jha 2003 macroeconomics for developing countries 2nded

Macroeconomics for Developing Countries,2nd Edition

This comprehensively revised and updated edition develops the themescontained in the first edition. Students and teachers who are familiar withthe book will notice that half of the chapters are entirely new, with the otherhalf having changed significantly to take into account the changes that haveoccurred in the global economy since the turn of the millennium.

With questions for discussion and excellent use of case studies, the bookcovers such themes as: standard closed and open macroeconomic models a full evaluation of the post-Washington consensus model IMF stabilisation programmes and their effects on developing economies the pressing problems of indebtedness financial sector reforms in developing countries. This informative, accessible and lucid textbook is the ideal accompanimentfor students of development economics; not only thatit will prove popularwith lecturers and academics alike.

Raghbendra Jha is Professor at the National University of Australia. Anotherof his books, Modern Public Economics, is also published by Routledge.

Macroeconomics forDeveloping Countries,2nd Edition

Raghbendra Jha

LONDON AND NEW YORK

First published 1994by Routledge11 New Fetter Lane, London EC4P 4EE Simultaneously published in the USA and Canadaby Routledge29 West 35th Street, New York, NY 10001 Second edition first published 2003 Routledge is an imprint of the Taylor & Francis Group This edition published in the Taylor & Francis e-Library, 2005.

To purchase your own copy of this or any of Taylor & Francis or Routledgescollection of thousands of eBooks please go to www.eBookstore.tandf.co.uk. 1994, 2003 Raghbendra Jha

All rights reserved. No part of this book may be reprinted orreproduced or utilised in any form or by any electronic,mechanical, or other means, now known or hereafterinvented, including photocopying and recording, or in anyinformation storage or retrieval system, without permission inwriting from the publishers. British Library Cataloguing in Publication DataA catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication DataA catalog record for this book has been requested ISBN 0-203-42282-1 Master e-book ISBN ISBN 0-203-42464-6 (Adobe eReader Format)ISBN 0-415-26213-5 (hbk)ISBN 0-415-26214-3 (pbk)

Dedicated to Mataji

Contents

Preface to this edition ix

Preface to the first edition xiii

PART I THE BASIC MACROECONOMICFRAMEWORK 1

1 Macroeconomic problems of developingcountries 3

2 National accounts and the macroeconomy 9

3 The basic IS-LM-AS model in the closedeconomy 27

4 The process of money creation and thedemand for money 75

5 Macroeconomic policy in an open economy 93

6 Current account and asset demand approachesto balance of payments 139

PART II MACROECONOMIC MODELS OFDEVELOPING COUNTRIES 175

7 IMF-type macro models for developingcountries 177

viii Contents

8 A structuralist macro model for developingcountries 193

9 Dualistic models of output and inflation indeveloping countries 211

10 Growth theory and developing countrymacroeconomics 233

PART III POLICY DILEMMAS FACED BYDEVELOPING COUNTRIES 263

11 An evaluation of the IMF programmes indeveloping countries 265

12 Macroeconomic dimensions of fiscal policyin developing countries 285

13 The inflation rate and seignorage 315

14 The problem of indebtedness of HIPCcountries 343

15 Exchange rate issues in developing countries 363

PART IV ISSUES IN DEVELOPING COUNTRIESMACROECONOMICS 385

16 Financial market liberalisation and economicgrowth in developing countries 387

17 The international financial architecture andthe developing countries 419

18 A final word 457

Bibliography 463

Name index 487

Subject index 491

Preface

The first edition of this book was published in 1994. The enthusiastic responseit received and the momentous developments in the global economy sincethen prompted me to write this second edition.

An abiding concern of the previous edition was that there was a need toexamine a variety of models in order to understand the macroeconomicperformance of developing countries. Developing countries are at differentstages of development and it would be simplistic to assume that one modelsuits all of them. Without much risk of oversimplification one can state thatthere is far more homogeneity in the macroeconomic structures of developedcountries. Yet there is disagreement on the macroeconomic model to be usedeven in their case. It would seem natural then to conceive of alternativemodels for developing countries.

This new edition takes this theme further. Apart from the versions of thestructuralist models discussed in the first edition, the present edition alsocarries a fuller evaluation of the Washington consensus model (the IMFversion) since the magnitude of the point of departure of the alternativemodels cannot be fully appreciated without a study of the dominant model.This new edition contains an exhaustive evaluation of IMF stabilisationprogrammes. In order to contrast this group of models with standardneoclassical doctrine as well as to build bridges with it, this new edition hasa self-contained examination of both closed and open economy standardmodels.

The study of economic growth and monetary policy assignment hasundergone important changes since the previous edition. Some of theseimportant changes are reflected in this edition. There are separate chapterson economic growth as well as on inflation and monetary policy. These includediscussions on new theories of economic growth and the determinants ofgrowth as well as issues of seignorage, credibility of monetary policy andinflation targeting. In view of the continued, even enhanced, emphasis onfinancial sector reforms, the links between financial liberalisation andeconomic growth are examined. In view of the recent emphasis onsustainability of internal and external debt of developing countries, there isa chapter on developing these notions of sustainability with applications to

x Preface

select developing countries. In view of the persistent economic crises in heavilyindebted countries, there is a chapter on the problems of heavily indebtedpoor countries.

Students and teachers who are familiar with the first edition of the bookwill recognise that half of the chapters of the present edition are new. Eventhe other half have been thoroughly revised. Hence this edition marks amajor departure from the first one.

The plan of this book is as follows. Part I entitled The Basic MacroeconomicFramework consists of six chapters dealing with the standard closed andopen macroeconomic models. Part II considers specialised models ofdeveloping country macroeconomics and has four chapters dealing with IMFand alternative structural models as well as theories of economic growth.The third section deals with policy dilemmas being faced by developingcountries. These include dealing with IMF conditionalities, internal andexternal debt issues and the emergent problems facing heavily indebted poorcountries as well as the choice of the exchange rate regime.

The final section of the book is entitled Issues in Developing CountriesMacroeconomics and deals with issues of financial sector liberalisation andthe international financial architecture. There is a final concluding chapter.

This book is primarily intended to be used in upper level undergraduatecourses in macroeconomics for developing countries. It would also be usefulin standard intermediate courses in macroeconomics. Since the book coversvery recent literature, it would be helpful to graduate students and researchscholars as well.

In writing this book I have run up a long list of debts far too many tomention; hence the following list is indicative, not complete. Many studentsin the Quantitative Development Economics course I taught at University ofWarwick in 1996 gave excellent comments on the first edition, as did batchesof students in the Macroeconomics course at IGIDR, Mumbai. Jerry Epsteinof the University of Massachusetts was helpful through these revisions. Inaddition, I would like to thank C.Rangarajan, former Governor of the ReserveBank of India, Ashima Goyal, Mridul Saggar, Deba Prasad Rath, SantoshKumar, Anurag Sharma and Partha Ray from IGIDR for their thoughts.Priti Torvi at IGIDR and Stephanie Hancock at the Australian NationalUniversity provided excellent secretarial support. Two anonymous Routledgereviewers gave very helpful comments. Commentsboth published as wellas those communicated to meon the previous edition were insightful aswell as encouraging. This book was written in its final form at the ANU. Iwould like to thank the University, particularly James Fox, Director of theResearch School of Pacific and Asian Studies, and Warwick McKibbin, theconvener of the Division of Economics, for providing such a congenialatmosphere for my work. I owe a debt of gratitude to Edmund Phelps who,as my PhD supervisor at Columbia several years ago, encouraged me toappreciate and take seriously the variety within macroeconomic thought

Preface xi

and eschew intellectual regimentation. Robert Langham and his staff atRoutledge have throughout been generous with their advice and support.My wife, Alka, and son, Abhay, have patiently seen me through yet anothermajor book. Without their encouragement, love, and unflinching supportthrough occasionally trying times, this book would not have been possible. Icannot even begin to thank them.

Raghbendra JhaCanberra, AustraliaMay 2002

Preface to the First Edition

Macroeconomics for developing countries has recently become important inthe curricula of many universities. This subject, however, is usually taught atan advanced level either in graduate school or in a Topics course at thesenior undergraduate level.

The rationale for this philosophy seems to be twofold. On the one hand,it is felt that students should have a thorough grounding in the basic tools ofeconomic analysis before they study specialised topics such as less developedcountry (LDC) macroeconomics. Second, most of the material on LDCmacroeconomics is available in esoteric papers in specialised journals and istherefore inaccessible to undergraduate students.

In writing this book I have tried to bridge both these gaps. Students workingthrough this book should be able to pick up the tools of modernmacroeconomic analysis at the same time as they learn about the specialmacro issues confronting developing countries. It then becomes possible topresent the advanced material pertaining to LDC macroeconomics asrelatively straightforward extensions of the tools of analysis already learnt.

In doing this I have tried to make the treatment of both the macroeconomicanalysis and the special problems of developing countries exhaustive. Webegin with elementary tools of analysis. In Part I of the book we develop thetools of analysis of the closed economy, and in Part II the open economy isstudied. A good part of this material is common to standard intermediatemacro courses. However, issues of relevance to developing countries arebrought up in key instances.

In Part III we study some alternative views of LDC macroeconomicsthat have gained considerable prominence and respectability of late. Wefollow this up in Part IV with a review of some key policy questionsconfronting developing countries. The material in this part harks back toa long-held belief of LDC macroeconomic theory that long-term growthrather than short-term stabilisation is the key question facing developingcountries.

This book can be used in a variety of courses on macroeconomics. Parts Iand II can be used for a standard one-semester course on intermediatemacroeconomics. In a one-semester Topics course, Parts III and IV and

xiv Preface to the First Edition

some sections of Part II can be used as material for studying specialmacroeconomic problems of LDC. Finally, the whole book can be used for atwo-semester course on intermediate/advanced macroeconomics with specialreference to developing countries.

The prerequisites for reading this book are a first-year course in economicsand a first-year course in mathematical analysis. I have relied primarily ongraphical methods, and advanced mathematical tools, whenever they appear,have been fully developed and explained in the text. There is an exhaustivebibliography at the end to help students plan additional reading.

In writing this book I have been the recipient of the help of severalpeople. The economics department at Queens University has provided acongenial and stimulating environment for my work. Professors RobinBoadway, Martin Prachowny, Dan Usher and Isao Horiba have beenespecially helpful to me during my tenure here. (The late) Professor DouglasPurvis provided critical encouragement and number of ideas when thiswork was in its infancy. The comments of an anonymous referee providedabsolutely critical input in restructuring and extending the originalmanuscript. The consistent and unflinching support of Alan Jarvis,economics editor of Routledge, throughout the three years over which thisbook was conceived and written is a pleasure to acknowledge. Dr BagalaBiswal was immensely supportive throughout and helped with the diagrams.Parts of this book were tried on students in a Topics course at QueensUniversity. Their forthright appraisals of the manuscript have beeninvaluable. I am deeply indebted to all these people for their help, patienceand friendship. My greatest debt, however, is to my wife Alka and our sonAbhay. I shall not be so presumptuous as to thank them.

Raghbendra JhaKingston, Canada

Part I

The Basic MacroeconomicFramework

1

Macroeconomic problems ofdeveloping countries

AN INTRODUCTION

This book is about macroeconomic problems of developing countries. Untilquite recently, there was scarcely any independent analysis of such problemswithin the purview of mainstream macroeconomics. There were severalreasons for this and two of them may be mentioned here. First, it was generallyperceived that a traditional concern of macroeconomic theorycountercyclical stabilisationwas not very relevant to developing countries.It was felt that the most important concern of policy makers in developingcountries was medium- and long-term growth and not short-termstabilisation. Second, there was a perception, almost up to the late 1980s,that the developing countries were not different from developed countriesexcept for levels of per capita income and the like. The developed countryrepresented to the developing country a mirror image of its future.

To be sure, so far as macro problems of developing countries are concerned,there was a significant and distinguished line of theory called structuralismthat had always challenged this point of view. It argued that the problem ofdeveloping countries were qualitatively different from developed countriesand, therefore, required separate treatment. Structuralism providedalternatives to the received doctrine. More recently, structuralism has beenenriched by significant contributions from economists such as Sweder vanWijnbergen and Lance Taylor.

The most significant impetus to structuralism, however, was provided notby concerted intellectual debate (although that certainly played a role) butby a historical turn of events in the 1970s. The price of fuel oil quadrupledovernight and the whole trading world was dealt a very significant shock.Developed and developing countries alike faced ever increasing bills forimported fuel oil. Developed countries were more able to deal with this shockfor several reasons. First, they produced goods that the Organisation of

4 The Basic Macroeconomic Framework

Petroleum Exporting Countries (OPEC) needed and the prices of these goodscould be increased to compensate to the sharp deterioration in the terms oftrade. Second, OPEC placed much of its revenues from fuel oil exports in thebanks of the developed countries. Third, developed countries had thetechnological capacity to develop fuel efficient processes and substitutes.

None of these conditions was satisfied in the case of developing countries.1

The prices of less developed countries (LDCs) exports could not be increasedsubstantially; indeed the prices of primary exports from many developingcountries have stagnated, LDCs faced adverse balance of payments positionsand their technological abilities were and are limited. The LDCs thereforefaced a sharp deterioration in their terms of trade as the prices of fuel oil andgoods imported from developed countries went up (see Gilbert, 1987). Thisled to a sharp drop in output potential, which the LDCs tried to counteractby increasing domestic money supply. The ensuing inflation and large balanceof payments deficits sent LDC economies into deep crisis. They borrowedfrom international banks, since borrowing in home markets could only bevery limited, and from the International Monetary Fund (IMF).

The IMF imposed severe conditions on loans advanced to LDCs. Theywere required to devalue currencies, reduce import and other indirect taxesand reduce government expenditure at home. The rationalisation for thesepolicy measures came from the monetary approach to the balance ofpaymentsa theory developed to analyse the balance of payments problemsof more developed economies.

The logic behind this approach was as follows. Devaluation was necessaryto make the price of foreign exchange realistic. In most LDCs it was felt thatthe official exchange rate of the home currency was overvalued. Devaluationwas often made a precondition for granting of assistance.

Devaluation was to be followed by reduction in credit and reduction ofindirect taxes and imported goods. The former, by controlling aggregatedemand, would reduce inflationary tendencies. Reduction in indirect taxeswould lead to more efficient allocation of resources, which would, in turn,improve aggregate supply. This step and devaluation would increase exports.Hence, inflation and the balance of payments deficit could be brought undercontrol.

This is the premise on which IMF conditionalities are based. The recordof the performance of countries that had agreed to the IMF conditionalities,however, is somewhat mixed. The immediate impact was to cause hardshipsto LDC populations as social programmes and employment were sharplycurtailed to accommodate lower ceilings on government expenditure. It washoped that the set of policy measures advocated by the IMF would result inLDC economies becoming more competitive and efficient in the mediumrun. In some cases this did turn out to be the case but, in other instances,LDC economies experienced sharp stagflationhigh unemployment and highinflationfor protracted periods.

Macroeconomic problems of developing countries 5

The crisis due to the oil shock helped to focus attention on the theoreticalunderpinnings of the IMF policy prescription. The IMF had been followingthe point of view that it is not necessary to develop a separate theory tounderstand the macroeconomic problems of developing countries. It hadbeen focusing almost exclusively on the demand side under the implicitassumption that supply side responses would improve under structuralreforms. The structuralist school, with a completely different theoreticalperspective, had been arguing that the IMF type demand stabilisation wouldonly exacerbate stagflationary tendencies in developing countries since supplyconditions would be adversely affected. The qualified success of the IMFstabilisation package gave the structuralist considerable support. The debateabout whether a different theoretical approach was needed for studying themacro problems of developing countries gained credence. That debate is, asof now, still unresolved. However, the alternative point of view is now treatedwith considerably more respect.

Several medium-term implications of the IMF stabilisation programmestrengthened this. For instance, since the 1980s many of the poorest countrieshave kept accumulating large stocks of foreign debt. This accumulation showsno sign of abating with recent figures indicating that many of the poorestcountries are now attracting a negative inflowi.e., the debt servicingpayments are far in excess of current financial inflows. This vast accumulationof debt far exceeds the capacities of these countries to pay with or withoutfree trade. The situation is emergent and needs to be treated as such.

If problems arising from international exposure for the poorest countrieswere not bad enough, even the richest among the developing countries startedhaving serious problems in response to international exposure beginning in1997. Many South-east Asian and East Asian economies, which had hithertobeen variously described as tigers and newly industrialised, went througha period of intense crisis. The reasons for this are many and varied butexcessive short-term external borrowing in order to augment domestic savingsfor purposes of investment seemed to be the most prominent. The collapseengendered massive reduction in wealth and prosperity across the regions.Recovery from this has been slow and uneven and is yet incomplete. Somenoted economists (including the Nobel Laureate Joseph Stiglitz), notnecessarily of the structuralist persuasion, have argued that IMF type policiesare wrong and that the consequences of such policy errors have been severe.However, as of yet, there is no consensus on what is the right macro modelfor developing countries.

PLAN OF THE BOOK

In this book we do not adhere to one point of view or the other. We presentthe received macroeconomic theory and point out the differences, in keyareas, brought about by considering the special characteristics of developing


countries. This is true of the first six chapters in Part I entitled The BasicMacroeconomic Framework. In this section of the book, then, the implicitassumption is that refinements to the received macro model are enough tounderstand the macro issues confronting the developing countries. Both closedand open economy versions of the received model are studied. The sectionbegins with national accounts and elementary Keynesian economics. We thenproceed, in Chapter 3, to the classical-Keynesian synthesis with the IS-LMand aggregate supply and aggregate demand models. We then generalise theIS-LM analysis to a variable inflation rate model. Chapter 4 discussesalternative models of money supply and Chapter 5 discusses open economyIS-LM analysis. Finally, Chapter 6 discusses alternative approaches to currentaccount and asset market approaches to the balance of payments. A numberof important policy issues such as demand management and the assignmentof policy to target are also taken up. When dealing with these policy issuesthe special circumstances of developing countries are also taken into account.

The second part of the book is entitled Macroeconomic Models ofDeveloping Countries and attempts to go into the underpinnings ofalternative macroeconomic models for developing countries. It begins withan elucidation of the IMFs approach to macroeconomic adjustment indeveloping countries. The next chapter discusses a variant of the standardstructuralist model and points out the differences that this makes to theanalysis of key policy questions. The model, as laid out, is aggregative andcould be said to be representative of the experiences of some Latin Americancountries. This is followed by dualistic versions of the structuralist model.Two versions of the dualistic model are consideredone with a South Asianorientation and the other African. Many LDCs, particularly African ones,have a very significant agricultural sector. Typically, the agricultural/ruralsector is qualitatively different in these countries from the nascent industrialsector. It would, then, be inaccurate to study the macroeconomic problemsof these countries within the context of an aggregative model. We consider,therefore, a dual economy along these lines. We also consider a model of anLDC which is definitely dual but where the industrial sector is fairly important.These characteristics can be claimed to be true of South Asia. Finally thissection reviews the implications of modern economic growth theory for themacroeconomic performance of developing countries.

The third section entitled Policy Dilemmas Faced by Developing Countriesconsists of five chapters. Chapter 11 is an evaluation of the IMF programmesdesigned for developing countries. Chapter 12 discusses fiscal policy and themacroeconomic implications of the twin deficits (fiscal and current accountdeficits) in developing countries. Chapter 13 considers the problem of inflationin developing countries and the incentive on the part of many LDCgovernments to earn revenue through an inflation tax. In Chapter 14 weturn to the pressing problems of indebtedness being experienced by manypoor countriesthe so-called Heavily Indebted Poor Countries (HIPC).

Macroeconomic problems of developing countries 7

Chapter 15 considers alternative exchange rate regimes in developingcountries.

The final section of the book is entitled Issues in Developing CountriesMacroeconomics. It begins (in Chapter 16) with an analysis of the role offinancial sector liberalisation in aiding the growth process in developingcountries. This is followed in Chapter 17 by an analysis of internationalfinancial architecturean issue that has gained considerable credence sincethe Asian currency crisis of 1997. Chapter 18 concludes the book with somefinal remarks on international institutions and developing countries.

DISCUSSION QUESTIONS

1 Make a list of important areas of differences between developed anddeveloping countries. Both quantitative and qualitative issues can beconsidered. Empirically quantifiable issues could include differences in(a) per capita incomes; (b) degrees of monetisation; (c) the type ofexchange rate regime; (d) structure of the economies; (e) skill compositionof the labour force; (e) existence and efficiency of unemploymentinsurance and other welfare programmes; (f) structure of exports andimports; (g) level of technological attainment; (h) representation ininternational financial institutions such as the IMF, the World Bank, theBank of International Settlements (BIS) and the like. Qualitative factorscould include differences in (a) efficiency of fiscal and monetary policies;(b) perceived credibility of government and financial institutions; (c)extent of tax evasion; (d) maturity of political institutions and the like.

2 On the basis of these differences argue the case for and against a separatemacroeconomic treatment of developed and developing countries.

NOTE

1 Sah and Stiglitz (1989) present a useful analysis of the profound technologicaldifferences that exist between developed and developing countries.

2

National accounts and themacroeconomy

INTRODUCTION

Aggregate income accounting is the centrepiece of Keynesianmacroeconomics. A key element of this analysis is the distinction betweenstocks and flows. A stock is a value of the macroeconomic variable underconsideration at a point in time, say the money supply in Kenya on 1 January2002 or the capital stock of Sri Lanka on 1 December 1900. A flow measuresa rate per unit time. National income during the calendar year 2001 oradditions to a countrys plant and equipment during 2001 or privateconsumption expenditure during 2001 are all examples of flows.

In this chapter we will learn about the basic framework of nationalaccounting. Just as private economic agents have balance sheets expressingthe relations between their incomes and expenditures, a nations books mustalso balance. This expression of the relationships between a nations output,income and expenditure is called the national accounts. These nationalaccounts also have the additional role of providing a framework formacroeconomic analysis. This is crucial since without it macroeconomicanalysis cannot proceed. In modern times, most countries follow the UnitedNations System of National Accounts, and the United Nations has apermanent statistical commission for this purpose. In addition, theInternational Monetary Fund (henceforth the IMF) has developed GeneralData Dissemination Standards (GDDS) and Special Data DisseminationStandards (SDDS) for countries to adhere to in reporting their nationalaccounts statistics. See, for example, Bloem, Dippelsman and Maehle (2001).We now turn to a rudimentary account of the national accounting framework.

AGGREGATE INCOME, OUTPUT AND EXPENDITURE

There are five sets of economic actors in the macroeconomy: domestic firms,domestic households, the domestic government, financial institutions andfirms, households and governments in the rest of the world, encapsulated


here under the heading of Rest of the world. The financial flows that takeplace between them are depicted in Figure 2.1. On this basis, economistsoften make distinctions between three different measures of aggregateeconomic activity: national income, national product and nationalexpenditure.

N.B. Double arrows () indicate Financial flows between the Rest of theworld and Domestic economic agents. Thus domestic households may investin foreign stock markets and foreign institutional investors may invest indomestic stock markets.

In modern macroeconomics the economy is thought of as consisting of anumber of firms and households interacting with each other and with thegovernment. These institutions, in turn, interact with foreign households,firms and governments. This is what is portrayed in Figure 2.1. During thisinteraction output is produced, incomes are generated and expenditures aremade. These three activities form the core of national accounting. We describeeach of these very briefly now. In addition, we comment on the nationsaccounts with the rest of the worldthe balance of payments.

National product

The sum of value added during an interval of time at various stages ofproduction is a measure of a nations output. Value added at any stage ofproduction is the value of output produced at that stage of production minus

Figure 2.1

National accounts and the macroeconomy 11

the cost of intermediate inputs. Value added at the bakery is the value ofbread minus the cost of flour and other intermediate inputs used in theproduction of bread. The sum of all value added is sometimes called thegross domestic product (GDP) of a country. The adjective domestic is usedhere because all value added within the geographic boundaries of the countryare considered irrespective of whether these values are produced by foreignor domestic firms. The emphasis in calculating value added is on theproduction of final goods and services produced and sold through the marketduring the current time period but not resold during the current time period.The goods and services produced are valued at market prices (this is what ismeant by saying sold on the market). This recognises, for instance, that anew house costs ten times as much as a new car. Hence the value of thehouse is assessed to be ten times the value of the car. GDP refers to finalgoods and services since intermediate goods (that are used in the productionof other goods) are netted out.

In measuring gross national product (GNP) we deduct from GDP thevalue added by foreign-owned firms and add to it the value added bydomestic firms working in foreign countries. It should be emphasised thatwhen measuring the national product the values of goods and services asexpressed in the market are used. Omitted are important non-marketactivities. Thus the services a housewife provides are not measured in thenational accounts whereas if the same services had been provided by anemployee these would have been included. Furthermore, national accountstypically ignore the impact of economic activity on the environment. To theextent that economic activity causes a net loss to environmental resources,current economic activity reduces future economic potential and this factshould be reflected in the value of current output.1 However, inmacroeconomics such issues are generally eschewed not because they areunimportant but because the agenda of macroeconomics is very fullotherwise.

National income

This is the sum of all factor incomes generated during an interval of time. Incomputing this we add up all wages, salaries, profits, interest, rent, dividendincomes and the like, i.e. all remuneration received for productive economicactivity2 by all factors of production. This is called net national income atfactor cost. If we add to it indirect taxes and subtract subsidies we get nationalincome at market prices. If depreciation is also added we get gross nationalincome.

National expenditure

A third way of measuring aggregate economic activity during an interval oftime is by summing up final expenditures. Hence we add up consumption,


investment and government expenditures. To this we add net exports, i.e.exports minus imports. Consumption is defined as the direct utilisation ofgoods and services by consumers not including the use of means of productionsuch as machinery and factories. Typically, this is the largest component ofnational expenditure in all countries. Consumption is divided into three majorcategories: consumption of durable goods such as cars or furniture,consumption of non-durable goods such as food, and consumption of servicessuch as health and financial services. Investment expenditure is defined toinclude all expenses incurred in augmenting the productive capacity of theeconomysay in plants and equipment. Thus final goods that firms andbusinesses keep for themselves (and do not consume) are called business orprivate investment. Expenditure on residential investment such as theconstruction of homes and apartment buildings is part of investment. Businessinvestment includes investment in plants and equipment as well as changesinventories. By including changes in inventories during a given time periodas part of expenditure we ensure that national product equals nationalexpenditure. The third major component of national expenditure isgovernment expenditure. In this category are included expenditures bygovernmentnational, state, localon final goods and services. Also includedare transfers made by governments. These include items like social securitypayments. The final category of national expenditure is net exportsexportsless imports. Net exports are a source of net demand (hence expenditures)for the home economy. Net exports are also part of balance of paymentsaccounts, which are discussed later in this chapter.

These three measures of aggregate economic activity are usually calculatedfor a year.3 Hence these are all flows. When a year closes national incomemust equal national product, which in turn must equal national expenditure.This is because they are realised magnitudes. Desired magnitudes, however,might differ systematically from realised ones.

Each of these magnitudes can be measured in real or nominal terms. Whenthe GNP for 2001 is measured with the prices of 2001 used to value output,then we have measured GNP in current prices. This is also called nominalGNP.

If, however, we wish to compare GNP figures of 2001 with those of 1980,we realise that there are some difficulties. Comparing nominal GNP for 1980with nominal GNP for 2001 may not be such a good idea, because duringthe period 19802001 the price level would have risen and the structure ofrelative prices would have undergone several changes.4 One way of gettingaround this difficulty is to calculate real GNP. Let be the year 0(or base year) prices of all n goods produced in the economy. Thecorresponding quantities transacted in the base year are Wemay evaluate current year quantities in terms of base year prices. Let thecurrent year quantities traded be Real GNP for year 1 (withyear 0 as base) can be written as


This measure has obvious disadvantages, such as the fact that the same bundleof goods may not be produced in year 1 as in year 0, but in macroeconomicswe must learn to be pragmatic rather than fussy.

We can similarly compute an index of how prices may have moved duringthe period. One such indicator is

Similarly one can define a GNP deflator (a measure of price change) asnominal GNP/real GNP. Let P2001 be the value of the GNP deflator in 2001and P1980 be its value in 1980. The rate of inflation between 1980 and 2001was

Price index numbers and GNP in real and nominal terms are some of themost important macroeconomic variables. Another importantmacroeconomic variable is the aggregate rate of unemployment. This isdefined as the aggregate number of people unemployed and actively searchingfor work during a period of time divided by the total size of the labour forceduring that period. Unemployment data are also collected annually but areavailable for shorter durations of time as well.

BALANCE OF PAYMENTS ACCOUNTING

The balance of payments accounts of a country record all payments into andout of the country within a given time period (typically a year). All flowsfinancial or consisting of goods and servicesbetween the residents of acountry and the rest of the world are so recorded. The balance of paymentsaccounts are made up of two major components each with its ownsubcomponents. The two major groups are: the current account and thecapital account.5


The current account is divided into four major categories

Transactions in goods

Transactions6 in goods are subdivided into four major categories: (a) generalmerchandise consisting of the bulk of commodities included in the balanceof payments. (b) Goods for processing are those that are imported with theintention of being re-exported after being transformed in some way throughprocessing or incorporating into another commodity. (c) Repairs on goodsand services includes repairs on movable property (such as cars and aircraft)without such property being physically transformed. (d) Non-monetary goldincludes exports and imports of gold not held as reserve assets by the centralbank of this country, e.g. the gold in jewellery.

Services

Transactions in services are divided into several categories. (a) Travel. Allgoods and services, irrespective of type, are classified under this heading ifvisitors to the economy compiling the balance of payments statistics purchasethem (credit) or if residents of this economy visit other countries (debit). (b)Government services. A good or service is recorded under government servicesif embassies or military units purchase it in the country of location of theembassy or the military unit. (c) Transportation. This consists of costs oftransportation of passengers and goods and auxiliary services such as storage,cargo handling, packing and towing. Thus this category includes allinternational transportation services and transportation services renderedby a non-resident to a resident user. (d) Computer and information relatedservices. Items classified in this category include software implementation,maintenance and repairs of computers, data processing, newspapers andmagazine subscriptions. (e) Insurance data includes figures on premiumsearned, premium supplements earned and claims. (f) Personal, cultural andrecreational services include items in audio-visual, entertainment, sports,museums, libraries and health.

Income

covers international transactions associated with income accruing to factorsof production such as capital and labour. Income on capital is referred to asincome on financial assets.

Current transfers

record unrequited transactions, i.e., those transactions in which an economicagent provides another economic agent with a good or service or a financialasset without any flow in the opposite direction.


The capital account

The capital account is divided into capital transfers, acquisitions/disposals ofnon-produced, non-financial assets and the financial account. Items recordedunder (a) capital transfers include the following: investment grants (includingcash transfers for purchases of investment goods), debt forgiveness andmigrants transfers. (b) Non-produced non-financial assets are, in the main,licences, franchises and patents. Also included is the acquisition/ disposal ofland by representative offices of foreign governments, such as embassies. (c)The financial account records transactions in financial assets and liabilities.Such transactions can be divided into four broad categories. Direct investmentincludes investment over which the owner exercises control. In practice adistinguishing criterion for inclusion in this category is that the owner shouldhold at least 10 per cent of the ordinary shares in the company. Portfolioinvestment is a residual category for transactions in shares, bonds, bills, notes,money market instruments and financial derivatives. It is residual becausethese instruments are also included under direct investment and reserve assets.Portfolio investment is typically divided into the categories of equity anddebt. Other investment lists all transactions in financial assets and liabilitiesthat are not classified under any of the other categories. The most importantof these other investments are currency, deposits and loans (including tradecredits). Reserve assets include gross assets to be used by the central bank ofthe country for balance of payments purposes where other assets cannot beused. Any asset can be included in the reserve assets category provided it iscontrolled by the central bank or accessible to the central bank at short noticeand is denominated in a convertible currency.7

Residence is defined in economic and not legal terms. The main criterionto determine residence of an entity is centre of economic interest. Thus adomestic branch of a foreign owned firm will be counted to be in residencewhereas the foreign branch of a domestic owned firm will typically not.

We have so far examined some key flow macroeconomics variables. Letus now look at some important stock variables. Macroeconomists areconcerned about several stock variables, e.g. the capital stock or the stock ofmoney in the economy.

MONEY

Money is anything that is generally accepted as a medium of exchange. Whatprecise assets constitute the medium of exchange varies from one society toanother and has varied over time. Gold, silver and several other preciousmetals have served as mediums of exchange. In developed countries personalcheques and interbank transfers are accepted as mediums of payment. Inseveral developing countries payment by personal cheques is oftenunacceptable. The use of cash is much more common.


In modern societies money is typically a financial asset, which is the liability(most commonly) of the central bank of the country. There are severaldefinitions of money but two are most common. Narrow money (M1) consistsof currency in circulation plus demand deposits in commercial banks. Broadmoney (M2) consists of M1 plus time deposits in commercial banks.

Money does not include plastic money such as credit cards. These plasticcards are convenient identification tags that enable the holder to create twodebts. One debt is between you and bank issuing the credit card and theother is between the credit card bank and the seller whose goods have beenbought.

Capital stock

In economics, capital is referred to as a factor of production (other than landor labour) from which an income is derived. In modern macroeconomictheory capital is deemed to consist of physical capital of tools, machines,stores of merchandise, houses, means of transportationany materials usedto extract, transport, create or alter goods. Marketable intangibles, such ascredits, goodwill, promises, patents and franchises, are also included by someeconomists. Capital goods are those that form a nations productive capacity,as opposed to consumer goods, which are bought for personal or householduse. A distinction is also made between capital stocks, or circulating capital(such as raw materials, goods in process, finished goods and sometimeswages), and capital instruments, or fixed capital (such as machines, tools,railways and factories). Capital may be classed as specialised, such as railwayequipment, or unspecialised, such as lumber or other raw materials havingmany uses. Economic theorists believe that capital arose out of the need touse the worlds limited natural materials efficiently. The scarcity of the earthsresources necessitates the creation of materials (capital) that can act on theresources in such a way as to make more goods available to society thanwould normally exist. Capital goods can be considered a form of deferredconsumption, because they produce goods for future consumption, but arenot themselves consumable items. The expansion of capital formationtheflow of savings into the creation of new productive facilitiesis often themost important target of economic planning.

ASSETS, LIABILITIES AND BALANCE SHEETS

An asset is something you own. A liability is something you owe. There aretwo types of assets: financial and real. A real asset is something tangible:cars, plots of land, mines, airplanes, apartments and steel factories are allexamples of real assets.

Financial assets are different. They are pieces of paper, which constitutean asset for one person and a liability for another. In other words they definea debt relationship between two economic agents. An example is your savings


account in your neighbourhood bank. The amount of money in your accountis your assetyou own the money. It is the banks liabilitythey owe thatmoney to you. A $5 currency with you is your assetthe correspondingliability is that of the Federal Reserve Bank of the USA.

The balance sheet of an economic agent is a comprehensive statement ofthat agents assets and liabilities. An individuals balance sheet may look likeTable 2.1. The balance sheet drawn here follows the principle that the sheetmust balance. Hence wealth is shown as a liability. One can think of it aswhat the individual owes to herself.

BALANCE SHEET OF SIX AGENTS

We may now examine the balance sheets of six major economic actors: firms(F), households (H), commercial banks (B), central bank of the country (C),the government (G), and the rest of the world (R).

Their balance sheets are represented in Table 2.2. A plus (+) denotes anasset and a minus (-) a liability. An explanation of the terms used in the tableis given below. 1 Commercial bank deposits with the central bank are commercial banks

accounts with the central bank of the country. These are the centralbanks liability and the commercial banks assets.

2 Currency consists of all the notes and coins held by (and, therefore,assets of) households, firms and commercial banks. The correspondingliability is that of the central bank.

3 Demand deposits are accounts from which funds may be withdrawn ondemand. They constitute a liability of the commercial banks and areassets of firms, households and the government.

Table 2.1 An example of a personal balance sheet


4 Other (term) deposits are held at commercial banks by firms andhouseholds. They may not be withdrawn immediately.

5 Government securities are loans issued by the government and held bymany agents; in the typical developing country they are held principallyby the central bank of the country.

6 Bank loans are personal and business loans, which form an asset for thecommercial banks, and are a liability of the people who have borrowedthe funds.

7 Equities are issued by funds to raise capital for their activities. An equityholder in a firm is in fact an owner of the firm, i.e. the householders andforeigners who own equity shares in a firm really own a share of thefirms capital stock. Actually, of course, the owner of a share can onlysell the share. The firm has a liability and the households and firms ownthe corresponding asset.

8 Corporate bonds are held by bondholders in a corporation. A bondholder,unlike an equity holder, is not an owner of the corporation. Rather sucha patron has simply made a loan to the corporation. A corporate bond isa liability to a firm and an asset to those advancing the loan (householdsand foreigners).

9 Foreign securities can in principle be held by the households, domesticfirms, commercial banks and the government. In practice, however, inmost developing countries foreign securities are held by the central bankand the government.

10 Foreign exchange reserves in developing countries are typically assets ofthe government and the central bank and the liabilities of the foreigngovernments that have issued them.

Table 2.2 Structure of financial indebtedness


NET FINANCIAL ASSETS

If we add up the elements along any column of Table 2.2 we shall get the netfinancial assets of that sector. Those for the commercial banks and the centralbanks will approximately add up to zero. This is because although the absolutesize of the real assets owned by these institutions is very large, in comparisonwith the size of their financial liabilities it is minuscule.

Households and firms have positive net financial assets. The government,on the other hand, typically has a net financial liability referred to as thenational debt. The net financial asset position of the country vis--vis therest of the world may be positive or negative.

REAL AND FINANCIAL ASSETS

Real assets are owned primarily by households, firms and government, andthe total of all these constitutes the non-human wealth of the economy. If thegovernment has liabilities that exceed its real assets then it is the householdand firms that will be responsible for meeting these liabilities. The governmentwill have to levy taxes on them, which equal in value the excess of its liabilitiesover its assets. This might be thought of as an implicit financial asset.

Households are the ultimate holders of wealth. Firms can be regarded asowing to households net undistributed profits, which are exactly equal to thedifference between the firms real assets and net financial liabilities. In the caseof firms that have issued equity, undistributed profits are already taken intoaccount provided that the equity has been valued correctly. The value of thefuture income of individuals constitutes the economys human wealth.

The net wealth or the real assets plus human wealth is the economyswealth. This is the same thing as the household sectors wealth. The reasonwhy the households own all the wealth is because of the implicit asset/ liabilityitems, which take into account future tax liabilities and undistributed profits.Government has no wealth of its own. It owes any excess of assets overliabilities to households who are liable for its net debts. Similarly, firms haveno net wealth because they owe to households any undistributed profits.These ideas are summarised in Table 2.3.

Table 2.3 Net asset positions of economic agents


THE NATIONAL ACCOUNTING FRAMEWORK

Aggregate demand in an economy can be written as the sum of consumptionexpenditure C, investment expenditure I, government expenditure G andnet sales to the rest of the world (exports X less imports Z). We know that expost aggregate expenditure equals national income y. Thus we can write

Domestic expenditure is often referred to as domestic absorptionA and is called the balance of trade, so that we may write

(2.1)

or

(2.2)

In other words the balance of trade is equal to the difference between nationalincome (which in equilibrium equals domestic supply) and domestic demand(absorption). Realise that if net factor payments from abroad are zero then

also equals the current account balance. Now any current accountssurplus (CAS) is equal to the net acquisition of foreign assets (NAFA). Thus

upon substitution for A. Now (savings). Hence we have

(2.3)

Hence the trade account can improve only by increasing net savings.Equivalently the trade account can only be increased by increasing nationalincome or reducing absorption.

SIMPLE MULTIPLIER ANALYSIS

Our analysis so far has been conducted in terms of the accounting framework.In the simple Keynesian framework these relationships have been used topredict casual linkage between aggregate demand and national income. Letus dwell in this somewhat.

Consider an economy in which the absolute price level, the nominal wagerate and the interest rate are fixed. The price level and the nominal levelwage rate may be assumed fixed because we are considering only the shortruna time period too short for any significant wage and price adjustments.We abstract from interest rate effects by assuming that the monetaryauthorities keep the interest rate pegged. The rate of interest is allowed tovary in the IS-LM model, which is discussed in Chapter 3.


Desired consumption C depends on disposable real national income yd.

Keynes hypothesised that with higher disposable income people consumedmore. But part of every additional dollar of disposable income is saved. Theconsumption function relates desired consumption in the aggregate todisposable income. A particularly simple example would be

(2.4)

where b is often referred to as the marginal propensity to consume (MPC).The average propensity to consume (APC) is defined as the ratio ofconsumption to income, C/yd, and varies inversely with yd.

Real national income equals disposable income plus direct (restricted toincome) taxes Hence if T is a relatively simple magnitude it iseasy to convert the consumption function from the (C, yd) plane to the (C, y)plane. We shall assume that this is the case.

Desired investment I is treated as exogenous. The rate of interest is fixed.Other factors such as expectations of profitability that might affect desiredinvestment do not depend on y.

Government expenditure G is treated as exogenous since the governmentsexpenditure is affected by factors other than y. Finally, exports X areexogenous and imports Z depend on imports. However, the marginalpropensity to import (the additional import following an increase in incomeof $1) is assumed fixed and less than one.

Total desired aggregate expenditure E is the sum of desired consumption,investment and government expenditure:

(2.5)

Algebraically, let

The equilibrium condition is that national expenditure equals national income.Thus,

Hence equilibrium national income is

(2.6)


This equation expresses equilibrium national income as a function ofexogenous variables and parameters of the system.

Suppose we wish to model taxes explicitly. Let Then we would have the consumption function

The other components of aggregate demand are as before. Equilibriumnational income would be given as

or

(2.7)

Where y** is equilibrium national income with taxes explicitly modelled.The multiplier is defined as the change in equilibrium national income

consequent upon the change in some exogenous component of aggregateexpenditure. From equation (2.7) we get

Consider now the simplified model with lump-sum taxes:

We will get

so that

so that and whence dy/T=(1-b)/(1-b)=i.e. if G and T change by the same amount (say $1) outputwould increase by $1. This is often referred to as the balanced budgetmultiplier.


There is another interesting interpretation of the equilibrium condition:

Savings S are the surplus of disposable income over consumption,

Now Now if

(2.8)

we get our equilibrium condition that aggregate income equals aggregateexpenditure. Now is the sum of leakages from the income streamwhereas are the injections. Hence equilibrium is attended whereinjection into the income stream equal leakages.

In the analysis in this chapter changes in demand drive the macroeconomy.A higher exogenous demand always leads to a higher income. Other criticalmacroeconomic variables like the price level, real wage and interest rate donot adjust. More output always means more employment from the productionfunction. More workers are always willing to work at the prevailing wagerate. Output demand constrains labour demand, which in turn, constrainsoutput demand.

The labour market equilibrium consistent with this view of the economyis depicted in Figure 2.2. The labour supply curve is horizontal at the goingwage rate. Employment is constrained by the demand for labour. Themodelling of the labour market is very simplistic here. A more sophisticatedanalysis is definitely possible. However, it needs to be remembered that in

Figure 2.2


most developing countries labour is plentiful and output is constrained notby labour so much as by availability of foreign exchange and capital. Theassumption about the labour market made in this chapter, therefore, maynot be as outlandish as it may seem at first glance.

CONCLUDING REMARKS

The analysis in this chapter is the starting point of almost all texts onmacroeconomics, even those that have the most developed countries as theirfocus. Does this mean that the same analysis can be used for developed anddeveloping countries?

This question is rather complicated and controversial. Complicated becausethere are many differences in the economic structures of developed anddeveloping countries. To name just a few of these differences: developedcountries, apart from the fact that they enjoy much higher living standardsthan developing countries, also have much more developed financial andbanking institutions, their currencies enjoy much more confidence than thecurrencies of developing countries in exchange markets and they have muchbetter supply responses than developing countries.

Many economists believe that these differences are quantitative ratherthan qualitative in nature. In other words the same economic mode withdifferent values of the parameters can be used for developed as well asdeveloping countries. The aggregate supply curve, for instance, is upwardsloping in developed as well as developing countries. The slopes might bedifferent.

Several other economists, however, argue that the differences betweendeveloped and developing countries are so deep that they amount to beingqualitative rather than merely quantitative. They argue that models used tostudy the macroeconomic problems of developed countries are inapplicableto developing countries. A whole new approach has to be developed.

This debate is controversial because, after all, the economic policy measuresthat one advance would depend on the model used to study the economy.The approaches of the two groups of economists to economic policy arefundamentally different. Given the severe economic predicament in whichmany developing countries have found themselves since at least the mid-1970s, this controversy assumes significance.

The approach taken in this book is agnostic. We do not necessarilysubscribe to the point of view of any school. We shall develop both approachesand, whenever possible, resolve differences by appealing to the facts.

DISCUSSION QUESTIONS

1 The simple Keynesian model studied in this chapter implies that anincrease in autonomous expenditure leads to a rise in income. What


assumptions do you think are necessary for this to hold? To what extentdo you think these assumptions are satisfied in developing countries?

2 We have studied the balanced budget multiplier in this chapter. Can youpoint out other instances when increasing one component of autonomousexpenditure and reducing another will imply a multiplier of one? Whenare such multipliers equal to zero?

3 Suppose the demand for money depends upon consumption rather thanincome. Consumption, in turn, depends upon after-tax income. Analysenow the impact of a tax cut on equilibrium output and employment.

4 Suppose the central bank is considering two alternative policiesholdingthe money supply constant or adjusting the money supply to hold theinterest rate constant. In the fixed price IS-LM model which policy wouldbe better if there were (i) shocks to consumption only, (ii) shocks tomoney demand only? The classic paper analysing this question is Poole(1970).

NOTES

1 Such considerations have led to the notion of green national accounting. See,for example, Aronsson, Johansson and Lofgren (1997).

2 Payments for intermediate goods are not included.3 Recently the Special Data Dissemination Standards of the IMF have called for

quarterly figures on GDP as part of its Special Data Dissemination System (SDDS).See the IMF website: www.imf.org.

4 An additional problem would be that the basket of goods in the market wouldhave changed between 1980 and 2001.

5 In some classifications, the capital account is split between a capital account anda financial account.

6 Transactions are divided as acts in which two parties exchange goods, servicesor assets. The two parties need not be separate legal entities. Thus two branches(in two different countries) of the same firm may enter into a transaction.

7 Part of these are special drawing rights (SDR) issued by the IMF which the centralbank of a country holds to settle claims between itself and other central banks.

3

The basic IS-LM-AS model in theclosed economy

INTRODUCTION

In this chapter we shall further develop the Keynesian analysis initiated inthe last chapter. We begin with an IS-LM analysis with fixed prices. We thenrelax the assumption of fixed prices and study output and price leveldetermination in a model of aggregate demand and supply. We then generalisethe model to include wealth effects in aggregate demand. Finally we studyPhillips curves and the natural rate of unemployment.

MACROECONOMIC ANALYSIS WITH FIXED PRICES: IS-LM

In the previous chapter we developed the Keynesian model for the case whereboth the interest rate and the price level are fixed. In this section we relax theassumption of a fixed interest rate but keep the price level fixed. This iscalled IS-LM analysis.

The IS schedule

To develop the IS curve, consider the model developed in Chapter 2.Equilibrium national income is given by

(3.1)

In the model presented in the previous chapter I, G and X were treated asexogenous. Hicks, and later Hansen, in an attempt to generalise this modelto include some concerns of the classical economists, allowed investment todepend negatively on the rate of interest, r. (Since prices are fixed there is nodifference between the real and the nominal rates of interest.) Thus

(3.2)

A simple rationale for the investment function postulated in (3.2) is that thehigher rate of interest the greater is the cost of borrowing for investment,


ceteris paribus, and the lower, therefore, will be investment. Equilibriumnational income is given by

(3.3)

or, equivalently,

(3.4)

Equation (3.4), or equivalently (3.3), is the equation of the IS schedule. Thisschedule gives us the r, y combinations for which leakages form the streamof national expenditure equal injections Totallydifferentiating equation (3.4) gives

for fixed T, G and X. A subscript denotes a partial derivative: Hence the IS schedule in the r, y plane is downward sloping,

The intuition behind the IS schedule is rather straightforward. The lower therate of interest, ceteris paribus, the higher is going to be aggregate demand.With higher aggregate demand, equilibrium national income is going to behigher.

We depict the IS curve in Figure 3.1 as the locus of combinations ofcombinations of r and y. To the left of the IS schedule at any level of incomethe rate of interest is too low to give us commodity market equilibrium. Ifthe rate of interest is too low then the rate of investment will be too high.Correspondingly, aggregate demand will be too high. This last step in theargument follows from the Keynesian assumption retained by Hicks andHansen that output and employment respond to aggregate demand changesin the commodity market. All points to the left of the IS schedule then denoter, y combinations that are associated with excess demand (EDG) in thecommodity market. Analogously, at any point to the right of IS, at the relevantlevel of income, the interest rate is too high to maintain equilibrium in thecommodity market. This implies that investment is too low and so will beaggregate demand. All points to the right of IS then denote r, y combinationsthat are associated with excess supply (ESG) in the commodity market. Thisis shown in Figure 3.1. Horizontal arrows in the diagram denote pressure ony. When there is excess demand for goods there is pressure for y to rise.Conversely, when there is excess supply in the goods market there is pressurefor y to fall.

The IS curve gives a relationship between r and y that must obtain to haveequilibrium in the commodity market. It is clear that, by itself, the IS curvecannot determine equilibrium r and y. To do this we have to introduce another

The basic IS-LM-AS model in the closed economy 29

equilibrium relation between r and y. To get this other relation let us dwell alittle on the general equilibrium underpinnings of the Keynesian model.

We have four aggregate markets: the labour market, the commoditymarket, the bond market and the money market. Keynes simplifies the analysisby assuming that the wage rate is fixed in the labour market. Employment,then, is entirely dependent on the demand for labour that is derived from thedemand for goods. Thus employment rises when demand for goods risesand, correspondingly, falls when the demand for goods falls. Hence the labourmarkets behaviour is entirely explained by the commodity market. Weexclude the bond market by Walras law (which says that excess demand inany market in an n1 market system is the sum of the excess supplies in theother market). Hence, we get the other relationship between r and y (the LMschedule) from the money market.

The LM schedule

Keynes had made a spirited departure from the classical tradition by assumingthat monetary influences determine the rate of interest. In the classicaltradition, r is determined by the equality of real saving and investment, andmonetary influences primarily affected the price level. Keynes majordepartures from classical thought (at this level of aggregate generalequilibrium analysis) are 1) that the price level and nominal wages are fixedand national income adjusts to clear the commodity market, and 2) thatmonetary influences determine the rate of interest.

Keynes visualised the demand for money (real cash balances) as risingfrom the transactions, speculative and precautionary motives. People hold

Figure 3.1


cash balances for transactions purposes because of the immediate liquidity ofmoney and because of the non-synchronisation of payments and receipts.People get salaries at discrete intervals of time, usually a month, whereasexpenses have to be incurred more or less continuously. These expenses haveto be paid for with cash. Hence people hold money for transactions purposes.We might reasonably expect that the higher a persons income the higherwould be expenses and the greater would be the transactions demand forcash. For the economy as a whole the higher the national income the greaterwould be the transactions demand for cash balances.

People often hold cash for precautionary purposesfor an unforeseencontingency that requires extra expensesan illness in the family, for example.We would reasonably expect the higher a persons income the higher wouldbe the demand for cash for precautionary purposes. For the economy as awhole the higher the national income the greater would be the demand forcash for precautionary purposes.

People demand money for speculative purposes as well. Suppose thatpeople can hold their financial assets in two forms: a riskless asset (cash) andrisky asset (bonds). For simplicity the bond is assumed to be an annuitythe bond pays an interest of r and the principal is never paid. The price of thebond, therefore, is 1/r: the higher the rate of interest the lower will be theprice of bonds. If we assume that at high interest rates people will expect theinterest rate to fall (bond prices to rise), it would be rational for an investorto buy more bonds and reduce the demand for money. Analogously, wheninterest rates are low (bond prices are high) investors will expect interestrates to rise (bond prices to fall) and will therefore tend to sell bonds tomake capital gains. In this process they will increase their demand for money.Therefore the demand for money for speculative purposes depends negativelyon the interest rate. Hence we may write the aggregate demand for money asL(r, y). When the interest rate rises, ceteris paribus, the demand for moneywill fall. When y rises, ceteris paribus, the demand for money will rise.Equilibrium in the money market is given by

(3.5)

where M is the nominal stock of money and P is the aggregate price level. M/P, therefore, is the real value of cash balances. Equilibrium in the moneymarket is shown in Figure 3.2.

If the real value of existing money supply is (M/P)0 and the national incomeis y0, the equilibrium rate of interest in the money market would be r0. At alower rate of interest, ceteris paribus, demand for money would be too highand at a higher rate of interest it would be too low in comparison to theexisting money supply.


Equation (3.5) represents the LM schedulethe locus of r, y combinationsgiving us equilibrium in the money market. Totally differentiating we have(for fixed M/P) so that

since and

Figure 3.3 displays the LM schedule. Above the LM schedule for a giveny the interest rate is too high. This means that the demand for money will betoo low relative to money supply. This is labelled as ESM. If, along withKeynes, we assume that monetary factors affect r (primarily) then there willbe pressures for r to fall in this region. Vertical arrows in Figure 3.3 denotethis. Below the LM schedule at any level of income the rate of interest is toolow to maintain equilibrium in the money market. There will be excessdemand for money (labelled as EDM) and there will be pressures for r to rise.

Equilibrium in the commodity and money markets

Figure 3.4 denotes simultaneous equilibrium in commodity and money marketswith (at point Z) the equilibrium interest rate being r* and equilibrium nationalincome y*. At this point there is simultaneous equilibrium in the goods andmoney markets. Students should satisfy themselves that the bond marketequilibrium schedule would go through quadrants I and III and pass through

Figure 3.2


Figure 3.3

Figure 3.4


Z, by Walras law. In any event, the bond market schedule is redundant andwe shall work with the IS and LM schedules.

Shifting the IS schedule

Assume that we have equilibrium at Z in Figure 3.4 with rate of interest r*and national income y*. A rise in any exogenous component of aggregatedemand would shift the IS curve to the right. To see this, suppose governmentexpenditure goes up. Now totally differentiate equation (3.4) with theunderstanding that This gives At anygiven r we have Similarly for given y we have

With higher government expenditure aggregate demandis higher, ceteris paribus, at every rate of interest. Hence every rate of interestis associated with a higher level of national income (correspondingly at everylevel of income the interest rate required to give us equilibrium in thecommodity market is higher). Consequently the IS curve shifts outwards.The analysis here is not confined to an increase in government expenditure:an increase in any component of aggregate demand would shift the IS curveoutwards. Conversely, any fall in any exogenous component (an increase inT) will shift the IS curve inwards.

Shifting the LM curve

A change in money supply will shift the LM curve. Totally differentiatingequation (3.5) with the understanding that gives d(M/P). Hence for given r we get Hence with anincrease in the money supply every interest rate is associated with a largervalue of real national income. In other words, the LM schedule shiftsoutwards.

POLICY ANALYSIS IN THE IS-LM FRAMEWORK

In this section we analyse economic policy. However, the kinds of policyissues that can be addressed within the IS-LM framework are rather limited:it is difficult to analyse price level changes.

Within this framework we can say that expansionary fiscal policy (anyincrease in exogenous expenditure which, as we know, shifts outwards theIS schedule) will most likely increase output. So will expansionary monetarypolicy (an increase in the money supply in real terms). Totally differentiatingequations (3.4) and (3.5) and writing in matrix form gives

(3.6)

Setting d(M/P) = 0 and solving by Cramers rule we get


(3.6a)

(3.6b)

(3.6c)

These are the fiscal policy multipliers. An increase in exogenous exports orgovernment expenditure or a reduction in taxes shifts the IS curve outwardswithout disturbing the LM schedule. It can be checked from equation (3.6)that in all these three cases r also rises (Figure 3.5). Clearly the magnitude ofthese multipliers depends upon the sizes of the coefficients Ly, Ir and the like.In particular we realise that as (the absolute value of) Ly rises these multipliersdrop. In the extreme case the LM is nearly vertical, Lr is very large and themultipliers are nearly zero. This is the so-called classical case. In anotherextreme case Lr is very small and the LM schedule is nearly horizontal. Inthis case the multiplier is large (the so-called liquidity trap case). Classroomexpositions of IS-LM analysis often depict a schedule as in Figure 3.6. Thisshows an LM schedule with three distinct ranges. At low rate of interesteveryone expects the interest rate to rise so that the LM schedule is horizontal

Figure 3.5


(the liquidity trap case). At moderate rates of interest the LM schedule isupward sloping; it becomes vertical at very high rates. Any increase inexogenous expenditure simply raises the rate of interest and crowds outprivate investment with no effect on equilibrium output. Some economistshave often used this last situation to argue against expansionary fiscal policy.If the LM curve is neither completely inelastic nor perfectly elastic, then theeffect of an increase in the supply of money will depend on the slope of the ISschedule.

To analyse the effects of expansionary monetary policy we go back toequation (3.6). Setting and solving by Cramers rule gives

(3.6d)

It can similarly be checked that We depict the situation inFigure 3.7. An increase in the money supply (leading to a shift in the LMschedule from LM to LM leads to a drop in the equilibrium interest rate anda higher equilibrium national income. Clearly, for any given shift of the LMschedule, the flatter the IS schedule the greater will be the increase inequilibrium y.

AGGREGATE DEMAND WITH VARIABLE PRICES

To study the dynamics of inflation we generalise the above IS-LM model andadmit continuing inflation.

Figure 3.6


The IS schedule

Define V as the natural log (henceforth written as ln) of saving plus taxes andJ as the ln of investment expenditure plus exogenous government expenditure.Let Y be the ln of real national income, i the nominal rate of interest and e

the expected rate of inflation, so that denotes the real rate of interest.We can write

(3.7)

(3.8)

Savings are assumed to depend on real national income alone whereasinvestment depends on real national income and the real rate of interest. 1and 3 are, respectively, the income elasticities of saving and investment. 4is an interest semi-elasticity. (Remember that is in terms of levels notlogs.) All parameters are positive.

Figure 3.7


What is the difference between the real and nominal interest rate? Supposeyou lend out $100 at an interest rate of 5 per cent for one year. You expect toget back If there is no inflation your real rate of returnwould be 5 per cent or, in this case, $5. Suppose, however, that the price levelwas expected to rise at 6 per cent? How much should you get back in orderfor you to get a real rate of return of 5 per cent? The answer is

In other words, if r is the real rate of return and e isthe expected rate of inflation you should get back for everydollar you lend out. Now Now re is a verysmall magnitude and can be ignored. Hence the gross of inflation rate ofreturn or the nominal rate of interest, i, can be written as

(3.9)

This is the famous Fisher equation after Fisher (1930). Sometimes a corollary(the so-called Fisher effect) is implied that so that r is impervious tomonetary disturbances. This, however, is not always true. See, for example,Jha, Sahu and Meyer (1990).

To derive the IS schedule we set leakages from national expenditure equalto injections into national expenditure. In other words, we set savings plustaxes equal to investment plus government expenditure. This gives us arelation between Y and i, which can be written as

(3.10)

where and Since the coefficient of iis the slope of the IS equation in the (i, Y) plane is However, the ISwill be negatively sloped only if This requires that the response ofsavings to income be larger than that of investment to income. We will assumethroughout that this assumption is justified.

The intercept of IS on the i axis is whereas its intercept on theY axis is The IS curve is shown in Figure 3.8. Disequilibrium zonesare also labelled in the diagram. An increase in expected inflation will leavethe slope of the IS schedule intact and shift it outwards. 0 is a summarymeasure of the exogenous components of aggregate demand. A change in0, therefore, may be taken as a change in fiscal policy. Thus an increase ingovernment expenditure will shift outwards the IS schedule without changingits slope.

The LM curve

Whereas the IS curve deals with the market for goods and services as flowsper period of time, the LM curve deals with asset markets as stocks at apoint in time. Let us write the demand for real cash balances as

(3.11)


where m is the natural log of the nominal supply of money, p is the log of theprice level and 2 and 3 are positive parameters. Notice that the opportunitycost of holding real cash balances depends on the nominal (not real) rate ofinterest.

Now let be the rate of growth of nominal money and the rate ofinflation. Thus real cash balances grow at the rate and we can writethe equation for the LM schedule as

(3.12)

is real money demand last period so that the right-hand side ofequation (3.12) denotes the growth of real cash balances from the demandside, whereas the left-hand side gives the equivalent expression from thesupply side. Upon substituting from (3.11) for mp we have the final formof the LM equation:

(3.13)

Let us examine the money market in steady state where real cash balancesare constant. The intercept of this schedule on the i axis occurs at and on the Y axis at its slope is This curve isshown in Figure 3.9 where the disequilibrium zones are also labelled.

In Figure 3.10 we plot both the IS and LM schedules. If we make theKeynesian assumption that the interest rate responds primarily to pressuresfrom the money market and national income responds to pressure from thegoods market we can label i, Y movements in the disequilibrium zones asshown.

Figure 3.8


Figure 3.9

Figure 3.10


With expansionary fiscal policy and unchanged inflationary expectations,the IS schedule in Figure 3.11 would shift outwards. Both i and Y would rise.With expansionary monetary policy LM would shift outwards leading to adrop in i and a rise in Y. This is shown in Figure 3.12; however, both thesepolicy experiments can be misleading if we keep e constant in the face ofchanges in the actual inflation rate. Therefore, Figures 3.11 and 3.12 shouldbe used only to show how macro policies are incorporated into the modeland not to show their final effect on the economy.

THE AGGREGATE DEMAND SCHEDULE

We can now use the IS-LM schedules to drive an aggregate demand (AD)schedule. To drive the AD schedule we rewrite the IS curve as

and then substitute for i from the LM equation to get, after rearrangement,

(3.14)

where Yd stands for output demanded as distinguished from Ys (outputsupplied) which we shall introduce later. We have drawn the AD schedule in

Figure 3.11


Figure 3.13. Its intercept on the axis is andthe slope of the AD curve is which is negativehence the AD schedule defines a negative relation between and Yd. Anincrease in the rate of inflation reduces the real quantity of money in the

Figure 3.12

Figure 3.13


economy creating excess demand in the money market. In turn, this causesthe nominal interest rate to rise. With e held constant the real interest ratealso rises which, in turn, reduces investment and aggregate demand.

Two other facets of the AD schedule should be pointed out. First, a changein fiscal policy will shift the AD schedule without changing its slope. Second,so long as the rate of growth of money and the rate of inflation are not equalto each other, will keep changing and so will the intercept of the ADschedule. An increase in e will shift the AD schedule by 3 times the changein e. At any given level of income this would also increase by 3. In thatway expected inflation pursues actual inflation. However, there must be somerestraint on this self-fulfilling prophecy otherwise and e would chase eachother without reference to . Students can check that the requirementconstraint is

THE AGGREGATE SUPPLY SCHEDULE

The AD curve, by itself, cannot determine and Y; to complete the systemwe introduce an aggregate supply (AS) schedule. The derivation of the ASschedule, which shows combinations of and Y consistent with productionconditions in the labour market, has two key elements: (i) an aggregateproduction function relates total output produced to labour input, and (ii)labour market supply and demand conditions relating labour supply anddemand to the rate of inflation.

The production function

Without loss of generality we shall take a specific form of the productionfunction:

(3.15)

where Ys is the ln of output supply, n is the ln of total labour input and k isthe In of total capital input. 5, 6 and 7 are defined as positive parameters.

In term of levels, then, we have the Cobb-Douglas production function.In the short run we shall take the amount of capital to be fixed and givenexogenously so that we can write the production function as

(3.16)

where This relation between Ys and n is shown as the straightline in Figure 3.14. Its intercept is 8 and slope is 6. An increase in thecapital stock will shift the production function 7 times the increase in capital.

The labour input

From our discussion in Chapter 2 we recall that labour demanded by firmsdepends negatively on real wage rate. Let us write this as


(3.17)

where wp is the ln of the real wage rate and 9 and 10 are defined as positiveparameters.

Since wages and prices are rising over time, we need to write the labourdemand schedule in terms of rates of changes rather than the absolute levelsof wages and prices. Writing equation (3.17) for the previous period and thesubtracting from (3.17) we have

or

(3.18)

where n-1 is labour demand in the previous period and is therate of change of nominal wages. From this perspective, the number ofworkers rises only if since, in that case, real wages would be fallingover time. Only if is the real wage constant and

The general AS schedule

By taking first differences of the production function (3.16) we obtain

(3.19)

Figure 3.14


Into this we substitute the expression for from (3.18) to get

(3.20)

According to this equation, an increase in the inflation rate, with given,would start to reduce real wages and increase the demand for labour withthe extent of this adjustment given by the parameter 10. The extra labourwill produce more output, as measured by the parameter 6, allowing Ys toexceed Hence there is a positive relation between Ys and . The AS curvein the , Y plane is drawn in Figure 3.15. Its intercept on the Ys axis is

and its slope is When the labour market is in equilibrium we must have and

so that output is independently of or and the aggregatesupply curve would be vertical.

Nominal wage determination

The last step in the process of determining the AS curve involves thedetermination of the rate of change of nominal wages (). Again a specialcharacteristic of the labour market is involved. A labour market is not aspot market where purchases and sales are made for current use. Laboursupply and demand usually requires some long-term commitment. In aninflationary setting the rate of change in the nominal wage will be set so asto maintain equilibrium in the labour market since firms want to be on theirdemand curve for labour, and households want to be on their supply curve.This requires a constant real wage. Given that commitments in the labourmarket must be made for some time in the future, and given that the actual

Figure 3.15


rate of inflation to prevail is not observed today, it seems reasonable that theexpected inflation rate will have to be used instead. This requirement can bewritten as

(3.21)

Substituting from (3.21) we have the final form of the AS curve:

THE COMPLETE SYSTEM

The complete macro model can be written as

This complete system is depicted in Figure 3.16. In Figure 3.16(a) we havethe IS-LM framework which is similar to Figure 3.8. Figure 3.16(b) combinesthe AS and AD schedules of Figures 3.15 and 3.13. Because of the connectionbetween IS-LM curves and the AD curve the equilibrium level of the incomepart (a) cannot be different from that in part (b).

The intersection of IS (e) and LM determine Y and i and from the IS we can read the real interest rate. Then from the intersection

of AD and AS we can derive the equilibrium values of and Y.

Long-run equilibrium

If left to itself, the economy would settle down to a particular combinationof i, Y and , and would replicate itself year after year. Keynesian and NewClassical economists would disagree about the time it would take to reachthis equilibrium. Keynesians argue that it would take a long time for theeconomy to reach its long-run equilibrium so that it would become necessa

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