution to production. Transfers are the analytical
equivalent of negative taxes.

3. Planning Expansionary Fiscal Policy

3 types of fiscal policies can be used to stimulate the economy :

Higher G

Lower T

Higher transfer payments

Fiscal Policy to Eliminate a Recessionary Gap

4. Planning Contractionary Fiscal Policy

3 types of fiscal policies can be used to slow the economy :

Lower G

Higher T

Lower transfer payments

💡 Note that the self-adjusting mechanism will

eventually perform the same task, but at
the cost of more inflation than will occur if
the government succeeds in reducing AD.

Macroeconomics Final 17
 5. Some Harsh Realities

A fiscal policy planner’s job is not simple

Economic variables change continuously

The “policy target” is constantly moving

Economists have only an uncertain knowledge of the value of the multiplier and the full-
employment level of GDP

Forecasts are uncertain and policies take time to work

6. Crowding out theory

The crowding out effect is an economic theory arguing that rising public
sector spending drives down or even eliminates private sector spending.

The public sector is the part of the economy owned, managed and
controlled by government or government bodies, while the private sector is
owned, managed and controlled by individuals or private companies.

7. Quantitative Easing

Quantitative easing (QE) is a form of monetary policy in which a central

bank, like the U.S. Federal Reserve, purchases securities from the open
market to reduce interest rates and increase the money supply.

Quantitative easing creates new bank reserves, providing banks with more
liquidity and encouraging lending and investment. In the United States,
the Federal Reserve implements QE policies.

Macroeconomics Final 18
 *Security refers to a fungible, negociable financial instrument that holds
some type of monetary value. A security can represent ownership in a
corporation in the form of stock, a creditor relationship with a governmental
body or a corporation represented by owning that entity’s bond ; or rights to
ownership as represented by an option.
*Liquidity refers to the efficiency or ease with which an asset or security
can be converted into ready cash without affecting its market price. The
most liquid asset of all is cash itself.

→ To execute quantitative easing, central banks buy government bonds and other securities,
injecting bank reserves into the economy. Increasing the supply of money lowers interest
rates further and provides liquidity to the banking system, allowing banks to lend with easier terms.

5. Money & The Banking System

1. The Nature of Money

Barter versus Monetary Exchange

A barter system (with no money) would be awkward and extremely inefficient.

In trade, barter is a system of exchange in which participants in a

transaction directly exchange goods or services for other goods or
services without using a medium of exchange, such as money.

Money greases the wheels of exchange and, thus, makes the whole economy more
productive.

💡 The primary difference between barter and currency systems is that a currency system
uses an agreed-upon form of paper or coin money as an exchange system rather than
directly trading goods and services through bartering

The Conceptual Definition of Money

The functions of money :

Medium of exchange

Unit of account

Macroeconomics Final 19
 Store of value

Money = whatever serves as the medium of exchange

The Nature of Money

What serves as money ?

Societies have gradually moved from the use of commodity money (it consists of objects
having value or use in themselves (intrinsic value) as well as their value in buying goods,
such as gold or silver coins) to the use of money that has no commodity backing at all (so
for example paper money).

How the Quantity of Money is Measured

There is no single, obvious place to draw the line between “money” and “near money”.

Money includes cash in hand or cash in the bank that can be obtained
on demand for use as a medium of transactional exchange. Near
money requires some time to cash conversion. Individuals & businesses
need to have cash money available to meet immediate obligations. An
example of near money can be a savings account.

How the Quantity of Money is Measured

→ In the Eurozone :

M1 = the sum of currency in circulation and overnight deposits

M2 = M1 + deposits with an agreed maturity of up to 2 years and deposits redeemable at

notice of up to 3 months

M3 = M2 + repurchase agreements, money market fund shares / units and debt securities
with a maturity of up to 2 years.

2. The Banking System

How Banking Began

Fractional reserve banking began when goldsmiths realised they could profitably lend out a
portion of the gold that had been deposited with them for safekeeping.

Fractional-reserve banking is the system of banking operating in

almost all countries worldwide, under which banks that take deposits
from the public are required to hold a proportion of their deposit liabilities

Macroeconomics Final 20
 in liquid assets as a reserve, and are at liberty to lend the remainder to
borrowers.

3 important features of the fractional reserve banking system :

Bank profitability

Banks discretion over the money supply

Exposure to bank runs (it occurs when many clients withdraw their money from a bank,
because they believe it may cease to function in the near future.)

Principles of Bank Management : Profits vs Safety

To make a profit, a banker must take risks.

But because the business is risky, the same banker must also emphasise safety.

The heart of banking is to be torn between the 2 principles.

Bank Regulation

Deposit insurance → The Federal Deposit Insurance Corporation insures people’s deposits
at banks.

Bank supervision

Ensures banks take only sensible, defensible risks

Controls the money supply

Money supply : the total amount of money in circulation or in

existence in a country.

Reserve requirements

Helps control the money supply

3. The Origins of the Money Supply

How Bankers Keep Books

Banks keep balance sheets

📌 Assets = Liabilities + Net Worth

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 Asset : brings the bank money
Liability : costs the bank money

Assets include : reserves + loans

Liabilities include : deposits owed to customers

Liabilities > Assets → Bankruptcy

Reserve requirements : 20% of deposits

4. Banks & Money Creation

The Limits to Money Creation by a Single Bank

Banks can lend money in their vault that is above the minimum required reserve ratio. In doing
so, they create new money.

Multiple Money Creation by a Series of Banks

When all banks make loans with funds they have that are above the required reserve ratio, the
society’s money supply expands.

Change in deposits = (1 / m) * Change in reserves

Assumes banks keep the minimum reserve ratio, m.

Assumes all new money held in the form of deposits.

Oversimplified deposit multiplier formula.

The Process in Reverse : Multiple Contractions of the Money Supply

Deposits, and with them the money supply, contract when reserves are reduced.

Banks reduce their loan commitments.

Calculation of the contraction in the money supply utilises the same formula as for money
expansion.

→ When you withdraw your money from the bank or the atm, it comes from the reserves.

5. Why the Deposit Creation Formula is Oversimplified

Individuals hold some portion of additions to their money in the form of cash.

Banks sometimes hold reserves above the required minimum.

6. The Need for Monetary Policy

Left uncontrolled, banks would :

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 Reduce the money supply in a recession

Increase the money supply during boom periods

Changes in the money supply would exacerbate the business cycle.

One reason for monetary policy, therefore, is to prevent this behaviour on the part of banks.

6. Monetary Policy

Monetary policy is a set of tools used by a nation’s central bank to control

the overall money supply and promote economic growth and employ
strategies such as revising interest rates and changing bank reserve
requirements.

1. Money & Income : The Important Difference

Stock variables are measured at a moment in time.

Flow variables are measured over time.

Money is a stock, income a flow.

Stock is defined as the variable Stock is defined as a variable that is

measured at a particular point in time, while flow is defined as a variable
which is measurable over a period of time

2. Implementing Monetary Policy

The ECB can increase the money supply by using 3 instruments :

Open market operations → an activity by a central bank to give liquidity in its currency to a
bank or a group of banks.

Lending to banks

Changing the reserve requirements (reserves : minimal amounts of cash that banks are
required to keep on hand in case of unexpected demand)

3. Open Market Operations

The ECB can increase the money supply by buying government securities on the open
market (government securities = bonds issued by the government)

Macroeconomics Final 23
 In simple terms, a bond is loan from an investor to a borrower such
as a company or government. The borrower uses the money to fund
its operations, and the investor receives interest on the investment. The
market value of a bond can change over time.

It pays for these securities by creating new bank reserves

These additional reserves → multiple expansions of the money supply

To reduce the money supply, the ECB sells securities

Securities are 2 things : stocks & bonds (bonds are debt instruments issued by the
borrower → companies of governments).

The main difference between stocks and bonds is that stocks give you
partial ownership in a corporation, while bonds are a loan from you
to a company or government.

Effects of an Open-Market Purchase of Securities

Open-Market Operations, Bond Prices & Interest Rates

When the ECB buys bonds :

Higher demand for bonds

Higher price of bonds

Higher price of bonds = lower interest rate

Opposite when ECB sell bonds

4. Other Methods of Monetary Control

Lending to Banks

The ECB lends to member banks, occasionally as a “lender of last resort.”

Macroeconomics Final 24
 The ECB sets 3 interest rates every 6 weeks :

The main refinancing operations (MRO) rate is the interest rate banks pay when they
borrow money from the ECB for 1 week.

The marginal lending facility rate is the interest rate banks pay when they borrow from
the ECB overnight.

The deposit facility rate is the interest banks receive for depositing money with the
central bank overnight. Since June 2014, this rate has been negative.

Lower MRO rate :

Higher borrowing by member banks

Higher reserves

Higher money supply

Opposite if the ECB raises its MRO rate

Balance Sheet Changes, Borrowing from ECB

Changing Minimum Reserve Requirements

Lower required reserve ratio :

Higher excess reserves

Higher loans

Higher money supply

→ Opposite if the ECB increases reserve requirements

Macroeconomics Final 25
 💡 Since Jan 2012, the min reserve requirements imposed to financial institutions in
the eurozone is 1% of their deposits with a maturity up to 2 years.
*Maturity or maturity date is the date on which the final payment is due on a loan or
other financial instrument

5. Supply-Demand Analysis of the Money Market

Higher interest rates :

Higher profit opportunities for banks

Decrease of excess reserves

Higher volume of loans → higher

money supply

Supply Schedule for Money

→ The money supply slopes upwards with the interest rate.

However, the ECB can shift the relationship between the money supply and interest
rates by employing any of its principal weapons of monetary control.

Open-market operations

Change in reserve requirements

Change in lending policy to banks

The Demand for Money

Money is demanded for transactions

Indeed, higher nominal GDP :

Higher spending

Higher demand for money

Interest = an opportunity cost of holding money

Higher interest rates → lower money demand

Demand curve for money curve

Negatively sloped

Shifts as nominal GDP changes

Macroeconomics Final 26
 💡 Nominal GDP reflects the raw numbers in current dollars unadjusted for inflation. Real
GDP adjusts the numbers by fixing the currency value, thus eliminating any distortion
caused by inflation or deflation.

The Demand Schedule for Money

Equilibrium in the Money Market

The interest rate equilibrates the demand and supply of money.

The ECB can lower (raise) interest rates by increasing (reducing) the money supply.

Effects of Monetary Policy on the Money Market

Equilibrium in the Money Market

6. How Monetary Policy Works

Of the 4 components of AD, investment and net exports are the most sensitive to monetary
policy.

Macroeconomics Final 27
 Here, we assume that net exports (X - IM) are fixed.

We focus on monetary policy’s influence on investment (I).

Investment & Interest Rates

Higher interest rates → lower investment

spending

Change in investment → multiplier effect

(here, lowers GDP)

Lower interest rates → opposite

Monetary Policy & Total Expenditure

ECB actions :

Change in money supply Effects of Interest Rates on Total Expenditure

Change in interest rates → change in
investment → change in AD →
change in GDP

7. How Monetary Policy Affects GDP

Money & the Price Level in the Model

Note that an expansionary monetary policy causes some inflation under normal
circumstances.

How much inflation it causes depends on the

state of the economy.

Represented by the slope of the AS curve

ECB policy :

M&r

AD

Y&P
The Inflationary Effects of Expansionary Policy

Macroeconomics Final 28
 Both output prices are normally affected by
monetary policy.

Effects of Monetary Policy on Output & Prices

Application : Why the AD Curve Slopes Downward

Higher price level :

Higher money demand

Higher interest rates

Lower investment

Lower investment → negative multiplier effect on GDP

This higher price level → lower GDP

Macroeconomics Final 29