Chapter 13

The Price Level, Real Output,

and Economic Policymaking

INTERNATIONAL MONETARY AND

FINANCIAL ECONOMICS

Third Edition

Joseph P. DanielsDavid D. VanHoose

Copyright © South-Western, a division of Thomson Learning. All rights reserved.

2

Deriving the Aggregate Demand Schedule

Panel (a) shows that a rise in the price level induces an increase in the equilibrium nominal interest rate through the real balance effect, as the LM schedule shifts back along the IS schedule from point A to point B. Because equilibrium real income falls as the price level increases, the aggregate demand schedule containing real income–price level combinations A and B slopes downward in panel (b).

3

The Effect of an Increase in the Money stock on Aggregate Demand in a Closed Economy

With an unchanged price level, an increase in the nominal quantity of money in circulation causes an increase in the amount of real money balances and shifts the LM schedule downward and to the right along the IS schedule in panel (a). Because the resulting real income level at point B in panel (b) corresponds to the same price level, this new equilibrium real income–price level combination lies on a new aggregate demand schedule to the right of the real income–price level combination at point A on the original aggregate demand schedule. Thus, an increase in the nominal money stock causes an increase in aggregate demand.

4

The Effect of an Increase in the Money Stock with a Fixed Exchange Rate

5

The Effect of an Increase in the Money Stock with a Fixed Exchange Rate

In all three pairs of panels, an increase in the money stock causes the LM schedule to shift downward and to the right. The induced increase in real income causes import spending to rise, and the induced decline in the nominal interest rate results in capital outflows, and these effects together lead to a balance-of-payments deficit.

If the central bank sterilizes its interventions to maintain a fixed exchange rate, then the money stock remains at its higher level, M2, and the aggregate demand schedule shifts fully to the position yd(M2). With unsterilized interventions, however, the money stock falls back toward its original level of M1. Consequently, the aggregate demand ultimately returns to its original position.

6

The Effect of an Increase in the Money Stock with a Floating Exchange Rate

7

The Effect of an Increase in the Money Stock with a Floating Exchange Rate

In all three pairs of panels, an increase in the money stock causes the LM schedule to shift rightward, resulting in a balance-of-payments deficit, which, in turn, causes a domestic currency depreciation. The rise in the exchange rate stimulates greater net export expenditures and raises equilibrium real income.

With higher capital mobility, the extent of capital outflow and, consequently, the size of the resulting depreciation and real income effect, rise. Hence, higher capital mobility enhances the amount of the expansion in aggregate demand induced by a rise in the money stock.

8

The Effect of An Increase in Government Spending on Aggregate Demand in a Closed Economy

With an unchanged price level, an increase in government spending shifts the IS schedule rightward along the LM schedule from point A to point B in panel (a). The resulting real income level at point B in panel (b) corresponds to the same price level, and this new equilibrium real income–price level combination is located on a new aggregate demand schedule to the right of the real income–price level combination at point A on the original aggregate demand schedule. Consequently, an increase in government spending causes an increase in aggregate demand.

9

The Effect of Government Spending with a Fixed Exchange Rate

10

The Effect of Government Spending with a Fixed Exchange Rate

•In all three pairs of panels, an increase in government expenditures causes the IS schedule to shift rightward, inducing initial increases in the equilibrium nominal interest rate from R1 to R′and in the level of equilibrium real income from y1 to y′.•Panel (a1) shows that with low capital mobility, there is a balance-of-payments deficit which requires the central bank to sell foreign exchange reserves, thereby resulting in a final equilibrium at point C in panel (a2). Panels (b) and (c) show that with higher or perfect capital mobility, a rise in government spending causes a balance-of-payments surplus at point B. To keep the exchange rate from declining in both cases, the central bank must purchase foreign exchange reserves, which leads to a final equilibrium at point C and larger increases in aggregate demand.

11

The Effect of Government Spending with a Floating Exchange Rate

12

The Effect of Government Spending with a Floating Exchange Rate

• In all three pairs of panels, an increase in government expenditures causes the IS schedule to shift rightward, inducing initial increases in the equilibrium nominal interest rate from R1 to R′and in the level of equilibrium real income from y1 to y′.

• Panel (a1) depicts a situation of low capital mobility, which the rise in government spending causes a balance-of-payments deficit at point B, which induces a currency depreciation and an additional rightward shift in the IS schedule. With high or perfect capital mobility an increase in government spending causes a balance-of-payments surplus, a currency appreciation, and a partially or fully offsetting leftward shift in the IS schedule.

• Thus, the aggregate demand effect of a rise in government expenditures is mitigated by higher capital mobility.

13

The Aggregate Production Function and the MPN Schedule

Given a fixed stock of capital and a current state of technology, higher levels of labor employment are necessary to achieve increased production of real output. The bowed, or concave, shape of the production function in panel (a) reflects the law of diminishing returns, which states that total output increases at a decreasing rate for each additional one-unit rise in employment of labor. Consequently, as shown in panel (b), the marginal product of labor declines as employment rises.

14

The Demand for Labor

A profit-maximizing firm employs labor to the point at which the value of labor’s marginal product is equal to the nominal wage. Thus, a rise in the nominal wage reduces the quantity of labor demanded by a firm.

15

Employment and Output Determination with Fixed versus Flexible Nominal Wages

16

Employment and Output Determination with Fixed versus Flexible Nominal Wages

• Panels (a) show that if wages are inflexible, then the overall level of nominal wages Wf does not vary with a change in the position of the VMPN schedule resulting from a rise in the price level.

• Consequently, employment rises from N1 at point A to N2 at point B, as the value of workers’ marginal product increases, inducing firms to demand more labor. The resulting increase in employment cause a movement from point A to point B along the aggregate production function, so that aggregate real output increases from y1 to y2.

• Hence, the aggregate supply schedule slopes upward with fixed nominal wages.

17

Employment and Output Determination with Fixed versus Flexible Nominal Wages

• In contrast, panels (b) show that if Wb is an initial, base level of wages, then automatic contractual adjustment of wages in response to an increase in the price level, to Wb P2 – P1), results in no change in employment or output.

• Hence, with complete wage adjustment to price changes, the aggregate supply schedule is vertical.

18

The Short-Run and Long-Run Aggregate Supply Schedule

Over the short run, when nominal wages are fixed and do not adjust to changes in the price level, the aggregate supply schedule, ys (Wf) slopes upward. In the long run, which is a sufficiently lengthy interval during which the wage determination process can account for an increase in the price level, the aggregate supply schedule is vertical, as illustrated by the schedule denoted ys LR.

19

Determination of the Equilibrium Price Level and Equilibrium Real Output

The equilibrium price level and the equilibrium level of real output arise at the intersection of the aggregate demand and aggregate supply schedules. This point, denoted E, is on the aggregate demand schedule and corresponds to a point of IS–LM equilibrium. At the same time, this point is on the aggregate supply schedule. If the price level happened to equal P2, then the level of aggregate desired expenditures is consistent with an output level equal to y3, but the aggregate output level that firms produce is equal to y2. Thus, the equilibrium price level must rise to P1.

20

The Effects of a Policy-Induced Increase in Aggregate Demand

An expansionary monetary,exchange rate, or fiscal policyaction causes the aggregatedemand schedule to shift tothe right along the short-runaggregate supply schedule.This results in a rise in theequilibrium price level and anincrease in equilibrium realoutput.

21

Nominal Wages and Employment under Rational Expectations

At the initial points labeled A, workers and firms have established an initial base wage given their expectation of the price level and their anticipation of the value of the marginal product of labor. If workers and firms form expectations rationally and recognize that a policy action is likely to raise the price level, then they will raise their price expectation to and negotiate a higher base nominal wage. As a result, equilibrium real output will remain unchanged in panel (b), so that the aggregate supply schedule will shift upward by the amount of the anticipated increase in the price level, from point A to point B in panel (c).

22

Inflation in Selected Nations

Since the mid-1980s, consumer price inflation rates in the United States, Germany, and Japan have been well below those in most other nations. Nevertheless, all nations typically have experienced positive inflation in nearly every year.

23

The Inflation Bias of Discretionary Policymaking

If the current equilibrium for the economy is point A, and if the policymaker’s goals are to raise output toward the capacity output level yT but to keep inflation low, then the policymaker’s temptation is to split the difference between these conflicting objectives by inducing a rise in aggregate demand, to point B. But if workers realize that the policymaker has an incentive to permit prices to rise, then they will bargain for higher contract wages, thereby shifting the aggregate supply schedule leftward. This means that if the policymaker ignores the temptation to induce a rise in aggregate demand, the result will be higher prices and lower real output at point D. To avoid this, the policymaker must raise aggregate demand as workers expect. The final equilibrium in the absence of policymaker credibility not to increase inflation, therefore, is at point C. The increase in the price level caused by a movement from point A to point C is an inflation bias resulting from discretionary policymaking.

24

Central Bank Independence, Average Inflation, and Inflation Variability