MacroeconomicsI_working_version (1)

Mendel University for Agriculture and Forestry in Brno 

___________________________________________________________________________ 

Macroeconomics 

Ing. Petr Rozmahel 

2004

Introduction into Macroeconomics 1 

1. Introduction into Macroeconomics 

Contents: 

1. INTRODUCTION INTO MACROECONOMICS........................................................... 1 

1.1. THE ECONOMIC PERSPECTIVE .......................................................................................... 3 

1.1.1. Scarcity and Choice ................................................................................................. 3 

1.1.2. Rational Behaviour .................................................................................................. 3 

1.1.3. Marginal Benefits and Costs.................................................................................... 3 

1.2. MACROECONOMICS VS. MICROECONOMICS...................................................................... 4 

1.3. POSITIVE VS. NORMATIVE ECONOMICS ............................................................................ 4 

1.4. ECONOMIC METHODOLOGY.............................................................................................. 5 

1.5. THE USE OF ECONOMIC MODELS ..................................................................................... 7 

1.6. POLICY ECONOMICS ......................................................................................................... 8 

1.7. DEMAND AND SUPPLY SIDES IN MACROECONOMICS........................................................ 9

2 

Chapter 1 

To understand the fundamentals of macroeconomics properly, let’s start with 

explanation of basic economic terms such as scarce factors of production, economic 

perspective or economic methodology. It is also necessary to grasp the meaning of 

economics as a science in general and the difference between micro and macroeconomics. 

Economics is the social science concerned with the efficient use of limited or scarce 

resources to achieve maximum satisfaction of human material wants. 

Economics is the study of the efficient use of scarce resources in the production of goods 

and services to satisfy as many wants as possible. 

Inputs 

(Land, Capital, Labour) 

Output 

(GDP) 

Figure 1.1 Relation between factors of production and output. 

Factors of production (Inputs): scarce resources. Generally we identify all natural, 

human, and manufactured resources, which get into production process of goods and 

services. This covers lot of fields: all the equipment, tools, and machinery used to produce 

manufactured goods and agricultural products; the factory and farm buildings; 

transportation and communication facilities; the numerous types of labour; and land and 

mineral resources of all sorts. Economists widely identify these as either human resources – 

labour and entrepreneurial ability or property resources – land or raw materials and capital. 

Capital. Capital (or capital goods or investment goods) involves machinery, equipment, 

and factory, storage, all tools, transportation, and distribution facilities used in production 

of goods and services and bringing them to the final (ultimate) consumers. In general we 

can say that capital works as all manufactured aids to production. The described process of 

producing and purchasing capital goods is also called investment. 

Land. From the economic perspective the meaning of land is rather broader than most of 

people think. Land includes all natural resources usable in the production process. These 

resources as forests, mineral and oil deposits, water resources and of course arable or 

cultivatable land count this classification. 

Labour. Labour is a wide term for all the psychical and mental talents of individuals 

available and usable in producing goods and services.


Entrepreneurial ability. The last (not least) factor of production is the special human 

resource that is labelled entrepreneurial ability or, simply, enterprise. There are four allied 

and connected functions accomplished by an entrepreneur: 

1) The entrepreneur takes the initiative in combining the resource mentioned above - 

resources of land, labour, and capital to produce a goods or service. 

2) The entrepreneur is an innovator - the one who tries to launch new products, new 

techniques of production, or even new types of business organisation. 

3) The entrepreneur gets into the decision-making process – he makes elementary 

business-policy decisions, that is, such non-conventional decisions, which drive the 

business enterprise to the desired aim. 

4) The entrepreneur runs the risk – he is a risk bearer. The entrepreneur takes 

responsibility for his actions. 

1.1. The Economic Perspective 

The economic perspective includes three elements: scarcity and choice, rational behaviour, 

and marginalism. The hearth of the matter is a belief that individuals and institutions make 

rational decisions, which are based on comparisons of marginal costs and marginal 

benefits. 

1.1.1. Scarcity and Choice 

In earth human and property resources are limited (scarce). Therefore we can say that the 

goods and services – results of production process – are also scarce. It follows that we must 

make choices, because scarcity limits our options and requirements. It is impossible to get 

all we want, that is why must decide and choose what to have. 

1.1.2. Rational Behaviour 

People try to spend their income to gain the greatest benefits from purchased goods and 

services they can afford. That example expresses the fact that economics is based on the 

idea of the “rational self-interest” of individuals. It means, that individuals think rationally - 

make rational decisions to satisfy or fulfil maximally their goals or needs. 

1.1.3. Marginal Benefits and Costs 

The word “marginal” used from the economic perspective means “extra” or “additional”. 

The economic perspective is widely concentrated on marginal analysis, which is the 

comparison of marginal costs and marginal benefits. For example, in making choice 

rationally, the firms must decide whether to hire more or few employees to produce more 

or less output. To choose an alternative means to compare marginal benefits and marginal 

costs (considering scarcity).

4 

Chapter 1 

1.2. Macroeconomics vs. Microeconomics 

Microeconomics and macroeconomics are closely related sciences. Good economists must 

understand both of them so that they could comprehend and examine all the relations and 

channels in a whole economy. Lets used few widely accepted definitions 1 : 

Macroeconomics examines either the economy as a whole or its basic subdivisions or 

aggregates such as the government, household and business sectors. An aggregate is a 

collection of specific economic units. Therefore, we might lump together the millions of 

consumers in the economy and threat them as if they were one huge unit called 

“consumers”. 

In using aggregates, macroeconomics seeks to obtain an overview of the economy and the 

relationship of its major aggregates. Macroeconomics speaks of such economic measures 

as total output, total employment, total income, aggregate expenditures, and general 

level of prices in analysing various economic problems. Macroeconomics examines the 

forest, not the trees. 

Microeconomics looks at specific economic units. At this level of analysis, the 

economists observe the details of an economic unit, or a very small segment of the 

economy, under the figurative microscope. In microeconomics we talk of an individual 

industry, firm or household. We measure the price of a specific product, of a number of 

workers employed by a single firm, the revenue or income of a particular firm or 

household, or the expenditures of a specific firm, government, entity, or a family. In 

microeconomics we examine the trees, not the forest. 

Macroeconomics looks at the economy as a whole or its major aggregates; 

microeconomics examines specific economic units or institutions. 

1.3. Positive vs. Normative Economics 

Microeconomics and macroeconomics, both, work with facts, theories, and policies. The 

way of examining the economy, used method and goals depend upon economist’s way of 

looking at things. From this point of view we can distinguish between positive economics 

and normative economics. 

Positive economics evades value statements related to economic behaviour. It concentrates 

on facts. What the economy is actually like - this is what positive economics deals with. 

Positive economics work with factually based analysis and avoid the policy analysis 

evaluation. 

On the contrary, normative economics include value judgements about what the economy 

should be like. It also involves the recommendations of some particular policy actions, 

1 McConnell-Brue [10], Dornbush-Fisher-Starz [7]; There are also many others definitions in other economic 

textbooks. See the list of literature in the end of the textbook.


which should be taken to get things better. Normative economics looks at the desirability of 

certain aspects of the economy. It underlies expressions of support for particular economic 

policies. 

Positive economics concerns what is, while normative economics embodies subjective 

feelings about what ought to be. 

Positive statements state facts (“what is”); normative statements express value judgements 

(“what ought to be”). 

1.4. Economic Methodology 

Economics is a social science, which examine the behaviour of individuals (workers, 

consumers) and institutions (firms, government) engaged in the production process, 

exchange, and consumption of goods and services. The examined behaviour should be 

observable and verifiable. Examining complex problems of the real world, all scientists, 

including economists, must be very careful about what information to gather for their 

analysis. The quality selection of gathered information is a basic precondition for a legit 

and provable analysis. 

The economists must choose the relevant facts, which are related to examined problem. 

The economists try to create principles – generalisations about behaviour of individuals 

and institutions. Such principles result from the process of economic analysis or 

theoretical economics in general. 

Economists use both deductive and inductive methods. That means that economists are 

likely to move from theories to facts as well as they could start with analysing facts and 

come up with relevant theories afterwards. The relation between facts, principles, theories 

and policies in economics is showed in Figure 1.2. It follows that the role of economic 

theorising or economic analysis is to systematically arrange facts, interpret them, and 

generalise from them.

6 

Chapter 1 

Policy economics 

Theoretical economics 

Theories 

Induction 

Deduction 

Facts 

Figure 1.2 The relationship between facts, principles, and policies in economics 2 . In analysing problem 

or aspects of the economy, economists may use the inductive method, through which they gather, 

systematically arrange, and generalise from facts. Alternatively, they may use the deductive method, in which 

they develop hypotheses, which are then tested against facts. Generalisations derived from either method are 

useful not only in explaining economic behaviour but also as a basis for formulating economic policies. 

Deduction is usually the way how economists create generalisations. They come up with a 

tentative untested principle called hypothesis, which results from the process of drawing on 

casual insight, observations, logic or intuition. To test the hypothesis, economists must 

subject it to systematic and repeated comparison with relevant facts. This testing process, 

sometimes called empirical economics, is suggested by the right, downward arrow from 

“theories” to “facts” in Figure 1.2. 

Induction starts with facts to theory, from the particular to the general. This approach 

describes the process, in which an accumulation of facts is arranged systematically and 

analysed to derive the underlying principle. The inductive method is depicted by the left, 

upward arrow from “facts” to “theories” in the figure. 

2 See McConnel-Brue [10]


Abstractions – We must bear in minds that economic principles, or theories, are 

simplifications (abstractions), which exclude irrelevant facts and circumstances. Such 

models cannot to depict the full complexity of the real world. The very process of sorting 

out and analysing facts involves simplification and removal of clutter. 

Economic principles and theories present meaningful statements about economic 

behaviour of the economy. Economic principles could be explained as tendencies of 

average or typical consumers, workers, or firms. Accordingly economic principles are 

generalisations associated with economic behaviour of individuals or with the economy as 

a whole. 

For example, when economists say that increase in personal income causes the rise in 

consumer spending, it is obvious that some households may save all of an increase in their 

incomes (and not to spend it). However, in general - on average, and for the entire 

economy, spending rises when income increases. 

Ceteris Paribus – “Other Things Equal” Assumption is used for creation of economic 

generalisations. They are based on assumption that all other variables apart from those 

under consideration remain unchanged (constant). 

1.5. The Use of Economic Models 

In economics we often use the simplified theories called models. Models examine the 

relations among economic variables (often in mathematical terms). The real world is full of 

complexity and the sense of models is to help us to omit the irrelevant details, remove 

clutter and to focus on relevant economic connections and relations. The function of 

models is to make things clear and understandable. 

We use two kinds of variable in models: exogenous variables and endogenous variables. 

Exogenous variables come from outside the model – they are the inputs into the model. 

Endogenous variables come from inside the model – they are the output of the model. In 

other words, exogenous variables are fixed at the moment they enter the model, whereas 

endogenous variables are determined within the model. As Figure 1.3 shows, the purpose 

of a model is to explain how the endogenous variables affect the endogenous variables. 

Exogenous 

variables 

Model 

Endogenous 

variables

8 

Chapter 1 

Figure 1.3 How models work 3 . Models are simplified theories that describe the fundamental relationships 

among economic variables. The exogenous variables come from outside the model. The endogenous variables 

explain the model. The model explains how a change in one of the exogenous variables affects all the 

endogenous variables. 

1.6. Policy Economics 

All the economists could be generally divided into two groups. Economists in first group 

fear market failures and believe that governments have the duty and means to correct the 

market failures. The other group of economists fear most from government failures, 

because the experiences of the past decades have shown that governments may fail as well. 

Nowadays the government are held responsible for the economic situation in a country. 

The economic performance is one of the most important topic of the campaigns at election 

times. The influential Keynesian revolution emphasised the meaning of policy (and 

politics) in macroeconomics. 

Applied economics or policy economics identify and recognise the principles and data, 

which can be used to formulate policies. Formulation of economic policy is an ultimate aim 

of the policy economics. Economic policy uses economic theories as a foundation. 

Economic Policy 

The creation of economic policy is not a simple process. The basic steps in policy making 

are described in the Figure 1.4: 

State the goal 

Determine the policy 

options 

Implement and 

evaluate the policy 

which was settled 

Figure 1.4 Process of the economic policy creation. 

Economic goals include: 

• Economic growth 

• Full employment 

• Economic efficiency 

• Price-level stability 

• Economic freedom 

3 See Mankiw [8]


• Equitable distribution of income 

• Economic security 

• Balance of trade 

1.7. Demand and Supply Sides in Macroeconomics 

The examined economy could be divided into two separated categories – the demand side 

and supply side of the economy. From this point of view, we can recognise the variables 

affecting the demand for goods and services and those that affect the supply of those goods 

and services. The demand side relates to spending decisions by individuals (economic 

agents) – households, firms, institutions, and government agencies – both home and 

abroad. The supply side is associated with the productive potential of the economy. The 

aggregate supply is determined by numbers of working hours provided by households, their 

productivity, and efficiency of allocation of resources engaged in generating a national 

output.

10 

Chapter 1

Brief Inquiry into History of Economic Thought 11 

2. Brief Inquiry into History of Economic 

Thought 

Contents: 

2. BRIEF INQUIRY INTO HISTORY OF ECONOMIC THOUGHT ............................ 11 

2.1. CLASSICAL ECONOMICS ................................................................................................. 12 

2.2. NEO-CLASSICAL ECONOMICS ......................................................................................... 14 

2.3. KEYNESIAN ECONOMICS ................................................................................................ 15 

2.4. (NEO)CONSERVATIVE ECONOMICS ................................................................................. 16

12 

Chapter 2 

The mainstream economics is based on the method of deduction and abstraction. The 

models are often used. The genesis of economics as a proper science discipline could be 

dated from 1776 (Publication of Adam Smith’s Wealth of Nations). 

Mainstream economics generally results from ideas of the following major economic 

schools: 

Classical Economics (Classical school) 

Neoclassical Economics 

Keynesian Economics 

(Neo)Conservative Economics 

2.1. Classical Economics 

• Considered to be the first modern school of economic thought; 

• 1776 – 1870; 

• begins with publication of The Wealth of Nations by A. Smith and finishes with 

publications of the first books by Marginalists; 

• major developers: Adam Smith, T.Malthus, David Ricardo, John S. Mill, Jean B. Say; 

• displaced economic ideas of feudalism (mercantilism) and formulated basic economic 

concepts of emerging capitalist system; 

• object of interest: macroeconomics, approach: liberalism, methodology: abstraction 

(universally valid general models) verbal deduction; 

• identified land, labour and capital as the three factor of production and the major 

contributors to a nation’s wealth; 

• laissez-faire, self regulating system (invisible hand), self regulating system, internal 

stability of the economic system, population theories, Say’s law of markets (markets 

law), laws of absolute and comparative advantage, division of labour – international 

trade; 

• capital accumulation, the labour theory of value → cost-of-production theory of value; 

the theory of distribution of income, internal stability of the economic system, 

population theories, Say’s law of markets (markets law), laws of absolute and 

comparative advantage, division of labour – international trade. 

Adam Smith’s Wealth of Nations: 

• The First complex system of political economy created from existing economic ideas. It 

was based on the principles formulated by naturalistic philosophers J. Lock and David 

Hume. 

• What is the source of the Wealth of Nations? Why there are the rich nations and the 

poor nations? The wealth of nation consists of the wealth of individuals. Nation’s 

wealth raises if the individuals’ wealth raises. The individual wealth depends on the 

effort of individual to profit. No government policy can substitute that individual 

voluntary effort to work, save and invest. 

• In Smith’s view the national economy is a self-regulating system, which satisfies the 

economic needs of the populations. The economic system has got its own self co-


ordinating mechanism called “the invisible hand”. It co-ordinates the individual 

activities and creates an economic order. 

• The source of the wealth of nation is a production of individuals motivated by their 

own self-interest. The second determiner is division of labour – everybody makes 

something different according his own best working abilities. International trade and 

free trade make the division of labour more effective and increase the potential of 

production. 

The Population Theory 

According to T. Malthus mankind is doomed to the inescapable poverty, because each 

increasing of a wealth results in increasing of the number of people. In addition the 

population tends to increase by geometric series, but the sources by arithmetic series. The 

slow growth of the resources is caused by diminishing returns. 

D. Ricardo developed this theory by the wage rule – the worker’s wage cannot overlap the 

minimum level in a long run – because each increasing of wage causes increasing of 

population and increasing of labour force. 

The Theory of Value 

The classics believed that price of any kind of goods tend to its natural (equilibrium) 

value in spite of the fact that the price fluctuates in a short time. They were looking for the 

natural value and its determiners. They came up with the labour theory of value. It was 

based on the belief that the value of an object is decided by the resources that went into 

making it. They believed that the amount of labour needed for the production of an object 

is the main determiner of its natural value. The labour theory of labour was consecutively 

displaced by the cost of production theory of value developed by J. S. Mill - the most 

influential economists of the second generation of classics. This theory added capital as 

another resource of production. 

Say’s Law 

Classical economists denied the possibility of long-term underspending – a level of 

spending insufficient to purchase the entire full-employment output. The denial was based 

in part on Say’s law. 

It is seemingly simple notion that the very act of producing goods generates an amount of 

income equal to the value of the goods produced. The production of any output 

automatically provides the income needed to take that output off the market – the income 

needed to buy what is produced. In other words supply creates its own demand. 

Adjustment in prices and interest rates would tend to produce full employment in the 

economy. 

Accumulation of Capital and Ownership of Land 

D. Ricardo considered accumulation of capital being the main resource of economic 

growth. However, there was a conflict between the landowners on one hand and labour and 

capital on the other. He posited that the growth of population and capital, pressing 

against a fixed supply of land, pushes up rents and holds down wages and profits. The 

fixed supply of land (corn) was a barrier for the accumulation of capital. This theory

14 

Chapter 2 

contributed to repealing of the Corn Laws preventing England from imported corn. D. 

Ricardo’s free ideas supported free trade helped to develop the process of industrialisation 

in England. 

J.S. Mill belonged among the classics of the second generation. He developed the cost of 

production theory of value. He shared the liberal ideas in term of market’s abilities to 

allocate the resources. However he doubted the market’s ability to distribute income 

effectively (in order to maximise the satisfaction (welfare) of the population.) 

2.2. Neo-classical Economics 

• Followed the classical economics in terms of liberal approach; 

• object of interest: Microeconomics; approach: Liberal; methodology: Abstraction, 

Individualism, subjectivism, Mathematical methods; 

• two main tasks: Economic equilibrium, Economic welfare; 

• based on ideas of Marginalists (C. Menger, W. S. Jevons); 

• main schools: Cambridge school (A. Marshal, A. Pigou), Lausanne school (l. Walras, 

V. Pareto). 

Marginalist School (Marginalist Revolution) 

• The year of 1871 was a milestone in history of economic thought. The books Theory of 

Political Economy by William S. Jevons and Principles of Economics by Carl Menger 

were published in that year. Those books brought a radical change in a way and method 

of economic theorising. 

• Both of them (independently) introduced the theory of marginal utility. 

• The marginal theory of value asserts that the economic value of an object or service is 

set by consumer’s marginal utility. This view presents the subjective theory of value 

(which opposed the objective theory of value by classics). The price of an object 

depends on the (marginal) amount of consumer’s satisfaction provided by individual 

goods and services. 

• The theory focused on a consumer (microeconomic view). 

• Theory of marginal productivity (John B. Clark) explained the way of distributing of 

income between wages and profits – wage is determined by marginal productivity of 

labour and profit (yield) by marginal productivity of capital. 

• Marginalist revolution was a starting point for two following schools – the neo-classical 

school and the Austrian school. 

Economic equilibrium (positive part of the neo-classical economics) 

• General equilibrium (L. Walras) – The idea of general equilibrium of all markets is 

based on the clearing prices and wages which clears markets (from the excess of 

demand or supply). L. Walras defined the preconditions (such as perfect 

competitiveness) and created imposing mathematical model of general equilibrium. 

• Partial equilibrium (A. Marshal) – Marshall examined the equilibrium on the market 

of individual goods or services. Famous Marshal’s scissors consisted of negatively 

sloped demand function and positively sloped supply function. The point of intersection 

determines the equilibrium price – the dualistic approach to the value (price) included 

both objective (supply side) and subjective (demand side).


Economic welfare (normative part of the neo-classical economics) 

• Does the market equilibrium situation lead to the maximising of satisfaction of the 

needs and wants from the limited resources? Is the economic system effective in that 

way? A. Pigou stated that economic system allocates limited resources effectively, but 

it does not always lead to the maximisation of the welfare. To prove it he applied the 

principle of diminishing marginal utility. 

2.3. Keynesian Economics 

• Till 20’s of the last century neoclassical economics was the most influential economic 

school. The neo-classics presented their school as a homogenous theoretical system 

capable to cope with all basic economic questions and problems. However the Great 

World-wide Depression put the neo-classical economics into a crises. Economic 

depression was not in line with their thought. 

• John Maynard Keynes (1883 – 1946): The General theory of Employment, Interest and 

Money (published in 1936); 

• R. Kahn, J. Robinson, R. Harrod, A. Hansen; 

• object of interest: Macroeconomics, approach: Interventionism; 

• refused the main neoclassical ideas (self-regulating system, Say’s law, liberalism). 

• National economy is not a stable system. 

• Keynes explained (clarify) the existence of a long-term depression. He theoretically 

doubted the Say’s law by reformulating a the savings function. There is no automatic 

mechanism that would transform savings into investments (classics: interest rate). 

Savings depend on income. 

• Unemployment is a result of a deficient aggregate demand. Thus the government 

interventions supporting aggregate demand (consumption, investment) are necessary. 

The effective aggregate demand theory. He justified theoretically the need of the 

state (external) interventions into the economy. (Expansive fiscal policy, 

accommodating monetary policy, fiscal deficits, fiscal multiplier). 

• Keynes considered his theory as a general economics and the neoclassical economics as 

a special case of his general economics. (A special case describing economy at the full 

employment level). 

• Preference of liquidity, interest as a reward for abandoning (surrendering) of liquidity; 

• neo-classical synthesis in 60’s (neo-keynesian economics) – synthesis of keynesian 

and neo-classical economics. Keynesianism became a special case of a general neoclassical 

economics (the special case for the economy with rigid wages). Keynesian 

theory – valid in a short run, neo-classical theory valid in a long run. 

• AS – AD model, IS – LM model, the Phillips curve; 

• 60/70’s (oil shocks) - crises of (neo) keynesian economics (Hicks, Samuelsson) loosing 

the influence; 

• 80’s New Keynesians – closer to liberal approach, focused on explanation of wage 

rigidities (microeconomic view) – Mankiw, Fischer. 

• Post-keynesian theory returns to the original (orthodox) Keynesian theory (Robinson, 

Kaldor, Weintraub).

16 

Chapter 2 

2.4. (Neo)conservative Economics 

• Return to the neo-classical economics, new macroeconomics; 

• main schools: monetarism, rational expectation school, supply side economics. 

• main common characteristics: liberalism, assumption of internal stability of economic 

system, criticism of keynesian economics, neutrality of money, inflation (vs. 

unemployment in keynesian economics). 

Monetarism 

• M. Friedman, the Chicago school; point of departure for the conservative economics; 

• central role of money in the economy, role of monetary policy; 

• capitalism is an internally stable system with self regulating abilities; 

• crises, depressions and fluctuations are results of the external monetary shocks caused 

by the central bank; 

• adaptive expectations (based on the past experience), natural rate of unemployment, 

vertical Phillips curve in the long run; 

• the golden rule of the monetary growth, change in money supply growth affects 

output in the short run and price level in the long run (with disappearing real effect on 

output). 

Rational Expectations School 

• 1961 J. Muth – rational expectations hypothesis; 

• 1971 R. Lucas, T. Sargent – founders of the rational expectation school (sometimes 

called New Classical Macroeconomics); 

• relates the traditions of Monetarism with the differences of rational expectations and 

strict neutrality of money even in the short run; 

• rational (individual) expectations – taking into account all possible information 

(including the future forecasts and estimations); 

• aggregate expectations are correct; 

• macroeconomic policy is effective only in case of the unexpected external shock; 

• recommendations for the macroeconomic policy: clear and stable rules, minimising of 

the public sector (deregulation, privatisation), transparent policy; 

• main school of the present conservative economics; 

• end of the neoclassical synthesis. 

Supply Side Economics 

• End of 70’s; A. Laffer, G. Gilder, M. Feldstein; 

• The Supply side economists related the old classics in terms of focusing on the supply 

side on economics. They pointed out individual economic motivation to work, save and 

invest. They were practically oriented – dealt with macroeconomic policy.


• They blamed the excessive tax burden for decreasing motivation of individuals, 

which causes decline of output and support the grey economy. It could also cause the 

decline of the tax revenues. 

• Laffer curve – an increase of tax rates leads to higher revenues until the Laffer point. 

From that point increase of tax rates causes the lowering of tax revenues. 

(Neo)conservative Macroeconomic Policy 

• 80’s; 

• USA – R. Reagan, GBR – M. Thatcher; 

• liberalisation, deregulation, privatisation, balanced state budget, constant growth rate of 

money supply; 

• main aim: low inflation.

18 

Chapter 2

Macroeconomics Equilibrium within Model AS – AD 19 

3. Macroeconomic Equilibrium within Model 

AS – AD 

Contents: 

3. MACROECONOMIC EQUILIBRIUM WITHIN MODEL AS – AD ......................... 19 

3.1. AGGREGATE DEMAND.................................................................................................... 20 

3.1.1. The Structure of Aggregate Demand...................................................................... 21 

3.1.2. The Slope of AD Curve........................................................................................... 22 

3.1.3. Determinants of Aggregate Demand...................................................................... 23 

3.2. AGGREGATE SUPPLY ...................................................................................................... 25 

3.2.1. The Slope of AS Curve............................................................................................ 25 

3.2.2. Determinants of Aggregate Supply ........................................................................ 27 

3.2.3. Keynesians vs. Classics.......................................................................................... 28 

3.3. EQUILIBRIUM WITHIN AS – AD MODEL: REAL OUTPUT AND THE PRICE LEVEL ............ 29

20 

Chapter 3 

In this chapter we introduce the first model. AS – AD model is a widely mentioned model 

in Macroeconomics. Before we start examining the economy through this model, let’s 

repeat briefly the essence of macroeconomics. 

Macroeconomics focuses on the behaviour of the entire economy. It is concerned with the 

economy’s total output of goods and services, the growth of output, the inflation rates, 

unemployment, exchange rates, and balance of payment. In Macroeconomics we examine 

the rises (booms) and recessions of the economic performance of a country. 

Macroeconomics is concerned with both long-run economic growth and the fluctuations in 

the short run that constitute business cycle. 

Macroeconomics also examines policies that affect consumption and investment, currency, 

trade balance or performance of the economy in general. It deals with the determinants of 

changes in wages and prices, monetary and fiscal policies, interest rates, the money stock, 

the budget of a country, and the national debt. 

Briefly spoken, macroeconomics is concerned with the main economic issues and problems 

affecting the living standards of the people. Sometimes we have to reduce or omit the 

complicated details of the economy to manageable fundamentals so that we could 

understand the essential interactions among goods, assets and labour markets in the 

economy and the linkages among national economies as well. 

Macroeconomic Models in Different Time Frames 

In Macroeconomics, we examine the real world through the models that have its greatest 

applicability in different time frames. The growth theory, which focuses on the growth of 

productive capacity, dominates the models examining the long–run behaviour of the 

economy. Productive capacity is considered as given in the medium-run. The level of 

productive capacity determines output, and fluctuations in demand relative to this level of 

supply determine prices and inflation. In the short run, we examine the fluctuations in 

demand, which determine how much of the available capacity is used. The extent of used 

capacity determines the amount of employed resources, and thus the level of output and 

employment. 

3.1. Aggregate Demand 

The level of aggregate demand represents the total demand for goods (and services) to 

consume, for new investment, for goods purchased by the government, and for net goods to 

be exported. 

Aggregate demand could be depicted as a schedule or curve, which shows the various 

amounts of goods and services (the amounts of real output) that domestic consumers, 

firms, government, and foreign purchasers collectively wish to purchase at each possible 

price level. Ceteris paribus (other things equal) the lower the price level, the larger the real 

GDP the purchasers will demand. Conversely, the higher the price level, the smaller the


real GDP they will buy. It follows that the relationship between the price level and the 

amount of real GDP (output) demanded is inverse or negative. 

The aggregate demand (AD) curve presents, for each given price level, the level of 

output at which the goods market and money markets are simultaneously in equilibrium. 

The position of the aggregate demand curve depends on monetary and fiscal policy and the 

level of consumer confidence. 

3.1.1. The Structure of Aggregate Demand 

Aggregate demand presents the total demand for domestic output at given price level. It 

consists of four components: consumption spending by households (C), investment 

spending by businesses and households (I), government (federal, state and local) purchases 

of goods and services (G), and foreign demand (NX). These four categories cover, 

definitely, all spending. Let’s bear in mind that aggregate demand comprises the planned 

(intended) expenditures corresponding to each given price level. 

AD = C + I + G + NX 

Consumption includes the goods and services purchased by households. It is usually 

divided into three subcategories: non-durable goods, durable goods and services. Nondurable 

goods are goods that last only a short period of time, such as food and clothing. 

Durable goods involve goods that last a long period of time, such as automobiles and 

refrigerators. In these cases the time to expiry is relatively longer. Services are the purchase 

of the personal services of individuals, for instance taxi drives, haircuts or use of post. 

Investment consists of the goods purchased for its use in the future. Investment is usually 

divided into three subcategories: residential fixed investment, non-residential fixed 

investment, and inventory investment. Residential investment is the purchase of new 

housing by households and landlords. Non-residential investment is the purchase of new 

plants, machines and other equipment by firms. Inventory investment is the increase in 

firm’s inventory of goods (if inventory is falling, inventory investment is falling). 

Government purchases involve the expenditures of federal, state, or local for purchases of 

goods and services. This category involves, motorways, teachers’ salaries, military 

equipment, and all the services that government workers provide. It does not include 

payments with any feedback in a form of goods or services. These payments involve 

transfers of finances to individuals such as social security and welfare. Such payments are 

not part of aggregate demand or GDP. 

Net exports take into account trade with other countries. Net exports are the value of goods 

and services exported abroad minus the value of goods and services that foreigners sell us. 

If the value of exports equals the value of imports, net export would always be zero. In that 

case trade is in balance.

22 

Chapter 3 

3.1.2. The Slope of AD Curve 

The aggregate demand is negatively sloped. The inverse (negative) relationship between 

the price level and real output is shown in Figure 3.1 where the aggregate demand curve 

AD is sloped downward as is the demand curve for an individual product. However, the 

rationale of the downward slope is not the same as for the single product! 

P 

AD 

Q 

Figure 3.1 The aggregate demand curve. 

The aggregate demand curve assumes fixed supply of money in the economy. The AD 

curve is downward sloping as higher prices reduce the value of money supply, which 

reduces the demand for output (aggregate demand). 

Let’s explain the downward sloping AD curve in more details: 

Assuming fixed supply of money we can distinguish among three main effects explaining 

(affecting) the downward sloping AD curve. 

Wealth effect. The real value of purchasing power of the public’s accumulated financial 

assets (saving accounts, bonds) is reduced as price level rises. The public is poorer in real 

terms and will reduce its spending due to erosion of purchasing power of these assets. 

Conversely, the real value or purchasing power of a household’s wealth rises if the price 

level decline. Accordingly, consumption spending rises. 

Interest rate effect. The aggregate demand curve is downward sloping due to impact of 

price-level changes on interest rates and, in turn, on consumption and investment spending. 

Rise in price level increases the demand for money. Assuming fixed money supply, this 

rise in demand for money pushes up interest rates (which is simply the price for its use).


Thus, we can say that interest rates rise as the price level rises. Increase in interest rates 

reduces investment spending and some parts of consumption sensitive to interest rates. 

Foreign purchase effect. Decline in the aggregate amount of domestic output demanded 

could result from decreasing net exports. A decline in net exports is a consequence of a 

relative increase in a nation’s price level. Conversely, the amount of domestic output 

demanded rises as a relative decline in a nation’s price level increases its net exports. 

3.1.3. Determinants of Aggregate Demand 

To define the determinants affecting aggregate demand we must distinguish between 

changes in the quantity of real output demanded (caused by changes in the price level) 

and changes in aggregate demand (caused by changes in one or more of the determinants 

of aggregate demand). 

Changes in the Quantity of Real Output Demanded 

A rise in the price level, other tings equal (ceteris paribus), will decrease the quantity of 

real output (GDP) demanded. Conversely, a decline in the price level will increase the 

amount of real output demanded. We can show these changes graphically as movements 

along a fixed aggregate demand curve (Figure 3.2). In general we can say that changes in 

price level change the level of aggregate spending, and thus, change the amount of real 

output (GDP) demanded in the economy. 

P 

AD 

p 1 

p 2 

Q 1 Q 2 

Q 

Figure 3.2 Changes in the quantity of real output demanded.

24 

Chapter 3 

Changes in Aggregate Demand 

Figure 3.3 represents graphically the changes in aggregate demand. These changes are 

caused by the factors we have assumed to be held constant under the phrase “ceteris 

paribus – other things equal”. Change in aggregate demand is shown as a shift of the whole 

curve. The following list includes the aggregate demand shifters - determinants of 

aggregate demand. 

1. Change in consumer spending (consumer wealth, consumer expectations, taxes, 

household indebtedness). 

2. Change in investment spending (profit expectations (expected returns on investment 

projects), interest rates, business taxes, technology, 

degree of excess capacity (unused existing capital). 

3. Change in government spending (government purchases of goods and services). 

4. Change in net export spending (foreign national income, exchange rates) 

5. Macroeconomic policy 

AD 2 

AD 1 

Q 

P 

AD 

Figure 3.3 Changes in aggregate demand. 

Consumer spending. Domestic consumers collectively may change the amounts of their 

purchases of domestically produced goods and services even if the price level is constant at 

the same level. In this case, the entire aggregate demand curve shifts. If consumers 

purchase less output then before, at each possible price level the aggregate demand 

schedule shifts leftward (from AD to AD2 in Figure 3.3). Conversely, it moves rightward 

(AD to AD1) when they purchase more output at each possible price level.


Investment spending. Investment spending involves the purchases of capital goods by 

firms and businesses. AD curve shifts leftward if the amount of new capital goods 

demanded by firms at each given price level decrease. Conversely, a rise in the demanded 

amount of investment goods will increase aggregate demand and thus shifts AD curve 

rightward. 

Government spending. The third major determinants are purchases of goods and services 

by local, state (and federal) government. Aggregate demand rises if the government 

purchases more real output at each price level. Increased government expenditures for real 

output at each price level will increase aggregate demand as long as interest rates and tax 

collections do not change eventually as a result. 

Net export spending. Aggregate demand is also influenced by net foreign demand for 

domestic goods. The nation’s aggregate demand curve (in country B) shifts when foreign 

consumers (from country A) change their purchases of goods produced in country B 

independently of changes in the price level in country B. 

3.2. Aggregate Supply 

The aggregate supply (AS) curve depicts, for each given price level, the quantity of 

output firms are willing to supply. The position of the aggregate supply curve depends on 

the productive capacity of the economy. 

Aggregate supply is a schedule showing the level of real domestic output, which will be 

produced at each price level. 

The level of aggregate supply is the amount of output the economy can produce given the 

resources and technology available. The aggregate supply trade-off between price and 

output represents firms’ decisions to raise or lower prices when demand for output rises or 

falls. 

3.2.1. The Slope of AS Curve 

Relationship between the price level and the amount of real output firms and businesses 

produce and offer for sale at markets is positive or direct. Aggregate supply curve is 

positively sloped. The reason is that the enterprises are motivated by higher prices to 

produce and sell more output. Conversely, lower prices reduce output.

26 

Chapter 3 

Let’s assume, for now, that AS curve consists of three distinct segments or ranges: the 

horizontal, intermediate (upward sloping), and vertical ranges. 

P 

AS 

vertical 

range 

upsloping or 

intermediate 

range 

horizontal 

range 

Q 

Q u 

Q f Q c 

Figure 3.4 The aggregate supply curve. It consists of three ranges: the horizontal, intermediate (upward 

sloping) and vertical. 

Horizontal range. Let’s first notice the potential output Q f (full employment output) in 

Figure 3.4. This level of output corresponds with the natural rate of unemployment. 

Horizontal part of aggregate supply curve involves only real levels of output, which are 

substantially less than the potential output (Q f ). Accordingly this range of AS indicates that 

economy experiences recession or depression and that large amount of unused inputs 

(machinery, workers) are available for production. Because producers can acquire labour 

and other inputs at stable prices, per-unit production costs do not rise as output is expanded 

up to Q u (The Keynesian view). 

Vertical range. The vertical shape of AS curve represents the other extreme, when 

economy reaches its potential capacity of production. This corresponds with the level of 

potential output (full-employment output) in Figure 3.4. In the vertical range any rise in 

prices will not produce additional (extra) real output, because the economy is already 

working at its full capacity level. 

Intermediate (Upsloping) Range. The economy consists of numerous product resources 

markets and in the various sectors (or industries) full employment is not reached 

simultaneously. In the upsloping range of AS curve, per-unit production costs increases and 

businesses must obtain higher prices for their products to make profits. Thus, in this range, 

between Q u and Q c , rising real output is accompanied by increasing price-level.


The AS schedule, described above (except vertical range) corresponds with the short run 

AS curve. In the long run the shape of AS curve is vertical reaching the level of 

potential output (full-employment level of output) – the Classical view. The natural rate 

of unemployment occurs at this output. 

Full employment output also called potential output is output economy could produce at 

full employment level given the existing resources. Full employed output (natural level of 

output, potential output) is the level of output at which economy’s resources are fully 1 used 

(employed), or more realistically, at which unemployment is at its natural rate. Full 

employment corresponds with natural rate of unemployment, which means that the rate of 

unemployment is not zero! 

Natural rate of unemployment could be defined as the rate of unemployment relating to 

normal frictions at labour market that exist when labour market is in equilibrium. 

3.2.2. Determinants of Aggregate Supply 

Aggregate supply curve shows that real output rises as the economy moves from left to 

right through horizontal and intermediate ranges. Such changes in output originate from 

movements along the aggregate supply curve. It follows that we must keep in 

distinguishing between movements along the aggregate supply curve and shifts of the 

curve itself, similarly as in the case of aggregate demand. 

Lets examine the determinants of aggregate supply, which shift the entire aggregate 

supply curve. 

1. Change in input prices (availability of domestic resources as land, labour, capital, 

entrepreneurial ability; prices of imported resources; market power). 

2. Change in productivity. 

3. Change in legal-institutional environment (business taxes and subsidies, government 

regulations). 

4. Macroeconomic policy. 

Input prices. First we must distinguish the input prices from the output prices, which 

constitute the price level. A number of factors influence input prices. Ceteris paribus (other 

things equal) an increase in input prices raises per-unit production costs and reduce amount 

of aggregate supply. Conversely, decline in input prices work in opposite way. 

Productivity. Productivity relates the level of real output in the country to the quantity of 

input used for production of that output. It means that productivity is a measure of real 

output per unit of input (or average real output): 

Productivity = total output / total inputs 

1 Bear in mind that fully in this case does not mean maximally. Fully employed labour refers to natural rate of 

unemployment as is mentioned above.

28 

Chapter 3 

A rise in productivity means the economy can receive more real output from its scarce 

resources – its inputs (factors of production). Accordingly the per-unit production costs 

decrease and an increase in productivity shifts the aggregate supply curve rightwards. The 

aggregate supply curve moves leftward when a decline in productivity increases the perunit 

production costs. 

Change in legal-institutional environment. The per-unit costs of output could be 

influenced by a change in the legal-institutional setting such as changes in taxes and 

subsidies, and changes in the extent of regulation. Such changes may eventually change 

aggregate supply. 

3.2.3. Keynesians vs. Classics 

There are two extreme views on the shape of the AS schedule within economic theory. 

Vertical classical aggregate supply curve suggests that no matter what the price level is, 

the same amount of goods will be supplied. The basic assumption of this approach is that 

the labour market is in equilibrium with full employment of the labour force. The full 

employment output is also called potential output, Y*. The position of classical aggregate 

supply curve moves to the right over time, because potential output grows over time as the 

economy accumulates resources and technology improves. Potential output moves each 

year independently on the price level. 

The Keynesian aggregate supply curve is horizontal, which indicates that firms will 

supply whatever amount of goods is demanded at the existing price level. The fundamental 

idea of the Keynesian approach is that firms can receive as much labour as they want at the 

current wage due to persisting unemployment. The changes in output are not accompanied 

by the changes in average costs of production. Thus firms are willing to produce and offer 

as much as is demanded at given price level. Under Keynesian aggregate supply curve 

assumptions, the price level does not depend on GDP. 

P 

(a) 

P 

(b) 

AS 

AS 

Q 

Q* 

Q 

Figure 3.5 Keynesian (a) and Classical (b) aggregate supply functions.


Box 1: Keynesian and Classical – Short Run and Long 

We repeatedly use the terms “Keynesian” and “Classical” to describe assumptions of a 

horizontal or vertical aggregate supply curve. Note that these are not alternative models 

providing alternative descriptions of the world. Both models are true: the Keynesian model 

holds in a short run, and the Classical model holds in the long run. Economists do have 

contentious disagreements over the time horizons in which either model applies. Almost 

economists (almost all) agree that Keynesian model holds over period of a few months or 

less and the classical model holds when the time frame is a decade or more. 

Source: Dornbush-Fisher-Starz [7] 

3.3. Equilibrium within AS – AD Model: Real Output and the 

Price Level 

The aggregate supply – aggregate demand model (AS – AD model) belongs to the basic 

macroeconomic tools used for studying output fluctuations and the determination of the 

price level and inflation rate. This model helps us understand why the economy deviates 

from a trend path of smooth growth over time and to examine the impacts of government 

policies intended to decrease unemployment, keep prices stable, and reduce output 

fluctuations. 

AS – AD model is a macroeconomic model, which uses aggregate demand and aggregate 

supply to determine and explain price level and the real domestic output. 

The intersection of the aggregate demand and aggregate supply curves determines the 

economy’s equilibrium price level and equilibrium real domestic output. 

Generally we can distinguish between three situations in economy – three types of 

equilibrium.

30 

Chapter 3 

P 

AD 

E 

AS 

1. Equilibrium output equals 

the potential level of output. 

There is full employment in 

the economy - the natural rate 

of unemployment occurs at 

this level of output. All the 

possible (accessible) inputs 

(factors of production) are 

effectively used. 

Q* 

Q 

P 

AD 

E 

AS 

2. Equilibrium output does not 

reach the level of potential 

output. All the possible 

(accessible) inputs (factors of 

production) are not effectively 

used. The rate of unemployment 

is higher then the natural rate of 

unemployment. There is 

involuntary unemployment in 

the economy. Output gap = 

potential output – actual output. 

Q* 

Q 

P 

AD 

E 

AS 

3. Equilibrium output reaches the 

higher level then the potential 

level. The actual rate of 

unemployment is temporarily 

lower than the natural rate of 

unemployment. The economy is 

“overheated”. This situation is 

always temporary. It is impossible 

for the economy to be kept under 

such conditions in a long term. 

Q* 

Q

Economic Growth 31 

4. Economic Growth 

Contents: 

4. ECONOMIC GROWTH ................................................................................................... 31 

4.1. THE FACTORS DETERMINING THE LONG-TERM ECONOMIC GROWTH ............................ 33 

4.2. GROWTH ACCOUNTING AND THE GROWTH THEORIES.................................................... 33 

4.2.1. Growth Accounting: The Production Function...................................................... 34 

4.2.2. Growth Theories: Neo-classical Growth Theory (R. Solow) ................................. 34 

4.2.3. Growth Theories: Endogenous Growth (P. Romer, R. Lucas)............................... 35

32 

Chapter 4 

The main aim of human economic activity is to increase the standards of living. In the short 

run the standards of living rise if the economy goes from the recession phase towards the 

expansion or recovery. In the long run the higher standards of living could be reached 

solely by the increase in productive capacity, which is the increase in potential output. A 

rise in the economic standards doesn’t depend on the whole amount of GDP. It depends on 

the growth of the potential output per capita (per head). 

Economic growth belongs to main economic goals from macroeconomic prospect. The rise of 

total output relative to the population means increasing real wages and incomes. Accordingly 

the standards of living rise as well. An economy experiencing economic growth is better able 

to meet people’s wants and resolve socio-economic problems. 

Economic growth means the growth of the potential product (output). Therefore the 

economic growth results from the growth of the productive capacity. 

P 

AD 

AD’ 

AS 

P 

AD 

AS 

AS’ 

E’ 

P‘ 

P 

E 

P 

E 

E’ 

AD’ 

Q* 

Q‘ 

Q 

Q* 

Q* 

Q 

Figure 4.1 Cyclical expansion vs. economic growth. 

The long-term economic growth – the growth of the potential output is influenced solely 

by the factors lying on the supply side (the supply factors) of the economy (the rise of 

factors of production – land, labour, capital; technological changes, growth in productivity, 

specialisation etc.) The growth of the actual output could be caused by the determinants lying 

on the demand side (the demand factors). 

The long-term economic growth (growth of potential output) and the growth of actual output 

should not be used interchangeably.


The long-term economic growth could be influenced by: 

• the increase in the amount of used factors of production (natural resources, labour, capital) 

– extensive growth; 

• the increase in the factor productivity – intensive growth. 

Technological progress is the major determinant of economic growth. It is closely related to 

the capital accumulation. 

4.1. The Factors Determining the Long-Term Economic 

Growth 

• Natural resources are important factors determining economic growth. However, these 

are not the most important and most significant sources. The scarcity of the natural 

resources causes the increase in their prices. That is why the producers try to invent new 

technological improvements, which could decrease the need to use the limited natural 

resources. 

• Capital accumulation and technological progress is often considered the main factor of 

economic growth. Capital involves the fixed capital (machinery, buildings...) and the 

human capital (investment in research, education, schooling). The technological progress 

needs broad investment in education and research. Therefore the technological progress is 

considered as the result of capital accumulation. Because of the diminishing marginal 

product of capital the producers seek for new technological improvements. 

• Market size. The big market allows the better specialisation of the producers, effective 

division of labour and better conditions for the transactions based on the theory of the 

comparative advantages. 

4.2. Growth Accounting and the Growth Theories 1 

Why are some nations rich and some of them poor? What causes the vast differences in 

economic standards (incomes or GDP per capita) in rich countries and poor countries? What 

will determine our standard of living in the future? Growth accounting and growth theories 

answer such questions. The function of growth accounting is to explain what part of growth 

in total output (GDP) results from growth in different factors of production (capital, labour, 

etc.) Growth theory helps us understand the linkages among economic decisions and use of 

production factors. In other words, the theory explains how economic decisions control the 

accumulation of factors of production, for instance, how the present saving rate influences 

stock of capital in the future. 

1 See Dornbush-Fisher-Starz [7]

34 

Chapter 4 

4.2.1. Growth Accounting: The Production Function 

Growth of output results from rises in inputs (factors of production) and from rises in 

productivity due to improved technology and more available labour force. The production 

function provides a quantitative link between inputs and outputs. To make a simplification, 

let’s first assume that labour (L) and capital (K) are the only important inputs. Equation (1) 

shows that output (Y) is determined by inputs and technology (A). 

Y = AF (K,N) (1) 

The production function in equation (1) could be transformed into a very specific prediction 

relating input growth and output growth. The growth accounting equation summarises this 

prediction: 

ΔY/Y =[(1 - Ө) * ΔN / N] + (Ө * ΔK / K) + ΔA /A (2) 

Equation (2) summarizes how rise in input and improved productivity contribute to the 

growth of output: 

• An amount by which labour and capital each contribute to growth of output equal to their 

individual growth rates multiplied by the share of that input in income. 

• The third term in equation (2) is technical progress presented by the rate of improvement 

of technology (also called the growth of total factor productivity). 

The growth rate of total factor productivity is the amount by which output would increase as a 

result of improvements in methods of production, with all inputs unchanged. 

4.2.2. Growth Theories: Neo-classical Growth Theory (R. Solow) 

The model: The origins of Neo-classical Growth Theory come from the late 1950’s and the 

1960’s. Robert Solow is the best-known contributor to this growth theory. The theory 

concentrates on accumulation of capital and its link to savings decisions and the like. 

Neoclassical growth theory begins with a simplifying assumption: there is no technological 

progress in the economy. This implies that the economy reaches a long-run level of output 

and capital called the steady-state equilibrium. The steady-state equilibrium for the economy 

is the combination of per capita GDP and per capita capital where the economy will remain at 

rest, that is where per capita economic variables are no longer changing, Δy = 0 and Δk = 0. 

The growth theory mostly deals with studying the transition from the economy’s current 

position to this steady state. The technological progress is added to the model, as a final step.


Conclusions of the Neo-classical Model: 

• First, the growth rate of output in steady state is exogenous. It follows that the growth rate 

of output is equal to the population growth rate (n) and therefore independent of the 

savings rate (s). 

• Second, an increase in the savings rate increase the steady-state level of income by 

increasing the capital output ratio, despite it doesn’t affect the steady-state growth rate. 

• Third, considering productivity growth, we can show that if there is a steady state, the 

steady-state growth rate of output remains exogenous. The steady-state rate of growth of 

per capita income is determined by the rate of technological progress. The steady-state 

growth rate of aggregate output is the sum of the rate of population growth and the rate of 

technological progress. 

• Convergence hypothesis is the final prediction of neo-classical theory: Two countries will 

eventually reach the same level of income if they have access to the same production 

function, the same rate of population growth and the same savings rate. The rationale for 

remaining poverty of some countries is that of lack of capital. They will eventually catch 

up as long as if they save at the same rate as rich countries and have access to the same 

technology. 

4.2.3. Growth Theories: Endogenous Growth (P. Romer, R. Lucas) 

The Neo-classical growth theory had become a frequent topic of scientific dissertations, 

particularly in the field of further mathematical improvements of the model. However the 

theory had few strong weaknesses and led few unanswered questions. Dissatisfaction with the 

neo-classical growth theory had intensified on both theoretical and empirical grounds by the 

late 1980’s. Neo-classical growth theory presents technological progress as the main cause 

(source) of long-run growth but it doesn’t explain the economic determinants of that 

technological progress. Empirical dissatisfaction developed over the prediction that economic 

growth and savings rates should be uncorrelated in the steady state. The data make it clear 

that the savings rates and growth are positively correlated across countries. 

Both the theoretical and the empirical problems with neo-classical theory could be clarified 

by modifying the assumed shape of the production function in a way that allows for selfsustaining-endogenous 

growth. Endogenous growth theory relies on constant returns to scale 

to accumulable factors to generate ongoing growth. The fundamental statement of this theory 

is that the positive externalities could result from investment into fixed and human capital 

Positive externalities work through spreading knowledge and increased working abilities of 

workers around the economy. The constant (increasing) returns to scale are the consequences 

of these externalities. Because of the constant (cumulative) returns to scale the increase in rate 

of savings could result in the permanent self-sustaining economic growth (income per capita 

growth rate). The innovations need relatively high rate of savings. This could be the 

explanation why the rich countries become richer and the disadvantages of the poor countries 

are deep and permanent. Present empirical evidence denote low importance of that 

endogenous growth theory in terms if its ability to explain differences in growth rates of 

output among nations.

36 

Chapter 4

Business Cycles 37 

5. The Business Cycles 

Contents: 

5. THE BUSINESS CYCLES................................................................................................ 37 

5.1. PHASES OF THE CYCLE ................................................................................................... 39 

5.2. NON-CYCLICAL FLUCTUATIONS ..................................................................................... 39 

5.3. TYPES OF BUSINESS CYCLES .......................................................................................... 40 

5.4. IMPULSES IN THE AS – AD MODEL: BUSINESS CYCLES OF DEMAND SIDE AND SUPPLY 

SIDE ...................................................................................................................................... 40 

5.4.1. Demand Side Business Cycles................................................................................ 40 

5.4.2. Supply Side Business Cycles .................................................................................. 42 

5.5. THE SOURCES OF BUSINESS CYCLES: THEORIES............................................................. 42

38 

Chapter 5 

The business cycle could be described as the more or less regular pattern of expansion 

(recovery) and contraction (recession) in economic activity around the path of trend 

growth (potential output). 

We can distinguish among four distinct phases of the cycle. Unemployment, inflation and 

growth all have clear cyclical patterns. At a point of cyclical peak, economic activity is 

high relative to trend. Conversely, at a cyclical trough, economic activity is weak relative to 

trend path of potential output. Inflation, growth and unemployment all have clear cyclical 

patterns. 

Peak 

Output 

Reccesion 

Recovery 

Trend 

(Potential Output) 

Trough 

Figure 5.1 The business cycle. 

The trend line in Figure 5.1 shows the trend path of real GDP. The trend path of GDP 

corresponds to full-employment output when factors of production are fully employed. 

Output does not always operate at its trend level, that is, the level corresponding to full 

employment of the factors of production. Rather, output fluctuates around the trend path. 

During an expansion (or recovery) the employment of factors of production increases, 

which is a source of increased production. Output can rise above trend because people 

work overtime and machinery is used for several shifts. Conversely, during a recession 

unemployment declines and less output is produced than could be in fact produced with the 

existing resources and technology. The cyclical deviations of output from trend are 

represented by the wavy line in the figure. Departures of output from trend are referred to 

as the output gap. 

The output gap measures the difference between actual output and output the economy 

could produce at full employment given the existing resources. Full employment output is 

also called potential output. 

Output gap ≡ potential output – actual output


The output gap allows us to measure the extent of the cyclical deviations of output from 

potential level of output. However, it should be mentioned that it is difficult to measure the 

potential output in real world. Published numbers of potential GDP always refer to some 

estimation based on relevant economic models. 

5.1. Phases of the Cycle 

Peak The highest point called pragmatically “peak” lying on the line of real GDP 

relates to the situation at which the enterprising activity reaches its temporary maximum. 

Here the level of real output is very close to capacity of the economy. The inputs are used 

fully and the rate of unemployment could be temporarily lower than the natural rate of 

unemployment. The price level is likely to rise during this phase and sometimes economists 

warn against overheating the economy. 

Recession The phase of recession (contraction) represents a period of decline in total 

real output. This is accompanied by decreased business’ profits, reduced investment and 

increased unemployment. The behaviour of the price level is not unambiguous. Contraction 

originated from decline in aggregate demand (negative demand shock) is connected with 

decline in the price level. Decreased aggregate supply (negative supply shock) implies 

rising price-level. High unemployment accompanied by rising price level is called 

stagflation. 

Trough The lowest level of the contraction phase is called the trough or the bottom. 

Very low economic activity in this point is accompanied by high level of unemployment. 

This phase of the cycle may last short as well as relatively long time. 

Recovery Both real output and employment rise during the recovery (expansion) 

phase. We can distinguish between two possible trends in the price-level similarly as in the 

phase of contraction. In the case of positive demand shock (rise in aggregate demand) the 

price level rises. Positive supply shock (rise in aggregate supply) is connected with decline 

in the price level. 

5.2. Non-cyclical Fluctuations 

It is important to remain that not all changes in economic activity originates from business 

cycles. There can be some seasonal variations in economic activity, which could appear as 

a business cycle. In these cases in fact GDP does not overreach its potential level. Thus, 

they cannot be labelled as business cycles. Pre-Easter and Pre-Christmas buying rushes 

causing noteworthy fluctuations in economic activity every year are the typical examples of 

such non-cyclical fluctuations.

40 

Chapter 5 

5.3. Types of Business Cycles 

Minor or short-term business cycles are associated with the fluctuations in inventory 

investment and production in stock. The length: 36 – 40 months. (Sometimes called the 

Kitchin cycles according to Josef Kitchin, a South African statistician and economist). 

Middle term or Juglar cycles are connected with the fluctuations in investment spending. 

The length: 7 – 10 years. (Clement Juglar, a 19 th -century French physician.) 

Long term or long-wave cycles so-called Kuznets cycles involve fluctuations in the 

supply trends of resources, and the productivity and efficiency, with which they are used, 

last about 25 years. The longest type of fluctuation is called Kondratieff cycle. That type 

of a cycle is connected with technological changes and political affairs. (Simon Kuznets 

was a Russian born US economist who received the Nobel Prize for his work on growth. 

Russian economist Nikolai Kondratieff developed his theory of long-wave cycles in the 

1920s before he was arrested and disappeared; the official Soviet Encyclopaedia then wrote 

about his work: “this theory is wrong and reactionary”.) 

5.4. Impulses in the AS – AD Model: Business Cycles of 

Demand Side and Supply Side 

The previous lessons showed us how to use the AS – AD model to understand the basic 

determinants of output, unemployment and inflation (in the short and long run). The model 

can also be used to study business cycles. The point of departure is to identify the factors 

(sometimes called shocks) that shift either the AS or AD curve. Demand shocks shift the 

AD schedule, while supply shocks affect the position of the AS curve. Both demand and 

supply shocks can be positive or negative. Positive shocks, for example, move the relevant 

schedule rightwards. 

5.4.1. Demand Side Business Cycles 

The movements (shifts) of aggregate demand cause this type of fluctuations of actual 

output around its potential. 

Let’s assume the initial equilibrium in point E – the point of intersection of the AS and AD 

curves. The actual output equals the potential output in that point. If the investment activity 

or the amount of consumers’ spending falls, the aggregate demand decreases and moves 

leftwards. See the new point of equilibrium in Figure 5.2.


P 

AD’ 

AD 

AS 

P 

E 

P‘ 

E’ 

Q’ 

Q* 

Q 

Figure 5.2 Decline in aggregate demand and output. 

If a decline in aggregate spending is sudden – the demand shock – it is less probably that 

the aggregate supply schedule will accommodate that movement consecutively (in a short 

time). In that case the actual output falls at the level of Q’ and price level declines at P’. 

The difference between potential output and actual output is the output gap (this type is 

sometimes called the deflation gap). The economy goes through recession. 

If any components of AD rise, particularly consumption spending or investments, the AD 

schedule moves upwards. This leads to the increase in actual output and decrease of the 

output gap. 

The increasing output is accompanied by the increase in price level. If the actual output 

exceeds its potential level, the price level rises significantly. This type of output gap is 

sometimes called the inflation gap. 

Okun’s Law 

The fluctuations of actual output around its potential level are also connected with the 

changes in unemployment. Arthur Okun codified an empirical relation between 

unemployment and output over the business cycle. Okun’s law states that 1 extra point of 

unemployment costs 2 percent of GDP. 

Okun’s law, based on recent estimates, suggests that for every 1-percentage point, 

which the actual unemployment rate exceeds the natural rate, a GDP gap of about 2 

percent occurs. (This estimation is based on the US-economy data). 

The main importance of this law is to identify the causality between changes in output and 

changes in employment.

42 

Chapter 5 

5.4.2. Supply Side Business Cycles 

The fluctuations of output could also be triggered by the supply shocks. The supply shocks 

include the decline in productivity, increase in prices of inputs – the production costs that 

lead to the decline in aggregate supply. The sudden unexpected increase in energy prices is 

an example of supply side shock. (See OPEC and its influence on the oil-price volatility 

during 70’s and 80’s.) 

AS‘ 

P 

AD 

AS 

P‘ 

P 

E’ 

E 

Q’ 

Q* 

Q 

Figure 5.3 Decline in aggregate supply and output. 

5.5. The Sources of Business Cycles: Theories 

External theories assume that fluctuations in economic activity or business cycles are 

caused by factors from outside the economic system. They include, for example sunspot 

cycles (an obsolete nineteen-century theory), wars and revolutions, and political and social 

events. Other external factors, which lead to fluctuations, are the rates of immigration and 

population growth, discovery of new resources, and scientific and technological 

innovations. 

Internal theories acknowledge that certain external factors influence economic activity but 

contend that, on the whole, the major causes of business cycles are forces within the 

economic system. Among endogenous theories are profit motive (psychological), 

monetary, overinvestment, and underconsumption. Some internal theories suggest that 

mechanism within the system will naturally generate economic cycles so that, predictably, 

every expansion will be followed by recession, contraction and renewed expansion.

Measuring Domestic Output, National Income 43 

6. Measuring Domestic Output, National Income 

6. MEASURING DOMESTIC OUTPUT, NATIONAL INCOME ................................... 43 

6.1. NATIONAL INCOME ACCOUNTING .................................................................................. 45 

6.1.1. Gross Domestic Product ........................................................................................ 45 

6.1.1.1. Avoiding Multiple Counting ........................................................................... 45 

6.1.1.2. Omitting Non-production Transactions .......................................................... 46 

6.2. TWO APPROACHES TO GDP MEASURING: SPENDING AND INCOME................................ 47 

6.2.1. Expenditures Approach.......................................................................................... 48 

6.2.2. Income Approach ................................................................................................... 50 

6.2.2.1. Three Adjustments to Balance the Accounts .................................................. 51 

6.3. OTHER NATIONAL ACCOUNTS........................................................................................ 52 

6.3.1. Net Domestic Product ............................................................................................ 52 

6.3.2. National Income (NI) ............................................................................................. 53 

6.3.2.1. Personal Income (PI)....................................................................................... 53 

6.3.2.2. Disposable Income (DI) .................................................................................. 54 

6.4. PROBLEM OF COMPARISON: REAL VERSUS NOMINAL GDP............................................ 55

44 

Chapter 6 

The goal of this chapter is to explain the ways the overall production performance of the 

economy is measured. Measuring of the main overall economic indicators is a function of 

national income accounting, which is as important for the entire national economy as 

private accounting is for individual enterprises or, for that matter, for households. 

Costs 

Resources 

RESOURCE 

MARKET 

Money income (wages, 

rents,interest, profits) 

Labor, land, capital, 

enterpreneurial ability 

BUSINESSES 

HOUSEHOLDS 

Revenue 

Goods and 

services 

PRODUCT 

MARKET 

Goods and 

services 

Consumption 

expenditures 

Real flows 

Financial flows 

Figure 6.1 The circular flow of output and income. There are two groups of decision makers depicted in 

the figure: households and firms. (We are omitting the government for now in the figure.) Product and 

resource markets work as a co-ordinating mechanisms, which adjust the decision processes of households 

and firms. 

The upper part of the figure shows the resource market. Firms demand labour and other 

resources there whereas households act as suppliers of the resources. The prices paid for 

the use of capital, land, labour (and entrepreneurial ability) are determined in the resource 

market. The prices of final goods and services are determined by households on the 

demand side and by firms on the supply side in the product market. This is shown in the 

lower part of the figure. 

The resource market depicted in the upper part of the diagram represents the place where 

resources (factors of production) supplied by households are bought and sold. The firms 

demand and purchase these resources, in order to produce final products and services. The


interaction of the households’ supply and firms’ demand for the vast variety of resources 

(human and property) determine the prices paid for use of each individual kind of resource. 

The lower part of the diagram portrays the product market, where final goods and services 

supplied by firms are bought and sold. Households demand these goods and services there 

in order to satisfy their needs and wishes. The money income they have received from the 

sale of the resources in the resource market is used for purchasing the final goods and 

services in the product market. Firms use various types of resources they have obtained in 

the resource market to produce and supply the immense variety of final goods and services. 

Thus, the product prices are established due to interaction of consumers’ demand and 

firms’ supply decisions in the product market. 

6.1. National Income Accounting 

There are three main functions of national income accounting: 

a) A national accounting allows us to keep the economy of the nation under permanent 

control. It permits to measure the overall level of production in the economy in a 

particular time frame. 

b) System of a national accounting allows us to compare the national accounts in a chosen 

period of years. By comparing these numbers we can examine the long run course of 

the economy and explore the growing, declining or steady trend path. 

c) National accounts provide us with information that serve as a basis for planning, 

designing and pursuing macroeconomic policies. We can asses the health of the 

economy due to national accounting and accordingly formulate policies to stabilise and 

improve actual performance of the economy. 

6.1.1. Gross Domestic Product 

We can use quite broad variety of measures of an economy’s economic performance. 

Aggregate output belongs among measures based on the economy’s annual output of goods 

and services, which are considered the best available measures. Gross domestic product 

(GDP), including goods and services produced by domestic and foreign resources operating 

within geographical boundaries of a country, measures aggregate output. GDP is 

measured as the total market value of all final goods and services produced within a 

country in a particular year. 

6.1.1.1. Avoiding Multiple Counting 

Gross domestic product includes only the market value of final goods. It doesn’t 

involve intermediate goods neither re-sold products. If we want to measure aggregate 

output of some particular year accurately, we must avoid multiple counting. Some goods 

(or their parts) could be bought and sold many times. Such goods must be counted only 

once.

46 

Chapter 6 

Final goods cover goods and services bought only for final use by the consumer. Such 

defined goods must not be resold or used for further processing or manufacturing. The 

value of final goods is included in GDP. The value of intermediate goods that are 

purchased for further processing or manufacturing is excluded from GDP. 

The national income accountants can use method based on summing up the values added to 

avoid multiple counting. Value added equals the market value of a firm’s output less the 

value of the inputs. We can count the GDP - the market value of total output - by summing 

the values added by all firms (producers) in all sectors in the economy. 

6.1.1.2. Omitting Non-production Transactions 

The measure of GDP gives the evidence of annual production in a country. In spite of the 

fact that many monetary transaction cover currently produced final goods and services, 

some of the transactions does not relate to production process. We can distinguish between 

two types of non-production transactions: (1) purely financial transactions and (2) secondhand 

sales. 

Purely financial transactions: 

a) Public transfer payments. These are the payments from government to public without 

any feedback in a form of production of goods and services. The receivers don’t contribute 

to production process in the economy for these payments. (Examples: social security and 

welfare, payments, veteran payments, state retirement pensions etc.) 

b) Private transfer payments. Such transfers involve the simple payments among the 

private individuals. These payments are not related to production of final goods (defined 

above). (Examples: occasional gifts among relatives or friends, allowances etc.) 

c) Security transaction. This kind of transactions covers dealing with stocks. Such 

transactions are excluded from the value of GDP. Gross domestic product includes only the 

services provided by the security broker in a current year (similarly as in the case of dealers 

with used cars, machines etc.). 

Second-hand sales usually involve multiple counting or don’t relate to current production. 

To avoid exaggerating a year’s output, these payments must be excluded from GDP.


6.2. Two Approaches to GDP Measuring: Spending and 

Income 

Aggregate 

Spending 

(Expenditures) 

Total 

Income 

Total 

Output 

Figure 6.2 The flow of income, spending and output. 

We can basically distinguish between two ways how to count GDP. We can sum up all the 

expenditures of final consumers – how much the final user pays for bought production. The 

other method is to add up all the wage, interest, rent and profit incomes created in 

producing the output. 

According to how we look at GDP we can use expenditure approach or income approach to 

measure aggregate output. Expenditures approach sees GDP as the sum of all 

expenditures in purchasing that output. Income approach measures GDP as the entire 

income derived from the production of that output. 

In other words this year’s GDP can be determined either by summing up all the 

expenditures to purchase this year’s total output or by counting up all the incomes created 

from the production of this year’s total output. Which, is 

Money spent to purchase 

this year’s GDP (total 

output) 

≡ 

All the income created from 

the production of this year’s 

GDP (total output)

48 

Chapter 6 

The relationship described above says that what is spent on product is an income to those 

who provided their resources (human or material) to create that product and get it to the 

market. Such an equation is an identity - purchasing (spending money) and selling 

(receiving income) are two side of the same transaction – one side of the equation always 

equals the other one. 

That identity could be expanded in details as is shown in figure 6.3. The left part of the 

figure presents that the total output – GDP is purchased by households, firms, government, 

and by foreign consumers. The left part shows the income side of GDP – all the income 

obtained from the sale of GDP, which is allocated among the suppliers’ resources in forms 

of wages, interests, rents and profits. 

Households’ expenditures for 

consumption 

plus 

Firms’ expenditures for gross 

investments 

plus 

Government purchases of goods 

and services 

plus 

Expenditures by foreign 

consumers 

= GDP = 

Wages 

plus 

Interests 

plus 

Rents 

plus 

Profits 

plus 

Statistical adjustment 

Figure 6.3 Two sides of GDP: the expenditures (spending) and income approach. We can measure GDP 

by summing all the expenditures paid for total output. Or, alternatively, we can count GDP as the total 

income derived form the production of that output. 

6.2.1. Expenditures Approach 

Let’s explain the expenditures approach in more details. To measure GDP in this way, we 

must sum up all spending - personal expenditures on consumption (C), gross private 

domestic investment (Ig), government purchases (G), and net exports (Xn) – spent on final 

goods and services. 

The GDP equation: GDP = C + Ig + G + Xn


Expenditures of households on consumption (C) involve personal expenditures by 

households on durable goods (automobiles, wash machines), nondurable goods (food, 

clothing) and services (post, hair-dressers). 

Gross private domestic investment (Ig) includes expenditures of firms on capital goods 

such as construction, machinery, equipment and various tools used by business enterprises. 

This group of expenditures involves also changes in inventories, because GDP measures 

total current output including all products produced in a current year even if they are not 

sold that year. To get accurate information about the GDP a rise in inventories must be 

included in GDP and, conversely, a decline in inventories must be subtracted from GDP. 

The accountants must be also careful about excluding of non-investment transactions, 

such as transfers of financial assets (bonds, stocks) or re-sales of physical assets. These 

transactions simply refer to change of ownership of existing assets. Such purchases are not 

a part of GDP. 

• Distinguishing among the gross and net investment. Net private domestic investment 

is a part of gross private domestic investment. It refers solely to investment in added 

(new) capital whereas gross investment covers both investment – in replacement capital 

(replacement of machinery, equipment, and buildings used up to produce output in a 

current year) and investment in added capital (additions to the economy’s stock of 

capital). 

Government purchases of goods (capital and consumption goods) and services involve all 

government expenditures on final goods produced by firms and on use of resources such as 

labour. This item does not include the government transfer payments (social security 

payments, state retirement pensions) because they do not reflect any contribution to current 

GDP. These payments represent only financial transfers from government to selected 

households, which is the reason why they must be excluded from GDP. 

Net exports (Xn). Gross domestic product involves also the item net exports, which is 

the difference between foreign consumers’ spending on nation’s final goods and amount of 

domestic consumers’ spending on goods and services purchased from abroad. Net exports 

equal total exports less total imports.

50 

Chapter 6 

Table 6.1 Accounting statement for the US economy, 1997 (in billions) 1 

Receipts: expenditures approach 

Allocations: income approach 

Personal consumption expenditures 

(C) 

Gross private domestic investment 

(Ig) 

$5489 Compensation of employees $4703 

1238 Rents 148 

Government purchases (G) 1454 Interest 450 

Net exports (Xn) -97 Proprietors' income 545 

Corporate income taxes 319 

Dividends 336 

Undistributed corporate profits 149 

National Income $6650 

Indirect business taxes 545 

Consumption of fixed capital 868 

Net foreign factor income earned in the 

U.S. 

Gross domestic product $8084 Gross domestic product $8084 

21 

6.2.2. Income Approach 

Table 6.1 shows how the amount of total expenditures (total output) is allocated in 

households’ wage, interest, rent and profit income. However, in real it does not work so 

simply. The process of redistribution is complicated by three adjustments, which are 

necessary to get the expenditures and national income in balance. 

Compensation of employees (wages) represents the widest income category, which 

includes particularly the wages and salaries paid by firms and government to households 

(suppliers of labour). This item also includes wage and salary supplements. These are the 

payments by employers into social insurance and into a variety of private pension, health, 

and welfare funds for their employees. 

Rents include for example the monthly payments of renters to landlords and the annual 

lease payments by corporate tenants for the use of office room. Rents are generally the 

income payments obtained by households and firms that supply their property resources. 

Interest represents the money paid by firms and enterprises to the suppliers of financial 

capital. The households offering their capital obtain the interest payments coming from 

saving deposits, corporate bonds, and certificates of deposit (CD’s). 

1 The examples of counting GDP and other related accounts have been taken up from McConnel – Brue [10]


Proprietors’ income. To characterise properly the item “profits” in national accounting we 

must distinguish between two accounts: proprietors’ income, which is the net income of 

sole proprietorship and partnership, and corporate profits. 

Corporate profits. The earnings of corporations are usually distributed further in three 

channels. 

• Firstly, a part of the profit is collected as corporate income tax, which flows to 

government. 

• The stockholders receive a part of (or all) remaining profit as dividends. The ultimate 

receivers of such payments are the households, because they are the ultimate owners of 

all corporations. 

• A part of remaining profit may be invested currently or in the future. This part of 

profits, increasing the real assets of the businesses, is called undistributed corporate 

profits. 

6.2.2.1. Three Adjustments to Balance the Accounts 

Three adjustments must be done to balance both sides of the account. These adjustments 

represent three items, which must be added. 

Consumption of fixed capital (depreciation). Capital purchased in some particular year is 

usually productively used for many years after. Depreciation is the annual charge, which 

corresponds to the amount of capital equipment used up in each year’s production. This 

part of capital must be counted to avoid some gross understatement of profit and, thus, of 

total income. The total costs of such “long-lived” capital goods must be allocated over all 

their lives. 

From the macroeconomic prospect a large depreciation charge, called consumption of 

fixed capital, should be made against the economy’s private and public stock of capital in 

order to count accurately the profits and total income. Public capital involves government 

buildings, motorways, port facilities, etc. Consumption of fixed capital represents the 

amount of capital goods, which is consumed in producing current GDP. That part of GDP 

is put aside to replace the capital goods used up in current production. The difference 

between gross private investment, Ig, and net private investment, In, equals the part of that 

depreciation charge relating to the private sector (without government). 

Indirect business taxes. These taxes are added to prices of products because they are 

considered to be a cost of production by firms selling these products. General sales taxes, 

excise taxes, business property taxes, license fees, and custom duties are the typical 

examples of such taxes. 

Net foreign factor income. To get the accurate balance between national income (NI) and 

gross domestic product (GDP) means to move from what is labelled under “national” to

52 

Chapter 6 

“domestic”. GDP measures the total output, which is produced within the boundaries of the 

domestic country – no matter what is the nationality of the suppliers of resources. On the 

contrary, NI is the total income of the country’s citizens, irrespective of the place (country) 

they are working in. If we want to move from NI to GDP we must consider the income of 

the domestic citizens (citizens of country A) gained from supplying resources abroad and 

the income foreigners (citizens of a country B) gain by supplying resources in the domestic 

country (A). The difference is labelled as foreign factor income. This value is derived from 

output produced within the borders of the domestic country and therefore we must add it to 

NI to get the value of GDP (domestic output). 

. 

6.3. Other National Accounts 

National accounting uses other related accounts of equal importance, which can be derived 

from GDP. 

6.3.1. Net Domestic Product 

The item consumption of fixed capital includes the amount of replaced capital goods used 

up in current year’s production. To get the value referring only to the output available for 

consumption and for addition of new capital – the measure of net domestic product is set 

up in national accounting. To measure NDP we must adjust GDP for appreciation. 

NDP = GDP – consumption of fixed capital 

Billion 

s 

Gross domestic product $8084 

Consumption of fixed capital -868 

Net domestic product $7216 

GDP is adjusted for depreciation both private and public capital. It follows that NDP 

includes only net (not gross) investment in the economy. Thus, NDP covers the total 

output, which can be consumed by the entire economy (including foreign consumers) 

without impairing its productive capacity in following years.


6.3.2. National Income (NI) 

We need to do two additional steps to derive national income (NI) from net domestic 

product (NDP). Two items must be subtracted from NDP: net foreign factor income earned 

in the domestic country (1) and indirect business taxes (2). 

Billion 

s 

Net domestic product $7216 

Net foreign factor income earned 

in the U.S. 

-21 

Indirect business taxes -545 

National income $6650 

6.3.2.1. Personal Income (PI) 

It is important to differ personal income (PI) from national income (NI). PI includes all 

income, which is finely received by households. It covers all income received – such as 

earned income, however it also covers unearned income such as transfer payments (which 

is added to NI). To get PI from NI we must adjust it for corporate income taxes, 

undistributed corporate profits, and social security taxes, which are not actually received by 

ultimate households. 

To conclude, three items of income must be subtracted from NI and one item must be 

added to adjust from national income to personal income. Examine the table: 

Billion 

s 

National income $6650 

Social security contributions -732 

Corporate income taxes -319 

Undistributed corporate profits -149 

Transfer payments 1424 

Personal income $6874

54 

Chapter 6 

6.3.2.2. Disposable Income (DI) 

To be accurate, personal income still includes some items, which must be excluded, to get 

disposable income. Disposable income (DI) is the amount of money, which households 

really receive to their dispose. This households’ income is usually partly spent on final 

goods and services, and partly saved. Therefore savings are defined by economists as the 

part of disposable income which is not spent on final goods and services. Disposable 

income is, thus, divided between consumption (C) and savings (S) by households: 

DI = C + S 

Personal income (income received 

before 

personal taxes) 

Billion 

s 

$6874 

Personal taxes -987 

Disposable income (income received 

after personal taxes) 

$5887 

To move from personal income to disposable income the item referring to all types of 

personal taxes (personal income taxes, personal property taxes etc.) must be subtracted. 

Table 6.2 The relationship between GDP, NDP, NI, PI, and DI in the United States, 1997. 

Billion 

s 

Gross domestic product (GDP) $8084 

Consumption of fixed capital -868 

Net domestic product (NDP) $7216 

Net foreign factor income earned in 

the U.S. 

-21 

Indirect business taxes -545 

National income (NI) $6650


Social security contributions -732 

Corporate income taxes -319 

Undistributed corporate profits -149 

Transfer payments 1424 

Personal income (PI) $6874 

Personal taxes -987 

Disposable income (DI) $5887 

6.4. Problem of Comparison: Real versus Nominal GDP 

In the end of the chapter let’s explain the difference between two frequently used terms: 

nominal and real GDP. Total output produced in a current year include the vast variety of 

heterogeneous products (including services). To be able to measure it, money or nominal 

values serve as a common denominator to get a meaningful total amount of production. 

However, a problem of comparison of that output in different years is connected with that 

modification. The comparison is useful only if the prices (value of money) in different 

years do not change. Otherwise we wouldn’t know if the change in output is a result of 

change in overall prices (inflation or deflation) or change in total produced quantity 

(or both). 

GDP is a price-times-quantity figure, which means that inflation or deflation may 

complicate its measuring. To resolve this difficulty, we can deflate GDP for rising prices 

and inflate it when prices are falling. The result of this modification is GDP adjusted for 

price changes, which is called real GDP. Nominal GDP refers to unadjusted total output. 

Another explanation may be used: real GDP is output valued at constant prices (baseyear 

prices); nominal GDP is output valued at current prices.

56 

Chapter 6

Labour Market, Unemployment 73 

8. Labour Market, Unemployment 

Contents: 

8. LABOUR MARKET, UNEMPLOYMENT .................................................................... 73 

8.1. SUPPLY OF LABOUR........................................................................................................ 74 

8.1.1. Substitution Effect vs. Income Effect ...................................................................... 74 

8.1.2. Individual vs. Aggregate Labour Supply Curve..................................................... 76 

8.2. LABOUR DEMAND, REAL WAGES AND PRODUCTIVITY................................................... 77 

8.2.1. Shifts in the Demand for Labour............................................................................ 78 

8.3. LABOUR MARKET EQUILIBRIUM .................................................................................... 79 

8.4. INTERPRETATION OF UNEMPLOYMENT ........................................................................... 81 

8.4.1. Rate of Unemployment ........................................................................................... 81 

8.4.2. Involuntary Unemployment and Real Wage Adjustment........................................ 82 

8.4.3. Types of Unemployment ......................................................................................... 84 

8.4.3.1. Frictional Unemployment ............................................................................... 84 

8.4.3.2. Structural Unemployment ............................................................................... 84 

8.4.3.3. Cyclical Unemployment.................................................................................. 85 

8.4.4. Definition of “Full Employment” .......................................................................... 85 

8.4.5. Costs of Unemployment.......................................................................................... 85

74 

Chapter 8 

This chapter is dedicated to the examination of the labour markets and related variables. 

Let’s first define labour as one of the primary factors of production. 

Literature offers many definitions of labour 1 . All of them are, however, just the 

modifications of the essential meaning – the primary factor of production. 

Labour is a wide term for all the mental and psychical talents of individuals engaged in 

producing of goods and services in the economy. 

Labour belongs among the primary inputs (primary factors of production). Labour 

represents the time spent in a production process. It covers thousands of occupations and 

tasks corresponding with all skill levels. Labour is considered the most crucial and most 

conversant factor of production in modern and high-developed economy of these days. 

Labour, as a factor input, involves relationship of demand and supply. 

8.1. Supply of Labour 

People can divide all their disposable time between time spent in work and their leisure 

time. Labour supply refers to the amount of time (number of hours) that people are willing 

to dedicate to working. The labour supply is determined by the size of population and 

people’s individual preferences – how people want to spend their disposable time. 

8.1.1. Substitution Effect vs. Income Effect 

One of the most frequently examined issues in analysing labour supply is the relationship 

between change in wages and changes in number of hours supplied. The question is how a 

rise in wages influences the labour supply – number of hours people want to spend by 

working in producing GDP. 

The question is answered in Figure 8.1 where the labour supply curve is depicted. The 

supply curve rises at first in a north-easterly direction until the critical point C. The slope 

and the relationship between wages and labour supply is positive in that phase. From the 

point C, the curve is bent back in north-westerly direction. The relationship is negative. 

These two parts of labour supply curve refer to substitution and income effect of increasing 

wage. In lower levels of wages the substitution effect overweighs. The worker is intended 

to work longer because each hour spent in work is now better paid. The leisure time has 

become more expensive and workers are motivated to substitute additional hours of 

working for leisure. 

The income effect acts against the substitution effect. With the higher wages, worker’s 

income rises. Thus, he can afford to buy more final goods and services to consume. In 

addition to that, he will also acquire more leisure time because he can afford it. The result 

1 To find more definitions, explore the textbooks named in the list of used literature.


of overweighed income effect is the negative relationship between wages and labour 

supply. The higher wage from the point C, the less labour is supplied – this corresponds to 

negative slope of the curve. 

But acting against the substitution effect is the income effect. With the higher wage, our 

income is higher. With the higher income, we will buy more goods and services and in 

addition we will also want more leisure time. We can afford to take a weeks vacation in the 

winter or an extra week in the summer, or to retire earlier than we otherwise would. 

What effect overweighs, or in other words, what effect will be more powerful depends 

upon the individual and its preferences. In general, we can say that until point C, the slope 

of the curve is positive – substitution effect dominates (labour supply rises with the rise in 

wages). From point C, income effect overweighs, which is depicted by negative slope of 

the supply curve (labour supply declines with the rise in wages). 

Household labour 

supply 

Real wage 

C 

(b) 

Figure 8.1 Backward-bending supply curve. The positive relationship between the wages and labour 

supply is valid until point C - the substitution effect dominates. Above the critical point C, the worker’s 

income is big enough to afford more leisure time. With higher wages, labour supply is reduced – the income 

effect overweighs. The worker can afford to work fewer hours, even though every additional hour of leisure is 

more costly.

76 

Chapter 8 

S 

Real wage 

Labour Supply 

Figure 8.2 Dominating substitution effect. The figure shows the situation when households’ reaction to a 

rise in wages is an increase in labour supply. With rising wages, households reduce their leisure time and 

increase their time spent in work – the net effect is positive – the substitution effect overweighs. 

The determinants of labour supply vary across individuals in a real economy. The decision 

process about how much to work is determined by individual’s preferences, family 

situation, age, education, etc. Considering the time horizon, we can generally state, that in 

the short run, the reaction to changes in real wage is not widely obvious. The income effect 

with decreasing supply of labour is supposed to dominate in the long run. 

8.1.2. Individual vs. Aggregate Labour Supply Curve 

The rationale for the shape of individual labour curve seems to be clear and strongly logic. 

Let’s examine the circumstances of supplying labour in more details and compare it to 

aggregate supply of labour. 

In many cases, the individual workers cannot change the number of hours in work 

according to the actual wage rate. The labour contracts often specify exactly the standard 

working time and other related things. The workers can only decide whether to work or not 

(take it or leave it). In some cases, the wage rates intend the workers not to work at all. 

That’s why the small increases in wages might not motivate individuals to take up jobs 

whereas the large increase might. The aggregate labour supply, consisting of many 

individual decisions, is measured in man-hours, which is the total number of hours supplied 

by all workers during given period. With rising wage, some new additional households, 

which decided not to work, can now decide to take up jobs. Accordingly, the aggregate 

labour supply rises in spite of the fact that those, who had already had their jobs before the 

wage increased, couldn’t adjust the number of working hours. The slope of the aggregate 

labour supply curve is, thus, flatter comparing to individual labour curve as is described in 

Figure 8.3.


Individual 

Aggregate 

Real wage 

0 

Labour 

Figure 8.3 Individual and aggregate labour supply. The aggregate labour supply curve is flatter than 

individual curve, because it consists of plethora of individual labour cuves. The other reason is that new extra 

households can decide to start working as wages rise. 

8.2. Labour Demand, Real Wages and Productivity 

Labour and capital are the primary factors of production, which are used by firms to 

produce final goods and services. To simplify the model let’s assume the capital stock as 

given at any particular point of time. Firms determine their output by an amount of 

employed labour (man-hours). The production function in Figure 8.4 shows the relationship 

between output (Y) and employed labour (L) – holding capital stock constant. The slope of 

that function is measured by the marginal productivity of labour (MPL), which refers to 

the amount of additional output resulting from adding one more unit of labour (input). The 

shape of the labour curve reffers to the principle of decreasing marginal productivity, 

which states that with increasing amount of employed labour (ceteris paribus) the MPL in a 

firm is declining. 

The highest possible profit under the given cost of labour – the real hourly wage (w) is the 

crucial criteria in the firm’s decision process about how much labour to employ. Let’s 

remind the assumption of fixed capital stock. The total cost of labour in a firm relating to 

different levels of employment is represented by the line OR. Its slope is w (because L 

hours of work cost wL). The vertical distance between the curve of production function and 

the total labour cost line OR determines the profit for each level of employment. At point A 

the production function is parallel to OR line, which means that, MPL, the slope of the 

production function is parallel to OR, which equals to real wage. At this point A the profit 

reaches its maximum level. Accordingly, at this point, the MPL, is equal to the real wage.

78 

Chapter 8 

In the case that the MPL exceeds real wage, it would be effective to hire some more extra 

working hours until MPL and w equalise. In the opposite case, where the real wage exceeds 

the MPL, the firm might increase its profit by decreasing its demand for labour. To 

conclude, it is optimal to set employed labour much that MPL = w, the MPL schedule in 

panel (b) in Figure 8.4 is also labour demand curve of the firm. 

Output (Y) 

A 

R 

Real wage 

Slope = w 

0 0 

Labour 

( (b) 

Labour 

MPL 

Figure 8.4 The Production Function and the Labour Demand Curve. Panel (a) describes the maximum 

amount of profit at point A, where the distance between total cost line OR and production function is 

maximal.This set the condition of maximizing the profit in the firm: MPL = w Panel (b) shows the firm’s 

demand for labour by declining curve of MPL. 

8.2.1. Shifts in the Demand for Labour 

Let’s cancel the assumption of fixed capital stock and consider the effect of its increase. A 

rise in capital stock K increases MPL - the production function becomes steeper at each 

level of production (panel a). Panel (b) shows that this improvement shifts out also the 

labour demand curve. The same effect is connected with a technological improvement, 

which could be the rationale for secular rise in wages over time. Conversely, the labour 

demand curve is shifted down to the left if capital stock declines (war, natural disasters, 

technical obsolescence). We should mention the case of labour-saving technical change, 

which might cause a decline in demand for labour whereas economy experiences a rise in 

total output.


Output 

Real wage 

0 0 

(a) 

(a) 

(b) 

Labour hours 

MPL 

MPL‘ 

Figure 8.5 An increase in labour productivity. Higher labour productivity rises demand for labour. Rise of 

productivity is caused either by enhanced stock of capital or by technological improvement. 

8.3. Labour Market Equilibrium 

After deriving both labour supply and labour demand schedules, we can implement them 

into a model of labour market. This model will help us to understand better the conditions 

of labour market equilibrium. We can also examine the process of real wage and 

employment determination. Figure 8.6 shows the interaction between labour supply and 

labour demand curves. The point of intersection A represents equilibrium. The intersection 

determines equilibrium wage rate (w) and equilibrium level of employed labour (L) – 

number of hours households are willing to offer and firms desire to hire. Wage w is also 

called clearing wage, because it clears the market from excess demand or supply. In the 

model of labour market the wage rate and employment are endogenous variables – 

determined within a model.

80 

Chapter 8 

Supply 

Real wage 

w 

A 

Demand 

L 

L‘ 

Labour hours 

Figure 8.6 Labour market equilibrium.. Demand and supply of labour are equal at point A, which is the 

equilibrium situation. Eguilibrium real wage clears the market from excess of demand or supply. Assuming 

total labour force as L’, voluntary unemployment corresponds to the distance L’ – L. 

We have briefly characterised the model of labour market. This model will help us to 

understand better the origins of unemployment and make some simple predictions about its 

variables. With shifting either demand or supply curves the labour market equilibrium is 

changing as is shown in Figure 8.7. Left part of the figure describes rise in demand for 

labour. This could be the outcome of a rise in labour productivity caused by capital 

accumulation or technical improvements. Holding supply curve fixed, demand curve shifts 

rightwards as a result employment increases with higher real wage. In the case that the 

curve is backward-bending, rise in demand will decline employment. A result of 

exogenous change in labour supply is depicted in the right panel of the figure. Rise in 

labour supply increases employment, but reduces real wages.


Supply 

Supply 

Real wage 

Real wage 

Demand 

Demand 

Labour hours 

Labour hours 

Figure 8.7 Shifting labour demand and supply. When labour demand increases (panel a), for example 

because of aditional capital or technological progress, the real wage and employment level both increase. 

When labour supply increases instead (panel b) – because of new entries into the labour force, for instance - 

employment rises but the real wage declines. 

8.4. Interpretation of Unemployment 

The situation described in Figure 8.6 presents a kind of optimal situation in the economy. 

Labour market reaches equilibrium at point A, where labour demand equals labour supply. 

Let’s assume that total (potential) labour force available in the economy is denoted by L’. 

The distance between L and L’ refers to voluntary unemployment. Such unemployment is 

a result of voluntarily made decisions about working at given wage rate. The amount of 

voluntarily unemployed force in Figure 8.6 relates to the equilibrium wage rate w, which is 

likely too low to persuade the voluntarily unemployed labour to reduce their leisure or 

other non-market activities and take a job. Some unemployed might wish not to work at all. 

However, it should be stressed that character of unemployment depends also on the 

decision of the firms, which examine the wage rate as well. There is no labour (hours) 

involuntarily unemployed at the real wage w, in the figure. 

8.4.1. Rate of Unemployment 

The previous example showed the optimum situation of its kind in the labour market. 

However, in real world, economies often suffer from involuntary unemployment. The 

International Labour Organization (ILO) and The Organisation for Economic Cooperation 

and Development (OECD) define an individual as unemployed if he or she does not have a 

job during the reference period and is actively looking for a job and is ready to work. Let’s 

characterise the labour force as the part of the population that is either working (L) or 

unemployed (U). The part of population excluded from labour force involves children, 

students at schools, retired people and persons that are not actively seeking for a job.

82 

Chapter 8 

If the total labour force is denoted as L s , we can write: 

L s = L + U 

labour force employment unemployment 

Rate of unemployment is given by following equation: u = U / L s . Rate of unemployment 

refers to a fraction of labour force, which is out of work. 

8.4.2. Involuntary Unemployment and Real Wage Adjustment 

To examine involuntary unemployment let’s use the model of labour market defined in the 

previous text. Figure 8.8 shows the situation, where the real wage prevailing in the labour 

market is fixed at ŵ. This wage is higher than the level w, which clears the market – or in 

other words – which equates supply and demand. At ŵ, firms want to hire Ľ labour, while 

workers supply L s . Actual level of employment is L’, because firms cannot be forced to 

demand more than they wish. Involuntary unemployment relates to distance L s – L’, 

which is labour supplied but not demanded by firms. Involuntary unemployment happens 

when households (individuals) supply labour at given wage rate ŵ, but cannot find a job no 

matter how hard they try. At point B, firms’ MPL (marginal product of labour) exceeds the 

valuation o leisure time by households, which are unemployed. Figure 8.8 helps us to 

explain the existence of involuntary by real wage rigidity. If real wage declined to w at 

point A, firms would increase their demand for labour and households would decrease their 

supply. Employment would move to L (as is shown in figure 8.6). All the remaining 

unemployment would be voluntary in that case. 

Household labour supply 

Real wage 

ŵ 

w 

B 

A 

Labour demand 

L’ 

L s 

Unemployment 

Figure 8.8 Involuntary unemployment. The real wage rate ŵ doesn’t clear the market because 

workers supply L s of labour whereas firms demand only L’. Involuntary unemployment is represented 

by L s – L’ , which is labour supplied by households but not demanded by firms. The labour market 

would clear at point A, if the real wage declined to w.


Wage rigidity (wage stickiness). Wages are rigid, or sticky, when the wage adjustment 

ensuring full employment is slow over time. 

Let’s explain some reasons for wage stickiness. 

• Collective bargaining: Insider-outsider model. Labour (or trade union) are 

employees’ organisations, which advocate interests of labour in a number of 

dimensions, most importantly, wages. However, the unemployed do not sit at the 

bargaining table. “While the unemployed would prefer firms to cut wages and create 

more jobs, firms effectively negotiate with the workers who have jobs, not with people 

who are unemployed. That has an immediate implication. It is costly to firms to turn 

over their labour force – firing cost, hiring costs, training costs – and, as a result, 

insiders have an advantage over outsiders. More important, threatening insiders that 

they will be unemployed unless they accept wage cuts is not very effective. People who 

are threatened may have to give in, but they will respond poorly in terms of their 

morale, effort, and productivity. It is far better to reach a deal with the insiders and pay 

them good wages even if there are unemployed workers who would be eager to work 

for less.” 2 

The insider-outsider model suggests that wages will not adjust unemployment 

considerably, and hence give a reason why economy remains longer in recession and do 

not return quickly to its full employment level. 

• Social minima. Social minima represent the minimum standards for income and 

earnings set by government because of social equity protection. Minimum wages 

establish the lowest level below which wages may not fall. This contributes to wage 

rigidity, and thus, involuntary unemployment. 

• Efficiency wages. According to efficiency wage theory, firms consider wages a means 

of motivating labour. The amount of effort workers make in work corresponds to how 

well the job is paid comparing to alternatives. Firms may be willing to pay wages above 

the market-clearing wage to ensure that employees work hard enough to avoid losing 

their good position. 

• Imperfect Information – Market Clearing. The imperfect information models 

consider wages as fully flexible. However, their adjustment is slow because of 

temporarily wrong expectations. Slow adjustment of wages originates from imperfect 

information about changing price-level and slow reaction of workers. 

2 Explanation of Insider-Outsider model from Dornbush-Fisher-Starz [7]; to explore more about this model see 

Lindbeck, A. - Snower, D.: Wage setting, Unemployment and Insider-outsider relations. American Economic 

Review, 76. 1986, p. 235-9.

84 

Chapter 8 

8.4.3. Types of Unemployment 

Let’s introduce three types of unemployment: frictional, structural, and cyclical. 

8.4.3.1. Frictional Unemployment 

Frictional unemployment refers to the fact that the labour market is ceaselessly moving. 

Thus, the amount of unemployment is always moving. People give up their jobs and 

looking for new ones. Seeking for new jobs lasts longer time because of imperfect 

information about vacancies. The workers sometimes don’t accept the first job, which is 

offered to them. The students after graduations or women finishing their maternal duty 

looking for their new jobs are also frictionally unemployed. 

Generally spoken, frictional unemployment – consisting of search unemployment and 

wait unemployment – is a term used for workers who are either searching for jobs or 

waiting to take jobs in the near future. 

This type of unemployment is considered as inevitable and somehow desirable. Frictional 

unemployment is a part of natural unemployment. 

8.4.3.2. Structural Unemployment 

Structural unemployment is connected with structural changes in an economy, such as 

changes in consumer demand or technology. These changes influence the structure of 

demand for labour in terms of demanded skills (occupationally) or location 

(geographically). 

Structural unemployment relates to the fact that some industries expand whereas others 

experience a decline in a dynamic economy. Unemployment occurs because the 

composition of the labour force does not react quickly or completely to the new structure of 

firms labour demand. Skills and talents of some workers become no longer marketable. 

Such workers are structurally unemployed due to a mismatch between their skills and 

the skills required by firms demanding labour. 

Demand for labour also varies over time geographically. Some firms may move from cities 

and its centres to industrial parks located in suburban surrounding areas. Some people can 

become structurally unemployed, due to a mismatch between their location and the 

location of firms demanding labour. 

If we want to find the key difference between frictional and structural unemployment, 

we must focus on the skills of the unemployed workers. Frictionally unemployed workers 

have saleable skills whereas structurally unemployed persons must be retrained or reeducated 

or geographically re-allocated so that they could find a new job. Comparing to 

short-term frictional unemployment, structural unemployment is considered more serious, 

because it lasts longer.


8.4.3.3. Cyclical Unemployment 

Cyclical unemployment is associated with cyclical fluctuations of the economy. It equals 

the difference between actual and natural rate of unemployment. Accordingly, this type of 

unemployment refers to output gap – the difference between potential and actual output. 

Cyclical unemployment occurs in situation where the business cycle is in recession. The 

main reason is a decline or deficiency of total spending. As the aggregate demand for 

goods and services declines, employment decreases and unemployment rises. Cyclical 

unemployment is, thus, sometimes called deficient demand unemployment. 

8.4.4. Definition of “Full Employment” 

The explanation of full employment is not as easy as it could seem. One might think it 

means that everyone in the labour market is employed, and thus, that unemployment is 

zero. In real, there is a part of unemployment, which is considered normal, warranted or 

natural. 

Frictional and structural unemployment are considered as essentially unavoidable in a 

dynamically developing economy. Hence “full employment” is something less than 100 

percent employment of the labour force. Specifically, the full-employment 

unemployment rate covers the total frictional and structural unemployment. In other 

words, the full employment unemployment rate occurs when cyclical unemployment is 

zero. 

The rate of unemployment relating to full employment corresponds to natural rate of 

unemployment. The aggregate output produced in the economy with the natural rate of 

unemployment is known as potential output. This level of output is produced with fully 

employed labour. 

8.4.5. Costs of Unemployment 

Economic costs 

Unemployment above the natural rate implies large economic and social costs. The basic 

economic cost of unemployment is the lost output. Potential output is not reached in the 

economy, which is unable to create enough jobs for all who are willing and able to work. 

This loss in output is measured by output gap – the difference between the level of actual 

and potential output. 

Another cost of unemployment is that its cost is unequally distributed. This burden of 

unemployment is connected with the fact that the lost wage income is not reduced 

proportionally across the society.

86 

Chapter 8 

Noneconomic costs 

Long lasting severe involuntary unemployment implies idleness, which causes the loss of 

skills, loss of self-respect, family disintegration, moral decline, and social unrest. Deep 

unemployment means more than a pure economic problem – it brings society into 

misbalance.

Inflation 87 

9. Inflation 

Contents: 

9. INFLATION ....................................................................................................................... 87 

9.1. MEASUREMENT OF INFLATION ....................................................................................... 88 

9.1.1. CPI vs. GDP Deflator ............................................................................................ 89 

9.2. THREE GRADES OF INFLATION ....................................................................................... 90 

9.3. SOURCES OF INFLATION................................................................................................. 91 

9.3.1. Demand-Pull Inflation............................................................................................ 91 

9.3.2. Cost-Push Inflation ................................................................................................ 92 

9.3.3. Inertial Inflation ..................................................................................................... 93 

9.3.4. Inertial Inflation and Expectations ........................................................................ 93 

9.4. NOMINAL VS. REAL INCOME .......................................................................................... 94 

9.5. NOMINAL VS. REAL INTEREST RATE .............................................................................. 95 

9.5.1. Inflation and the Fisher Principle.......................................................................... 95 

9.6. THE IMPACT OF INFLATION, COSTS OF INFLATION.......................................................... 96

88 

Chapter 9 

We speak about inflation when the general level of prices rises. When the price level 

increases, some prices may not rise, even in case of rapid inflation. Some prices may be 

relatively constant and others falling. One of the problems of inflation, as we will examine 

later in the chapter, is that prices doesn’t rise evenly. 

Inflation denotes a rise in the general level of prices. The rate of inflation is the rate of 

change of the general price level and is measured as follows: 

price level 

(year t) 

– 

price level 

(year t-1) 

Rate of inflation (year t) = 

price level (year t - 1) 

But how do we measure the “price level“ that is involved in the definition of inflation? 

Conceptually, the price level is measured as the weighted average of the goods and services 

in an economy. In practise, we measure the overall price level by constructing price 

indexes, which are averages of consumer or producer prices. 

Deflation is the opposite of inflation. Deflation occurs when the general level of prices is 

decreasing. Such cases happened very rarely in the late twentieth century. 

Disinflation is a related term, which denotes a decline in the rate of inflation. 

9.1. Measurement of Inflation 

We measure inflation by price-index numbers. A price index is a weighted average of the 

prices of a number of goods and services. To create such index we must assign a weight to 

each price by economic importance of the good. The most important price indexes include 

the consumer price index, the GDP deflator, and the producer price index. 

Consumer Price Index (CPI). This index, often called CPI, is the most widely used 

measure of inflation. Consumer price index measures inflation of a market basket including 

most often purchased consumer goods and services such as food, clothing, housing, 

transportation, education, medical care and others. 

As we have explained above, the price index is constructed by weighting each price 

according to the economic importance of the commodity in the basket. In the case of CPI, 

each item in the basket obtains a fixed weight proportionally to its relative importance in 

consumer expenditure budgets. 

GDP deflator. The GDP deflator refers to price of all component of GDP (including 

consumption, gross investment, government purchases, and net exports), because it is 

counted as a ratio of nominal GDP to real GDP. GDP deflator is a variable-weight index 

weighting prices by the current-period quantities, which also differ it from CPI. There are 

88

Inflation 89 

also specific deflators used by economists measuring price changes in selected sectors of 

economy such as personal consumption, investment goods. 

Producer Price Index (PPI). This index focuses on prices of goods, which are important 

during the production process. PPI measures the level of prices at the wholesale or 

producer level. It includes a plethora of commodity prices, such as prices of foods, 

manufactured products, and mining products. The net sales of the commodity are used for 

setting the fixed weights used to calculate the PPI. This index is widely used by firms, 

because of its ability to focus on detail. 

9.1.1. CPI vs. GDP Deflator 

GDP deflator is the ratio of nominal GDP to real GDP in a given year. Consumer price 

index (CPI) measures the cost of buying a fixed basket of final goods and services by a 

common consumer. There are three main differences between CPI and GDP deflator. First, 

the GDP deflator measures the cost of all aggregate output, which covers much wider 

group of goods than CPI does. The structure of a market basket used for measuring CPI is 

fixed – it is the same every year. However, the basket of goods measured by GDP deflator 

differs from year to year. Its composition depends on what is produced in the economy 

each year. The weights also change in GDP deflator’s basket depending on how much of 

given good was produced in a given year. Third, GDP deflator covers only prices of goods 

produced in domestic economy, whereas CPI involves also prices of imports. 

The difference mentioned as the second one in the previous text refers to a different way of 

counting the indexes. The weights of prices of different goods are fixed in case of CPI, 

whereas the GDP deflator assigns changing weights over years. 

GDPDeflator = 

∑ 

∑ 

j 

j 

p 

p 

j 

t 

t 

0 

× q 

× q 

j 

t 

j 

t 

CPI 

= 

∑ 

∑ 

j 

j 

p 

p 

j 

t 

t 

0 

× q 

× q 

j 

0 

j 

0 

The formulas of counting the indexes suggest that CPI uses a fixed basket (base-year 

quantities), whereas GDP deflator uses a changing basket (current quantities). The price 

index with a fixed basket of goods is called the Laspeyres index (CPI) and a price index 

with a changing basket is known as the Paasche index (GDP deflator). 

Example 1 : To see the effects of these different approaches to aggregating prices, consider 

the following example. Suppose that a major frost in a country destroys the kohlrabi crop. 

The quantity of kohlrabies produced falls to zero, and the price of the few kohlrabies that 

remain on grocers’ shelves is driven sky-high. Because kohlrabies are no longer part of 

GDP, the increase in the price of kohlrabies does not show up in the deflator. But because 

the CPI is computed with a fixed basket of goods that includes kohlrabies, the increase in 

the price of kohlrabies causes substantial rise in the CPI. 

1 See Mankiw [8]

90 

Chapter 9 

9.2. Three Grades of Inflation 

Inflation is usually classified into three categories according to the levels of severity: 

moderate inflation, galloping inflation, and hyperinflation. 

Moderate Inflation. Moderate inflation represents almost stable or slowly rising price 

level in the economy. A rise in prices is considered moderate if it reaches single-digit 

annual inflation rates. Under such price conditions, when prices are stable, money doesn’t 

lose its value. People trust money and are willing to write long-term contracts because they 

believe that money will have almost the same real value next year as it has now. 

Galloping Inflation. We call inflation galloping if it reaches double- or triple-digit range 

of 30,100 or 300 percent a year. Such rise in prices causes serious economic distortions. 

People hold only the necessary minimum amount of money needed for daily transactions. 

Financial markets lose their function; loans are set only at very high nominal interest rates. 

People prefer buying real assets such as houses and land than financial assets. Some Latin 

American countries, such as Argentina and Brazil, experienced very high inflation rates of 

50 to 700 during 1970s and 1980s. 

Hyperinflation. The cases when price level raises a thousand or million percent a year are 

called hyperinflation. Under such conditions money loses definitely its functions (medium 

of exchange, unit of account and store of value). The real demand for money 2 falls rapidly. 

People swap goods (barter) and economy experiences severe distortions. 

2 measured by the ratio of money stock and price level 

90

Inflation 91 

9.3. Sources Of Inflation 

Inflation can originate from demand side or supply side of an economy. Whatever is the 

source, the key problem about inflation in dynamic economy is its inertial momentum, 

which is hard to disturb or stop once is arisen. 

9.3.1. Demand-Pull Inflation 

Demand-pull inflation occurs when aggregate demand rises more rapidly than the 

economy’s productive potential (supply side), pulling prices up to get aggregate supply and 

demand in balance. Such shock in aggregate demand could originate from changes in 

consumers’ spending, investment, government spending or net exports. The central bank 

can also affects economic activity by its policy. 

P 

AD 

AD’ 

AS 

P‘ 

P 

E 

E’ 

Q* 

Q 

Figure 9.1 Process of demand-pull inflation. Expansion in aggregate spending shifts the AD curve to the 

right. With a steep AS curve it brings new equilibrium at point E’. Price level rises from P to P’. Demand-pull 

inflation has taken place. 

Figure 9.1 depicts the process of demand-pull inflation using the standard AS-AD model, 

respectively aggregate supply and aggregate demand curves. Let’s assume there is 

expansion of spending that pushes the AD curve upward to the right from the initial 

equilibrium at point E. The economy shifts to new equilibrium at point E’. The rise in 

demand caused increase in price level from P to P’ and thus demand-pull inflation.

92 

Chapter 9 

9.3.2. Cost-Push Inflation 

Demand-pull inflation was often used by the classical economists to explain the historical 

price movements. However, the inflation process changed during last century. Nowadays 

we may experience the significant rise in wages and prices even if potential output is not 

reached. Such type of inflation resulting from rising costs during periods of high 

unemployment and weakly used resources is known as cost-push or supply-shock inflation. 

A typical example of cost-push inflation is an oil-shock referring to rapid increase in prices 

P 

AD 

AS’ 

AS 

P‘ 

P 

E’ 

E 

Q* 

Q 

of oil or other inputs. 

Figure 9.2 Cost-push inflation. This type of inflation occurs when aggregate supply decreases. The rise in 

the price level is accompanied with a decline in output. The situation of rising inflation and increasing 

unemployment is called stagflation. 

Demand inflation occurs when aggregate spending exceeds the economy’s ability to 

supply goods and services at the existing price level. Aggregate spending pulls up the price 

level. 

Cost-push inflation occurs when a rapid rise in prices of inputs (increases in wages, prices 

of raw materials, oil etc.) push up per-unit production costs. Higher costs push up the price 

level. 

92

Inflation 93 

9.3.3. Inertial Inflation 

The crucial problem of inflation in dynamic economies is its inertial momentum. Inflation 

is highly inertial in modern times. The inertial or core rate of inflation is represented by the 

expected inflation, which is built into contracts and informal agreements. 

How long inertial inflation will last depends upon people’s expectations. It could persist for 

a long time in an economy, as long as people expect the inflation rate to remain at the same 

level. Once inertial inflation is built into the system, it is very hard to stop it. 

However, inertial inflation could be also disturbed by frequent shocks such as changes in 

aggregate demand, oil-prices, exchange rate fluctuations, changes in productivity and 

numerous others. This shocks brings rate of inflation above or below its inertial rate. In 

general, we can state that inertial inflation is disturbed by demand side or supply side (costpush) 

shocks. 

An ongoing (inertial) rate of inflation is reached in the economy if people have 

adapted their expectations to this rate. Such inertial inflation, which is built in the 

economy, tends to persist until it is disturbed by an economic shock. 

9.3.4. Inertial Inflation and Expectations 

Let’s answer the question why inflation has such strong inertia momentum. The economic 

conditions in the future are taken into account during the process of setting prices and 

wages. If there is a rapid rise in prices and wages in the economy, people expect a similar 

rise in the future. They will build their expectations into their price and wage decisions. 

Thus, such inflation really occurs. These kinds of expectations about high or low inflation 

are considered to be “self-fulfilling prophesies”. 

The process of inertial inflation is depicted in Figure 9.3 Let’s assume that initial 

equilibrium corresponds to potential output and that there are no supply or demand shocks 

in the economy. If people expect rise in prices and wages at 4 percent each year, average 

costs will increase at the same rate. Rise in costs will shift AS curve leftward at 4 percent 

per year. If there are no shocks in the economy, AD curve will move up as well at that rate. 

Accordingly, macroeconomic equilibrium shifts from E to E’ to E’’. Price level rises 4 

percent each year inertial inflation has been established at the same rate. 

Inertial inflation occurs when AS and AD curves are shifting constantly upward at 

the same rate.

94 

Chapter 9 

P 

AS’’ 

AS’ 

P‘‘=(1,04)P‘=(1,04) 2 P 

E’’’ 

E’’ 

AS 

P‘ = 1,04P 

P 

E 

E’ 

AD’ 

AD’’ 

AD 

Q* 

Q 

Figure 9.3 Inertial inflation relates to upward spiral of prices and wages when aggregate supply and 

demand move up steadily together. 

9.3.4.1. Wage – Price Inflationary Spiral 

Let’s start the explanation of wage-price inflationary spiral by the claims of labour unions 

for rise in wages. With the rising price level, labour unions will require increase in wages. 

However, unions may demand wage increases sufficient not only to cover last year’s price 

increases. They may collectively demand at the bargaining tables such increase in wages, 

which would also compensate the inflation anticipated during the future at the bargaining 

tables. Firms don’t want to risk strikes or some social unrest and will agree with such 

claims. To keep the profit, they will recoup raising labour costs by increasing prices of their 

products. Firms could boost their prices an extra nick to ensure their rising profits. 

Accordingly the overall price level increased further, which is the proper reason for other 

claims about wages for the labour unions. This implies another round of rising prices. As a 

result – inflationary spiral occurs, which refers to cumulative wage-price rises. 

9.4. Nominal vs. Real Income 

It is necessary to be clear about the difference between money (or nominal) income and 

real income. Nominal income is the number of currency units (dollars, euros etc.) obtained 

as wages, rents, interest or profits. Real income could be expressed as the amount of goods 

and services that could be purchased by nominal income. 

94

Inflation 95 

Our real income will rise in case that nominal income increases faster than the price level. 

A faster rise in the price level than in our nominal income will imply a decline in real 

income. These relationships could be approximately expressed by the following formula: 

Percentage 

change in 

real income 

Percentage 

= 

change in 

nominal 

– 

income 

Percentage 

change in 

price level 

9.5. Nominal vs. Real Interest Rate 

Economists distinguish between the nominal interest rate and the real interest rate. The 

problem of this distinction emerges because of the volatile price level inducing times of 

inflation or deflation. Nominal interest rate represents a rate that investors pay to borrow 

money. If we correct the nominal interest rate for effect of inflation (or deflation) we get 

real interest rate. 

9.5.1. Inflation and the Fisher Principle 3 

The rate of inflation independently influences money demand. An unexpected increase in 

the price level raises nominal money demand proportionately. In contrast, continuous price 

increases – inflation – reduce the purchasing power of money. For example, with a 10% 

annual inflation rate, a given stock of money in real terms is worth 10% less then a year 

later. 

The effect can be understood by the distinction between nominal and real interest rates. By 

definition, the real interest rate (r) is the difference between the nominal interest rate (i) and 

the expected rate of inflation (π e ): 

r = i - π e 

real interest 

rate 

nominal 

interest rate 

expected 

inflation 

For decision such as consumption and investment, we have seen that the interest rate is the 

one that matters. In principle, no one would lend money at a nominal interest rate lower 

than expected inflation because the interest payment does not compensate for the loss of 

purchasing power. Implicitly, at least, borrowers and lenders agree that a positive real 

interest rate should remunerate the lender. Over long periods, real interest rate should 

remunerate the lender. Over long periods, real interest rate shows no trend. The nominal 

rate can therefore be seen as the sum of the reward to the lender, or the cost of borrowing 

(the real interest rate), and expected inflation. This is just rewritten as: 

3 See Burda – Wyplosz [4] 

i = r + π e

96 

Chapter 9 

This relationship, known as the Fisher principle, shows that the negative effect of expected 

inflation on real money demand works itself through the nominal interest rate. The nominal 

interest rate includes both the forgone real opportunity cost (r) and the expected capital loss 

on the nominal value of the loan (π e ). The long-run stability of the real interest implies 

therefore that the nominal interest rate fully reflects expected inflation. The store-of-value 

and standard-of-deferred payment properties of money are eroded when its value in terms 

of the goods it can buy is deteriorating because prices keep increasing. 

9.6. The Impact of Inflation, Costs of Inflation 

At the beginning of the chapter we identified inflation as the rise in the general price level. 

The problem is that during periods of inflation all prices and wages do not raise at the same 

rate. This brings changes in relative prices. The diverging relative prices affect negatively 

the economy by following ways: 

• An uneven redistribution of income and wealth. The main redistribute impact works 

through its effect on the real value of people’s wealth. In general, unanticipated 

inflation helps those who have borrowed money and harms those who have lent money. 

In other words, unforeseen inflation redistributes wealth from creditors to debtors. An 

unanticipated disinflation (decline in the inflation rate) has the opposite effect. 

• Distortions in the relative prices and outputs of different goods, tax rates, real 

interests, or sometimes in output and employment for the entire economy. 

Anticipations. The impact of the redistribution effects of inflation depends upon people’s 

expectations. If inflation is expected fully (anticipated), lenders and other receivers of 

income may avoid or reduce the adverse impacts of inflation on the real value of their 

incomes. Accordingly, we can say in general, that unanticipated inflation is the rise in 

prices whose extent was not accurately foreseen or expected. 

Uneven redistribution of income and wealth and changing level and efficiency of 

production are the main impacts of inflation on economy. In such cases, that inflations and 

deflations are balanced and anticipated, all prices and wages are expected to shift by the 

same rate, without harming or helping anyone by its run. However, such situations are not 

very common. Unanticipated (unforeseen) inflation usually harms lenders or creditors, 

fixed-income receivers or “log-run” investors. This type of inflation may favour profit 

seekers, speculators and, of course, debtors. 

Considering the costs of inflation, stable prices belong to main goals of macroeconomic 

policy. Unanticipated inflation leads to failed investments, to discouraging of enterprises, 

and unforeseen income redistribution. Unbalanced inflation distort relative prices, tax rate 

and real interest rates. The policy aiming to lower accelerating rate of inflation is usually 

costly in terms of reduced output and employment, and thus, painful. 

96

Macroeconomic Policy 103 

11. Macroeconomic Policy 

Contents: 

11. MACROECONOMIC POLICY............................................................................... 103 

11.1. POLICY INSTRUMENTS............................................................................................ 105 

11.1.1. Fiscal Policy................................................................................................... 105 

11.1.2. Monetary Policy ............................................................................................. 106 

11.1.3. International Trade Policy............................................................................. 106 

11.1.4. Incomes Policies............................................................................................. 106 

11.2. MACROECONOMIC POLICIES AND GOALS IN PRACTISE........................................... 107

104 

Chapter 10 

Macroeconomic policy represents a crucial and powerful instrument for influencing the 

national economy. The way, how macroeconomic policy is designed and conducted, is a 

cardinal determinant of country’s living standards. The classical economists, influential in 

nineteenth and at the beginning of twentieth century paid a small attention on how to 

stabilise economy in the time of crisis. They actually didn’t believe in positive impacts of 

some governmental policy on a national economy. It was a pioneering theory by John 

Maynard Keynes, which helped to understand the forces causing economic fluctuations in a 

country. The works of Keynes and his successors suggested how to use macroeconomic 

policies (influencing government spending, money stock, redistribution of national income 

etc.) to smooth out the business cycle (economic fluctuations) and thus control 

development of unemployment, inflation, trade balance and other main economic variables 

in a country. 

If we want to examine the economic performance, we must set the proper macroeconomic 

indicators showing the objective results. In terms of evaluation of an overall performance in 

the national economy we set the key indicators such as gross domestic product (GDP), the 

unemployment rate, rate of inflation, and net exports. We use these indicators also as 

measures judging the efficiency of a selected macroeconomic policy. 

Table 11.1 includes the main goals and instruments of macroeconomic policy. 

There are four areas of an economy examining by the economists to evaluate the success of 

an economy’s overall performance: aggregate output, employment, price stability, and 

international trade: 

OBJECTIVES 

Aggregate output: 

High level 

Sustainable growth rate 

INSTRUMENTS 

Fiscal policy: 

Government expenditures 

Taxation 

Employment: 

High level of employment 

Low involuntary unemployment 

Price level stability 

under free markets 

Monetary policy: 

Control of money supply 

affecting interest rates 

Foreign economics: 

Trade policies 

Exchange-rate interventions 

International trade: 

Incomes policies: 

Export and import equilibrium Controlling the wage-price setting process 

Exchange-rate stability 

Table 11.1 Goals (objectives) and instruments of macroeconomic policy. The left-hand column includes 

the list of the main goals of macroeconomic policy. The major instruments or policies affecting economic 

performance of a country are listed in the right-hand column.


We can summarize the goals of macroeconomic policy as follows: 

1) A high and growing level of national aggregate output (real GDP) 

2) High level of employment (with low involuntary unemployment) 

3) A stable or gently rising price level, with prices and wages determined by supply 

and demand in free markets. 

4) Large international trade in goods, services, and capital, with a stable foreign 

exchange rate and exports balancing imports (trade balance). 

11.1. Policy Instruments 

Government and other state institutions 1 can use a range of instruments that can be used to 

affect macroeconomic activity in a country. These policy instruments can be expressed as 

economic variables under control of government that can influence one or more of the 

macroeconomic goals. In other words, fiscal, monetary, incomes and other policies might 

be used so that government could drive the economy towards required shape in terms of 

desired combination of output, employment, price stability and international trade. The 

policy instruments can be summarised to four major sets described in the right-hand 

column in the table 11.1. 

11.1.1. Fiscal Policy 

The taxes and government spending are the instruments used in a frame of fiscal policy. 

The government control its expenditures, which is government spending on goods and 

services (purchases of army equipment, building motorways or dams, paying salaries to 

state employees etc.) Government spending also affects the distinction between private and 

public sectors, that is how much of GDP will be consumed collectively rather than 

privately. The crucial function of government expenditure in terms of macroeconomics is 

that, government spending influences the total level of spending in the economy and thus 

affects the level of aggregate output (GDP). 

Government can use another tool in its fiscal policy – taxation. Taxes reduce people’s 

incomes. Thus, taxes decrease people’s disposable income that would be used for 

consumption. Accordingly taxes reduce the amount of aggregate consumption and in turn 

decrease demand for goods and services. The ultimate effect is slowing down the growth of 

real GDP (or a decline in real GDP as a whole). 

The taxes also work as a factor of motivation. High taxes reduce profits, increase prices and 

as a final effect they could discourage firms to invest in new capital goods or launch new 

business projects. 

1 For instance the national central bank represents the state institution pursuing monetary policy in a country. 

Most of central banks are independent on government in a majority of modern economies.

106 

Chapter 10 

11.1.2. Monetary Policy 

Monetary policy presents an instrument, which government or the central bank uses to 

control the nation’s money, credit, and banking system in a country. The main tool of 

monetary policy is controlling the money supply. Changes in money supply affect various 

financial and economic variables (interest rates, prices of stocks, bonds or exchange rates). 

Central bank can increase money supply in order to improve economy’s performance. 

Rising money supply lowers interest rates, which stimulates investment and consumption. 

Accordingly GDP rises. Conversely, the central bank can reduce money supply, which 

leads to an increase in interests, which in turn reduce investment, consumption and 

accordingly GDP and inflation. 

The issues from the area of monetary policy become very modern in these days. The 

serious research of usefulness and impacts of a national monetary policy became up-to-date 

due to forthcoming enlargement of European monetary union, which begun its history in 

1999. 

11.1.3. International Trade Policy 

Globalisation and internalisation have become very frequent terms in modern age. The 

economies become more closely linked; therefore policymakers pay more attention to 

international economic policy. The traditional approach in this field is the trade policy 

consisting of tariffs, quotas, and other devices that restrict or encourage imports and 

exports. These measures are established to protect domestic market and support exporters. 

However, it should be stressed that the opposite efforts – removing of free trade barriers - 

are obvious in these days over, particularly in Europe. 

An exchange-rate management is the second set of policies included in a frame of 

international economic policy. Exchange rate, which represents the price of its own 

currency in terms of the currencies of other nations, is one of the key determinants of a 

country’s international trade. There are different systems of exchange-rate management – 

free float systems, managed float systems or fixed exchange rate systems. The choice of a 

particular system reflects government approach to exchange rate controlling (i.e. fixed or 

free). 

11.1.4. Incomes Policies 

The incomes policies are put in place when the threat of accelerating inflation is emerging. 

The usual and traditional approaches to stable prices and lower inflation and stable prices 

are through some restrictive steps of monetary and fiscal policy. However, these ways are 

considered too costly in terms of reduced output and employment. Income policy represents 

an alternative of slowing down inflation through influencing of the wage-price setting 

process. It covers a range of measures from wage and price controls (as a strict measure in 

inflationary times) to less drastic measures like voluntary wage and price guidelines. Such 

policies controlling wages and prices are called incomes policies.


The efficiency of income policy is a controversial topic. The economists still argue if the 

income policy represents an inexpensive way to lower inflation or it is a simply ineffective 

policy disturbing the assumptions of free markets with a weak impact on rising prices. 

Summary: 

Let’s sum up the variety of instruments that can be used to reach macroeconomic goals. 

The four main areas include: 

Fiscal policy consists of government expenditures and taxation. Government expenditures 

influences the relative size of collective as opposed to private consumption. Taxation 

subtracts from incomes and reduces private spending; in addition, it affects investment and 

potential output. Fiscal policy affects total spending and thereby influences real GDP and 

inflation. 

Monetary policy conducted by the central bank determines the money supply. Changes in 

the money supply move interest rates up or down and affect spending in sectors such as 

investment, housing, and net exports. Monetary policy has an important effect on both 

actual and GDP and potential GDP. 

Foreign economic policies – trade policies, exchange-rate setting, and monetary and fiscal 

policies – attempt to keep imports in line with exports and to stabilize foreign exchange 

rates. Governments work together to coordinate their macroeconomic goals and policies. 

Incomes policies are government attempts to moderate inflation by direct steps, whether by 

verbal persuasion or by legislated wage and price controls. 

11.2. Macroeconomic Policies and Goals in Practise 

We should mention that reaching of the macroeconomic goals through chosen policies is 

not as easy as it could seem. There is a problem of trade-offs in macroeconomics in 

practise. To pursuit macroeconomic policy implies to choose among competing objectives. 

Lowering a high inflation rate requires either a period of high unemployment and low 

output of interference with free markets through incomes policies. Decline in domestic 

consumption and investment is needed in order to reduce trade deficits.

108 

Chapter 10

Fiscal Policy in Details 109 

12. Fiscal Policy in Details 

Contents: 

12. FISCAL POLICY IN DETAILS................................................................................... 109 

12.1. DISCRETIONARY FISCAL POLICY ................................................................................ 110 

12.1.1. Expansionary Fiscal Policy ............................................................................... 110 

12.1.2. Restrictive Fiscal Policy..................................................................................... 111 

12.1.3. Supply-Side Fiscal Policy................................................................................... 112 

12.2. NON-DISCRETIONARY FISCAL POLICY: AUTOMATIC STABILISERS............................. 114 

12.3. STRUCTURAL VS. CYCLICAL DEFICITS........................................................................ 115 

12.3.1. Financing the Deficits and Disposing the Surpluses ......................................... 115 

12.4. CROWDING-OUT EFFECT............................................................................................ 116 

12.5. PROBLEMS OF TIMING ................................................................................................ 116 

12.6. THE ADVANTAGE OF MONETARY POLICY .................................................................. 116

110 

Chapter 12 

The main tools of government’s fiscal policy are the budgets to control and record their 

fiscal affairs. The budgets include the expected revenues from tax systems on one side and 

the planned expenditures of government programs (education, health care, defence, 

welfare, etc.) on the other one. 

There are three situations describing the results of state finance. The government has a 

balanced budget when revenues and expenditures are equal during a given period. A 

budget surplus occurs when all taxes and other revenues exceed government 

expenditures. The most often situation is a budget deficit, which occurs when 

expenditures exceed taxes. 

To pay a budget deficit, government must borrow money from the public to pay its bills. 

The public purchase bonds issued by government that confirm to return money at some 

specified time in the future. The total value of government bonds owned by the public 

(households, banks, firms, foreigners, and other entities) referring to total or accumulated 

borrowings by the government is called the government debt. 

12.1. Discretionary Fiscal Policy 

Discretionary fiscal policy refers to the intentional or deliberate manipulation of 

government spending or taxes by government to influence GDP, stimulate economic 

growth, support employment and control inflation. “Discretionary” means that the changes 

in taxes and government spending do not occur automatically, independent of specific 

government action. Such measures are at the options of government. 

12.1.1. Expansionary Fiscal Policy 

Expansionary fiscal policy becomes useful when the business cycle is in its contraction 

phase. Let’ s suppose a large decline in investment spending has shifted the economy’s 

aggregate demand curve leftward from AD to AD’ in Figure 12.1. The figure describes an 

economy experiencing decline in output (recession) and cyclical (involuntary) 

unemployment. 

Government may use some form of fiscal policy to improve and stabilise the economy. 

Generally, there are three main alternatives of taking some fiscal actions: increase in 

government expenditures (1), cuts in taxes (2), combination of the previous two (3). A rise 

in government spending implies a government budget deficit (government spending 

exceeding tax revenues) in case that the deficit was in balance before that fiscal option. 

This rise in government expenditures (ceteris paribus) will move an economy’s 

aggregate curve to the right, as from AD’ to AD in Figure 12.1. The reduced taxes will 

bring the same effect, which is moving the aggregate demand curve rightward from AD’ 

to AD.


The combination of a rise in government spending and tax cuts will increase total 

spending, and thus aggregate demand, which should finally lead to the increase in GDP. 

P 

AD’ 

AD 

AS 

Q* 

Q 

Figure 12.1 Expansionary fiscal policy. In the recession phase government may increase its expenditures or 

reduce taxes to support aggregate demand and output. 

12.1.2. Restrictive Fiscal Policy 

Contractionary or restrictive fiscal policy may be used to slow down the process of 

rapidly growing aggregate demand. A very fast rise in aggregate demand resulted from a 

large increase in investment; consumption or net export spending can result in demand-pull 

inflation. To control it, government can decrease government expenditures (1), increase 

taxes (2), or use some combination of these two policies (3). In that case of demand-pull 

inflation, the mentioned fiscal actions might bring the government budget towards its 

surplus when tax revenues exceeds government expenditures.

112 

Chapter 12 

P 

AD’ 

AD 

AS 

Q* 

Q 

Figure 12.2 Restrictive (contractionary) fiscal policy. Government decreases its spending or increases 

taxes in order to slow down too rapid growth in total demand causing demand-pull inflation. 

Restrictive fiscal policy including reduced government spending or increased taxes reduces 

total spending, and aggregate demand respectively, and thus, controls inflation. This 

process is described in Figure 12.2. A restrictive fiscal action shifts the aggregate demand 

curve leftward to reduce total demand and control demand-pull inflation 1 . Government can 

combine spending decreases and tax increases to reduce aggregate demand and check 

inflation. 

12.1.3. Supply-Side Fiscal Policy 

The fiscal policy actions may also affect the aggregate supply curve. Particularly, it is the 

option of tax changes, which may alter aggregate supply and affect the level of total output 

and employment. 

Assume the aggregate demand AD and aggregate supply AS are at the equilibrium level 

corresponding to the level of real GDP Q 1 and the prices level P 1 in Figure 12.3. Let’s 

suppose the government consider the level of employment relating to Q 1 too low. 

Therefore it pursuits the expansionary fiscal policy in a form of reduced taxes. It results in 

a rise in aggregate demand from AD to AD’ which implies an increase in GDP to Q 2 and 

price level to P 2 . 

1 By controlling inflation we mean preventing prices from continuous rise bringing them to the initial level.


However, the tax cuts also affect aggregate supply. The economists supporting the idea of 

deliberate influencing aggregate supply conclude that the aggregate supply curve moves to 

the right from AS to AS’ due to tax cuts. This is the domain of supply-side economics. 

The supply-side economists suggest three main reasons to explain the impact of reduced 

taxes on aggregate supply 2 : 

1) Saving and investment. Reduced taxes will increase disposable incomes, 

increasing household saving. Tax reductions on businesses will also increase the 

profitability of investment. In brief, lower taxes will increase saving and 

investment, increasing the rate of capital accumulation. The size of the potential 

production capacity of the economy will grow more rapidly. 

2) Work motivation. Reduced personal income tax rates also increase after-tax wages 

from work and thus increase work incentives. Many people not already in the 

labour force will offer their services because after-tax wages are higher. Those 

already in the labour force will want to work more hours and take fewer vacations. 

3) Risk bearing. Lower tax rates encourage taking risks. Individuals and businesses 

will be more motivated and willing to risk their energies and financial capital on 

new production methods and new products when lower tax rates ensure a larger 

potential after-tax profit. 

These are the effects, through which reduced taxes move aggregate supply to the right from 

AS to AS’ in Figure 12.3. As a result real GDP rises with reduced inflation. 

P 

AD 

AD’ 

AS 

AS’ 

P2 

P3 

P1 

Q1 Q2 Q3 

Figure 12.3 Effects of fiscal policy on aggregate supply. In addition to the increase in aggregate demand 

increasing output and prices, reduced taxes induce the supply-side effects moving aggregate supply 

rightwards from AS to AS’. As a result an even larger output (Q 3 compared with Q 2 ) and reduced rise in price 

level (P 3 compared with P2) occur. 

Q 

2 See McConnel – Brue [10]

114 

Chapter 12 

12.2. Non-Discretionary Fiscal Policy: Automatic 

Stabilisers 

In examining the fiscal policy we can conclude that fiscal policy is very demanding for its 

permanent vigilance by the government authorities. We can think that somebody must 

always check ceaselessly the overall performance of the economy and decide what kind of 

fiscal action should be taken. In fact, there are inherent automatic stabilising properties, 

which are built-in the economy. These measures work automatically when recession or too 

rapid growth of aggregate demand accelerating inflation occurs. 

The public budgets are determined by the business cycle. In the phase of contraction the 

public budgets tend to go into deficit whereas during expansion of output the budgets tend 

to go into surplus. The net taxes 3 are strongly procyclical, thus, when incomes and 

spending rise, tax collection automatically rises, and conversely. On the other hand, public 

transfers including unemployment benefits, tend to decrease during expansion and rise 

when economy experiences recession. However, we should mention that government 

consumption is not affected by the business cycle, because it is a part of discretionary 

fiscal policy. 

When the economy slows down, the budget deficit will normally increase, or its surplus 

will shrink or even shift into deficit. This automatic lowering of taxes amounts to an 

implicit fiscal expansion. Conversely, a better-than-expected economic performance 

reduces the budget deficit or increases the surplus because of enhanced tax income for the 

government, a contractionary fiscal policy of sorts. In the end, we see that exogenous shifts 

in private demand are automatically cushioned – if not completely offset – by shifts in 

public demand: these are so-called: automatic stabilisers (or built-in stabilisers).They 

work in the absence of any policy action: simply by enacting the budget as approved by the 

parliament, the government finds itself conducting a countercyclical fiscal policy, 

dampening both recessions and expansions. 

What are these automatic stabilisers? They are primarily the following: 

1) Progressive tax system - automatic changes in tax receipts. The modern tax systems 

are based on progressive personal and corporate income taxes. (Progressive taxes mean 

that when income rises the average tax rate rises as well. This system is a useful 

automatic measure against the unexpected changes in economic performance. If total 

output (income) starts falling, tax receipts will automatically decline so that personal 

incomes and spending will be cushioned. This means that output will not decline as 

much as in case that the taxes would not decline. Conversely, a rise in tax revenues will 

reduce personal income, consumer spending and thus lower aggregate demand in 

inflationary times when upward spiral of prices and wages might accelerate. 

2) Public transfers - unemployment insurance, welfare, and others. The social 

security system includes various types of welfare transfer payments cushioning 

people’s loss in income. Unemployment insurance is the typical example. As soon 

employees are laid off, they begin to obtain unemployment insurance. These types of 

payments work in countercyclical, stabilising way because they prevent economy 

against rapid fall in consumption demand during recessions. The other welfare 

3 Net taxes refer to total taxes less transfers from the government to the private sector.


programs (such as aid to families with dependent children, handicapped people) etc. 

have similar dampening effect. 

An automatic stabiliser (built-in stabiliser) is anything, which increases the government 

budget deficit (or reduces its budget surplus) during a recession and increases its budget 

surplus (or reduces its budget deficit) during inflation without requiring explicit action by 

policymakers 4 . 

12.3. Structural vs. Cyclical Deficits 

Analysing the public finance of a country, we must distinguish between structural and 

cyclical deficits. The structural part of the budget is active. It is determined by the actions 

of discretionary policies such as size of defence spending, social security payments, and 

setting tax rates. Conversely, the cyclical part of the budget relates to the business cycle. It 

is passively determined by the fluctuations of GDP around its potential. 

Economists define structural and cyclical deficits as follows 5 : 

The actual budget records the actual expenditures (dollar, euro expenditures…), revenues 

and deficits in a given period. 

The structural budget calculates what government revenues, expenditures, and deficits 

would be if the economy were operating at potential output. 

The cyclical budget calculates the effect of the business cycle on the budget – measuring 

the changes in revenues, expenditures, and deficits that arise because the economy is not 

operating at potential output but is in boom or recession. The cyclical budget is the 

difference between the actual budget and the structural budget. 

12.3.1. Financing the Deficits and Disposing the Surpluses 

The final effect of the fiscal expansion on the economy depends on the way of financing 

the deficit. Similarly, the anti-inflationary impact of the creation of a budget surplus 

depends on what is done with the surplus. 

• Borrowing. When government decides to borrow money and enters the money market, 

its borrowings may compete with the private business borrowers. This additional 

demand crowds out some private investment spending and interest-sensitive consumer 

spending. The expansionary impact of the deficit government spending is thus reduced 

by a decline in private spending. 

• Money creation. The crowding out of private spending can be avoided by financing 

the deficit through newly crated money by government and monetary authorities. In that 

case, government may increase its expenditures without any adverse effect on 

investment or consumption. The effect of financing deficit by new money is more 

expansionary than by borrowing, however it is more inflationary. 

4 see McConnel,– Brue [10] 

5 see Samuelson-Nordhaus [11]

116 

Chapter 12 

12.4. Crowding-Out Effect 

Having mentioned the effect of financing deficit through government’s borrowing at the 

money market, we now move to a basic criticism of fiscal policy itself. This criticism is 

based on frequently discussed crowding-out effect. This effect describes the competition 

between government and private investors borrowing at money markets, which increases 

the interest rate and thus reduce private spending, Accordingly, the expansionary fiscal 

effect is weakened or cancelled at all. 

Let’s assume the economy is in the contraction phase (recession) of a business cycle. 

Government takes an action of discretionary fiscal policy in the form of increased 

government spending. Government borrows funds in the money markets to finance its 

budget deficit. The resulting increase in demand for money raises the interest rate as a price 

paid for borrowing money. Some part of investment or interest-sensitive consumption 

spending will be crowded out because investment spending varies inversely with the 

interest rate. 

12.5. Problems of Timing 

In addition to discussed problem of crowding-out effect there are some other problems 

associated with enacting and applying fiscal policy. In the case of fiscal policy, some 

problems of timing may arise. We can characterise the problem of timing through the lags: 

1) Recognition lag. The recognition lag refers to the time between the outset of some 

economic problems (such as contraction of output or accelerating inflation) and the 

actual recognition of those problems by economists. 

2) Administrative lag. This lag relates to the time between recognition of some 

problems in the economy and the moment when a fiscal action is actually taken. 

The administrative lag is typical for democratic governments with long and difficult 

ratification process. 

3) Operational lag. The impact of some fiscal action on output or employment 

doesn’t reveal immediately. There is a lag between a change in output, employment 

or the price level caused by the change in fiscal policy and the time when the 

relevant fiscal action was actually taken. 

12.6. The Advantage of Monetary Policy 

Most economists in these days prefer monetary policy as the main tool to stabilise the 

economy in the short or middle-run. Fiscal policy, according to them, should be used to 

deal with the nation’s investment-saving imbalances. In this view, the fiscal policy should 

be used to deal with some deep economic crisis in terms of a decline in output, 

employment or rapid growth in inflation. The advantage of monetary policy is that 

monetary policy can be changed quickly because of an independence of the central bank, 

which does not need any approval of parliament to use any chosen monetary measures 

such as change in credit conditions, interest rates or money stock. In addition to that, 

monetary policy is considered very effective in expanding or contracting the economy 

comparing to fiscal policy.

Monetary Policy in Details 117 

13. Monetary Policy in Details 

Contents: 

13. MONETARY POLICY IN DETAILS.......................................................................... 117 

13.1. TOOLS OF MONETARY POLICY ................................................................................... 118 

13.2. THE IMPACT OF MONETARY POLICY ON OUTPUT AND PRICES ................................... 119 

13.2.1. Transmission Mechanism: How Money Supply Affects Total Output................ 119 

13.2.2. The Money Market ............................................................................................. 120 

13.2.3. Supply and Demand for Money.......................................................................... 120 

13.3. MONETARY POLICY IN THE AS-AD FRAMEWORK...................................................... 122 

13.3.1. Monetary Effects in the Long Run...................................................................... 123

118 

Chapter 13 

Central banks have an important role in modern and highly developed countries. The main 

function of the central bank is to control money supply and credit conditions in the 

country. The central bank conducts national monetary policy, which should assist the 

economy in achieving the potential output (its non-inflationary level) and full employment. 

In addition to that fundamental objective, the central bank focuses on stabilising the price 

level in the country. The central bank may increase money supply in the economy to 

stimulate spending and investment during contraction of output. Conversely, it conducts 

restrictive monetary policy to slow down inflation and rapid rise in spending. Thus, a 

central bank may influence total output, employment and inflation by altering the supply of 

money in the economy. 

In fact, the central bank controls money supply by controlling the excess reserves held by 

commercial banks. These reserves play the key role in the money-creation process of the 

banking system in the economy 1 . In this chapter we will explain how altering money 

supply influences the nation’s interest rates, aggregate demand, total output and 

employment. 

13.1. Tools of Monetary Policy 

Figure 13.1 describes the relationship among the monetary policy instruments, 

intermediate targets and ultimate objectives. There is a number of policy tools 

(instruments) the central bank can use to influence the intermediate targets such as interest 

rates, reserves, and the money supply). Controlling intermediate targets is, in fact, the way 

to achieve the ultimate objectives (Stable prices, low unemployment and sustainable 

growth in real output) in the economy. 

• Open-market operations consist of dealing with government bonds by the central 

bank in the open market. The central bank is buying bonds from, or selling bonds to, 

commercial banks and the general public. The aim of such dealing in the open market is 

raising or lowering commercial banks’ reserves. The open market operations are 

considered to have the most stabilising effect in the variety of central bank’s policy 

instruments. 

• Reserve-requirements policy (the reserve ratio) influences the bank-system’s ability 

to create new money by lending. This policy covers altering the legal reserve ratio 

requirements on deposits in banks and other financial institutions due to controlling 

money supply as an ultimate objective. Lowering the reserve ratio leads required 

reserves to excess reserves and enhances the ability to create new money by lending 

within the bank system. Raising the reserve ratio increases the amount of required 

reserves bank must keep and thus banks lose excess reserves. This reduces the ability to 

create new money by lending and hence supply of money decreases in the economy. 

• Discount-rate policy allows the member banks borrow reserves from the central bank 

at the discount rate (set by the central bank). The central bank, as “a lender of last 

resort” provides funds to commercial banks, which reveal unexpected and immediate 

needs for additional financing. This is the case, when the central bank provides shortterm 

loans. The interest rate called the discount rate is the charge for the commercial 

1 To examine money-creation process see chapter 7.


banks, which lend funds from the central bank. These additional funds provided by the 

central bank extend credit of commercial banks and enhance the ability to create new 

money by the banking system. 

Open-market operations 

Discount rate 

Reserve requirements 

Reserves 

Money supply 

Interest rates 

Stable prices 

Low unemployment 

Sustainable growth in 

real GDP 

Instruments Intermediate targets Ultimate objectives 

Figure 13.1 The central bank uses its instruments to control intermediate targets so that the ultimate 

objectives could be reached. 

13.2. The Impact of Monetary Policy on Output and Prices 

Let’s describe the process of how the changes in money supply affect the ultimate 

objectives such as changes in total output, employment, prices and inflation. Such process 

is called the transmission mechanism. 

13.2.1. Transmission Mechanism: How Money Supply Affects 

Total Output 

We will describe the process by which the central bank affects output and the price level. 

Let’s use a concrete example, when the central bank has decided to slow down the 

economic activity because of rising inflation. The process is explained by following five 

steps: 

1) At the beginning, the central bank takes a restrictive monetary action towards 

reducing reserves. The central bank sells government bonds in the open markets to 

decrease the amount of reserves hold by commercial banks. It reduces total bank 

reserves in banking system. 

2) As we explained in chapter 7, a reduction in bank reserves produces a multiple 

larger contraction in checkable deposits. Accordingly, a nation’s money supply is 

reduced. 

3) Reduced money supply implies increased interest rates and tightened credit 

conditions. 

4) The higher interest rates will lead to a decline in the interest-sensitive spending 

especially investment. 

5) Finally, a decline in interest-sensitive spending will reduce aggregate demand, and 

thus, decrease total output, employment and inflation.

120 

Chapter 13 

We can summarise the steps as follows: 

R down → M down → i up →I, C, X down → AD down → real GDP down and P down 

13.2.2. The Money Market 

Let’s remind some facts about money demand and money supply for better understanding 

the transmission mechanism. A part of the mechanism refers to changes in interest rates 

and credit conditions caused by altering money supply. From Chapter 7 we know, that the 

part of demand for money undertaking transactions depends upon income. The other part 

of money demand, derived from the need for very liquid and super safe assets, is sensitive 

to interest rates – interest yields of other financial assets. 

The supply of money is influenced by the banking system including the commercial banks 

and the nation’s central bank. The central bank provides reserves to the banking system 

through the open-market operations and other monetary policy tools. Commercial banks 

then create deposits out of the central-bank reserves. The central bank can control the 

money supply by manipulating reserves more or less without some larger deviations. 

13.2.3. Supply and Demand for Money 

The market interest rate is jointly determined by the supply and demand for money. 

The supply and demand for money jointly determine the market interest rate. Figure 13.2 

depicts the total quantity of money (M) on the horizontal axis and the nominal interest rate 

(i) on the vertical axis. We assume the central bank manipulates its monetary instruments to 

control money supply at a given level. That’s why the money supply curve is drawn as 

vertical curve equal to level M* in Figure 13.2. 

Money demand curve is downward sloping showing the negative relationship between 

people’s willingness to hold money and interest rates. With higher interest rates people and 

firms prefer the assets bearing higher interest rate (interest yield) rather than no-yield 

money. 

The interest rates are the prices paid for the use of money. The market interest rate is 

determined by the intersection of the supply and demand curves as it is shown in Figure 

13.2. The money markets can be defined as the markets where short-term funds are lent 

and borrowed.


i 

MS 

i 0 

M* 

MD 

M 

Figure 13.2 The market interest rate is determined by demand and supply of money at the money 

market. The vertical supply-of-money schedule is exogenously determined by the central bank. The 

downward-sloping money demand schedule refers to negative relationship between money demand and 

interest rates. Equilibrium interest rate i 0 clears the market. 

Let’s examine the impacts of changes in the demand and supply of money in the money 

market 2 . Assume the central bank has decided to tighten monetary policy because of the 

threat of rising inflation. The central bank will reduce supply of money in the economy by 

selling government bonds. 

This case of a restrictive monetary policy (tight money) is described in Figure 13.3(a). 

Money balances will not meet people’s transaction and assets need at initial interest rate i 0 

as the money supply schedule moved leftward. People start to sell off some of their assets 

and increase their money holdings to reduce the gap associated with the extent of excess 

demand for money at the old interest rate. As the public tries to reach the desired moneystock, 

interest rates rise until the new equilibrium at level i 1 referring to E’. 

In the other case let’s assume the money supply is held constant by the central bank. The 

economy is affected by a shock in a form of rising prices due to increase in oil prices. 

Accordingly, the general price level rises and money desired to finance transactions 

increase with no change in real GDP. This situation is described in Figure 13.3 (b), where 

the demand for money would rise moving the money demand curve rightwards from MD to 

MD’, which force the equilibrium interest rates to increase. 

2 For broader descriptions of changes in money markets see Samuelson – Nordhaus [11]

122 

Chapter 13 

(a) Monetary Tightening 

(b) Money-Demand Shift 

i 

MS‘ 

MS 

i 

MS 

E‘ 

i 1 

E‘’ 

i 1 

E 

i 0 

M*‘ M* M* 

MD 

i 0 

E 

MD’ 

MD 

M 

M 

Figure 13.3 Interest rates affected by changes in monetary policy or prices. The panel (a) shows the 

impact of reduced money supply on interest rates. The impact of increased demand for money is described in 

the panel (b). 

There are two basic determinants of money markets: (1) the public’s desire to hold money 

(represented by the demand for money MD curve) and (2) the central bank’s monetary 

policy (which is shown in Figure 13.2 as a fixed money supply or a vertical MS curve at 

point M*). They jointly determine the market interest rate, i. A restrictive monetary policy 

(tight money) moves the MS curve to the left, which implies higher interest rates. A rise in 

overall price level or in national output moves the MD curve rightwards and increases 

interest rates. 

13.3. Monetary Policy in the AS-AD Framework 

In the previous text, we examined, how an increase in the money supply rises aggregate 

spending and thus aggregate demand. Accordingly, altering money supply influences 

macroeconomic equilibrium in terms of aggregate demand and supply model. 

As shown in Figure 13.4 the initial equilibrium corresponds to an economy in the situation 

with unemployed resources, output gap and relatively flat AS curve. The monetary 

expansion shifts the AD curve rightwards to AD’. The overall equilibrium also moves from 

E to E’. In this case the monetary expansion leads to an increase in prices and rise in real 

output. 

We can describe the process as follows: 

M up → i down → I,C, X up → AD up → GDP up and P up


Rise in money supply decreases market interest rates, which affects the interest sensitive 

spending particularly investment. Increase in spending pushes up the aggregate demand 

and thus real GDP and the price level. 

P 

AD 

AD’ 

AS 

E‘ 

E 

Q* 

Q 

Figure 13.4 Monetary expansion within AS-AD model. In case of unemployed resources and relatively flat 

AS curve, a rise in money supply shifts the aggregate demand curve rightwards and thus affects prices and 

real output. 

13.3.1. Monetary Effects in the Long Run 

Monetary policy is considered to be an effective tool of stabilisation in the short run. 

However, many influential economists believe, that the impact of a change in money 

supply diminishes in the long run. The final effect in the long term will be only an increase 

in prices and small or no change in real output. In terms of AS-AD model, the effect of 

some monetary action depends upon the shape of AS curve. As shown in Figure 13.4, 

monetary expansion shifts aggregate demand and affects GDP. This occurs in the short run, 

when the AS curve is relatively flat and there is an output gap and unemployed resources in 

the economy. 

In the long run, the AS curve becomes vertical, prices and wages tend to adjust and the 

output effect diminishes. Accordingly, the increase in money supply will turn up the overall 

prices whereas impact on real output is relatively small (or none) in the long run. The price 

effect will tend to dominate.

International Linkages 125 

14. International Linkages 

Contents: 

14. INTERNATIONAL LINKAGES.................................................................................. 125 

14.1. BALANCE OF PAYMENT .............................................................................................. 126 

14.1.1. The Balanced Accounts ...................................................................................... 127 

14.2. EXCHANGE RATES: FIXED AND FLEXIBLE .................................................................. 128 

14.2.1. Fixed Exchange Rate.......................................................................................... 128 

14.2.2. Flexible (Floating) Exchange Rates................................................................... 129 

14.2.3. Exchange Rate Regimes in Europe .................................................................... 129 

14.3. DEVALUATION, REVALUATION VS. DEPRECIATION AND APPRECIATION .................... 130 

14.4. EXCHANGE RATES DETERMINANTS............................................................................ 130 

14.5. PURCHASING POWER PARITY AND THE REAL EXCHANGE RATE................................. 131 

14.6. THE BALANCE OF TRADE ........................................................................................... 132 

14.7. CAPITAL MOBILITY, THE BALANCE OF PAYMENTS AND CAPITAL FLOWS .................. 133

126 

Chapter 14 

There is an obvious effort to remove the borders among nations in today’s world. 

Globalisation and internationalisation have become frequent terms. In this chapter we will 

examine the main linkages among the open economies and explain some main 

characteristics, variables and relations influencing international trade. 

Any economy is linked to the rest of the world through two broad channels: trade (in goods 

and services) and finance. 

The international trade linkages include imports and exports as the trade channel among 

economies. It is usual for a modern economy that some part of country’s production is 

exported to foreign countries whereas some goods that are consumed or invested in 

domestic country are produced and imported from foreign countries. Let’s present some 

examples of relatively closed and relatively open economies in the world. Whereas the 

United States is relatively closed economy, Netherlands is the opposite case. Dutch exports 

and imports each amount to about 60 percent of GDP, while in the case of USA it is 

roughly 10 percent 1 . 

International trade linkages are still important for the relatively closed economies as well as 

for the relatively open economies. Part of the income spent by domestic residents is spent 

on imported goods. This part is not spent on domestically produced goods and this amount 

of spending escapes from the circular flow of income in the economy. Conversely, demand 

for domestically produced goods is increased in the amount of exported goods. 

In addition, aggregate demand, output and employment are determined by the relative 

prices - prices of domestically produced goods compared relatively to prices of competing 

goods produced abroad. If domestic prices of competing goods produced in foreign 

countries decrease relatively to prices at which domestic firms sell, demand for domestic 

goods shifts away toward goods produced in foreign countries. In that case exports fall and 

imports rise. In the opposite case when domestic currency depreciates (its value declines 

relative to other currencies), exports rise and imports decline because domestic produced 

goods become relatively cheaper. In such case domestic and foreign demand move toward 

domestic goods 

The international financial linkages cover holding of domestic as well as foreign assets 

by domestic residents (households, firms, banks, etc.). Even though domestic households 

generally prefer holding domestic assets such us government bonds or corporation bonds, 

firms, banks and big corporations hold a variety of domestic and foreign assets. 

International dealing with assets connects the asset markets around the world and 

influences interest rates, exchange rates and thus national incomes in the economies. 

14.1. Balance of Payment 

The total numbers of all transactions, which take place among the domestic residents and 

foreigners, are covered in a nation’s balance of payment. It involves exports and imports of 

goods and services, tourist expenditures, dividends or interest obtained or paid abroad, and 

purchases and sales of financial or real assets abroad. 

1 See Dornbush – Fischer – Starz [7]


A nation’s balance of payments is the sum of all transactions, which take place between its 

residents and the residents of all foreign nations (rest of the world). These transactions 

include merchandise exports and imports, imports of goods and services, tourist 

expenditures, interest and dividends received or paid abroad, and purchases and sales of 

financial or real assets abroad. A country’s balance of payments is a systematic statement 

showing all the payments a nation receives from foreign countries and all the payments it 

makes to them. 

The balance of payments is the record of the transactions between the domestic residents 

and the rest of the world. It includes two main accounts: the current account and the capital 

account. 

The current account records all trade in goods and services, as well as transfer payments. 

Services include shipping, foreign travel, and interest payments. Services also include net 

investment earnings (income), which mean the interests and profits on domestic (our) 

residents’ assets abroad less the income foreigners earn on assets they own in domestic 

(our) economy. Transfer payments include gifts, grants and remittances. Basically, the 

current account includes the trade balance (recording trade in goods) plus invisibles. 

Invisibles cover trade in services and net transfers. 

There is a simple rule for balance-of-payments accounting we need to keep in mind: any 

transaction that gives a rise to a payment by country’s residents is a deficit item in 

that country’s balance payments. This means that the deficit (debit) items involve import 

of goods, purchases of assets abroad, gifts and grants to foreigners or financial transfers to 

foreign banks. Conversely, exports of domestically produced goods, interest payments from 

abroad or purchases of domestic assets by foreigners are the examples of the surplus 

(credit) items. 

If export exceeds imports plus net transfers to foreigners, that is, if receipts from trade in 

goods and services and transfers exceed payments on this account, we say the current 

account is in surplus 

The capital account records capital movements such as international loans, purchases and 

sales of assets including stocks, bonds, and the land. The capital account of a country is in 

surplus when receipts from the sale of stocks, bonds, land, bank deposits, and other assets 

obtained by domestic residents exceed payments made by domestic residents for purchases 

of foreign assets. 

The official reserves account is the third account in the overall balance of payments. The 

central banks of nations hold official reserves, which are quantities of foreign currencies. 

These reserves can be drawn on to make up any net deficit in the combined current and 

capital accounts. 

14.1.1. The Balanced Accounts 

We need to explain the basic relations between the accounts to understand the 

preconditions of country’s external balance. The key rule is that what is bought abroad 

must be paid. In case of an individual person: if spending exceeds income, the deficit must 

be financed by selling assets or by borrowing. Similarly, if a country runs a deficit in its 

current account, which means that receipts from exports do not reach the amount of

128 

Chapter 14 

expenditures for imports, the deficit must be paid by borrowing abroad or by selling assets. 

Accordingly net capital inflow equalizes (offsets) a country’s current account deficit. Such 

behaviour results in country’s a capital account surplus. 

External balance precondition: Current account deficit + net capital inflow = 0 

As we saw a current account deficit can be financed by private residents who sell off assets 

abroad or borrow abroad. However, the central bank also often contributes on financing this 

deficit by drawing on reserves of foreign currencies and selling them in the foreign 

exchange markets. Alternatively in case of current account surplus, the central bank may 

purchase the (net) foreign currency earned by the private sector and add that currency to its 

exchange reserves. Therefore the capital account is usually divided into two separate parts: 

the transactions of the country’s private sector and official reserve transactions, which 

correspond to the central bank activities. 

An overall balance of payments surplus occurs when official reserves increase. This 

situation is described by following equation 2 : 

Balance-of-payment surplus = increase in official exchange reserves 

= current account surplus + net private capital inflow 

The overall balance of payments could be in deficit when both the current account and the 

private capital account are in deficit. In that case the central bank is losing reserves. The 

overall balance of payments is zero – neither in surplus nor in deficit – if one account is in 

deficit and the other is in surplus exactly in the same amount. 

14.2. Exchange Rates: Fixed and Flexible 

Analysing systems of exchange rate we must distinguish between fixed and floating 

exchange rate systems. In case of fixed exchange rate, the central bank controls and 

maintains the national currency in terms of other currencies. Under the fixed exchange rate 

system, the central bank intervenes – sells or purchases national currency for foreign 

currencies in order to keep exchange rate stable at predetermined level. The other option is 

the flexible exchange rate regime, when the central bank may let the exchange rate float 

freely or with very limited room for interventions. The exchange rate regime could be a 

significant determinant of economy’s behaviour. 

14.2.1. Fixed Exchange Rate 

Under the fixed exchange rate regime the central bank stands ready to intervene i.e. buy 

and sell national currency for foreign currency at a fixed price in terms of domestic 

currency. Countries running this system usually fix (peg) their currencies to some stable 

foreign currency (or to a basket of stable currencies). 

How Interventions Work 

The central banks hold exchange reserves – foreign currencies, foreign assets – so that they 

could intervene if needed. The interventions mean influencing exchange rate towards 



required level - if exchange rate tends to deviate from the fixed trend. The central banks 

influence the exchange rate by buying and selling foreign exchange reserves for domestic 

currency in the foreign exchange market. For example, if the central bank tries to prevent 

an appreciation, which is the rise in external value, it sells its own currency and demand 

foreign assets. On the asset side of its balance sheet, foreign reserves rise, on the liability 

side, the monetary base is increased. In the case that the central bank desires to prevent 

from depreciation, which is the loss in external value of domestic currency, the central bank 

buys back its own currency on the foreign exchange markets and pays for it by drawing on 

its foreign exchange reserves. The stock of foreign assets decline and the monetary base is 

reduced since the domestic currency bought back in the foreign exchange market is 

effectively withdrawn from circulation. 

14.2.2. Flexible (Floating) Exchange Rates 

Under the flexible (floating) exchange rate system the central bank let exchange rate float 

freely. In this regime the central bank doesn’t control and maintain exchange rate 

permanently like in fixed rate regime and allow exchange rate to adjust to equate the supply 

and demand for foreign currency. On the contrary, under the fixed exchange rate regime, 

the central bank has to supply whatever amounts of foreign currency in case of payment 

imbalances to restore predetermined exchange rate trend. 

In the frame of floating exchange rate regime we can distinguish between clean (free) 

floating and dirty (managed) floating. In a system of clean floating, the central bank 

doesn’t intervene at all and stands aside. Exchange rate is thus completely determined by 

foreign exchange markets and central bank’s official reserve transactions are zero. 

Accordingly, under such system the balance of payment is never in surplus or deficit (it is 

zero). 

Under managed floating, central banks let exchange rate float freely, however they have 

the right reserved to intervene if needed. Therefore, central banks hold some amount of 

foreign exchange reserves and official reserve transactions are, thus, not equal to zero. 

14.2.3. Exchange Rate Regimes in Europe 

Burda and Wyplosz [4] give an overview of the exchange rate regimes in Europe. They 

used data provided by IMF. They conclude that at the beginning of 2001, European 

countries could be divided in five categories. A first category, the members of the European 

Monetary Union, has fixed exchange irrevocably among themselves by the adoption of a 

common currency, the euro. A second group includes countries, which did not join the 

monetary union and have instead fixed their exchange rate vis-ả-vis the euro. A third group, 

mostly from Eastern Europe, has pegged unilaterally to the euro or some combination of 

the euro and the US dollar. Some of them – Hungary for example – have an explicit 

programme of frequent depreciation, the so-called crawling peg. Countries in the third 

group do not declare any official parity but actively limit exchange rate fluctuations. 

Countries in the fourth group of „free floaters“ have freedom to set monetary policy, in 

principle. The countries that make up the fifth and final group have adopted currency 

boards: the peg to the euro allow the money base to change only when their foreign 

exchange reserves change.

130 

Chapter 14 

1) European Monetary Union: Austria, Belgium, Finland, France, Germany, Greece, 

Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain 

2) Euro-peggers (pegged to the euro): Denmark, Croatia, Hungary, Iceland 

3) Managed floaters: Norway, Sweden, Czech Republic, Finland, Latvia, Macedonia, 

Romania, Slovak Republic, Slovenia, Ukraine 

4) Free floaters: UK, Sweden, Albania, Moldavia, Poland, Russia, Switzerland 

5) Currency board: Estonia, Lithuania, Bosnia-Herzegovina, Bulgaria 

Source: IMF, Burda – Wyplosz (2001) 

14.3. Devaluation, Revaluation vs. Depreciation and 

Appreciation 

The terms devaluation, revaluation, depreciation and appreciation are very frequent in 

economic literature. Using these terms could be sometimes confusing. Let’s explain the 

actual meanings and differences of the terms. 

A depreciation and appreciation refers to a change in the price (value) of foreign currencies 

under flexible exchange rate regime. A currency depreciates when, under floating rates, it 

becomes less expensive in terms of foreign currencies. It means that the international value 

of the currency declines relative to another currency. Conversely, an appreciation refers to 

an increase in the international value of the currency relative to another one, which is that a 

currency becomes more expensive in terms of foreign currency. 

A revaluation or devaluation occur when the price of a currency is increased or decreased 

in terms of foreign currency under fixed rate regime by an official action. A revaluation 

thus means that residents of the revaluating country pay less for foreign currencies and 

foreigners pay more for the revaluated currency. A devaluation is the opposite of a 

revaluation. 

14.4. Exchange Rates Determinants 

Let’s examine what factors determine the changes in the price of a currency – the exchange 

rate. We will focus on factors causing appreciation or depreciation because the changes 

under fixed exchange rate regime (devaluation and revaluation) are always caused by an 

exogenous official action of government or the central bank. 

• Changing consumer preferences. Changes in consumer tastes or preferences for the 

products of foreign country may influence the demand for that nation’s currency and 

thus its exchange rate. If, for example technological advantages in German cars will 

make them more attractive to British consumers and businesses, then British will 

demand more euros so that they could purchase these cars. Supply of British pounds 

thus increases (the supply curve moves rightwards) and British pound depreciates. Euro 

appreciates. 

• Changes in national incomes. A country’s currency tends to depreciate if its national 

income raises more rapidly then that of other countries’. The reason is that a rise in 

imports is positively correlated with a rise in income. Thus, a country with higher 

growth in income will demand more foreign goods relative to a country with lower 

income growth. Households and businesses in expanding country will demand more


foreign currency and supply its national currency. Accordingly a currency in rising 

country depreciates and foreign currency appreciates. 

• Changes in the relative price-level. When, for example domestic price level rises 

more rapidly in a country relative to that of foreign country, the currency of an 

inflationary country (domestic) tends to depreciate. The rationale is that domestic 

residents will ask low-priced foreign goods and thus demand foreign currency and 

supply its own national currency. Accordingly foreign currency appreciates. 

• Speculation. The currency speculators are the risk-bearers dealing with currencies to 

earn profit. They buy, sell or resell currencies in order to profit from exchange rates 

fluctuations 3 . 

We could make following general conclusions (under ceteris paribus assumption) about 

changing exchange rates: 

• When a nation’s currency depreciates, some foreign currency appreciates relative 

to it and vice versa. 

• A currency appreciates if the demand for that currency in the exchange market 

increases. Conversely, if the demand for the currency declines, it depreciates. 

• A currency appreciates when its national supply declines. By contrast, if the 

supply of a nation’s currency increases, its currency depreciates. 

Dollar price of 1 Euro 

P 

$2 

1,5 

1 

Dollar 

depreciates 

Dollar 

appreciates 

Exchange 

rate: $2=€1 

S1 

D1 

Figure 14.1 The exchange market (Euro). 

The dollar price of euro is determined by supply 

and demand for euro. The equilibrium price of 

euro $ 2 is set by point of intersection of the 

curves. 

Q 1 

Q 

Quantity of Euro 

14.5. Purchasing Power Parity and the Real Exchange 

Rate 

The theory of purchasing power parity states that in a long run the exchange rate between a 

pair of countries is determined by the relative purchasing power of currency within each 

country. For instance if a pint of beer costs 3 USD in New York and the same amount of 

the same beer is 2 EUR in Brussels, thus we could expect that in some time the Dollar- 

Euro exchange rate would reach $1,5. Thus, according to the theory of purchasing power 

3 See McConnel- Brue [10]

132 

Chapter 14 

parity, or PPP two currencies are at purchasing power parity when a unit of domestic 

currency can buy the same basket of goods home and abroad 4 . The economic indicator 

measuring the relative purchasing power of two currencies is measured by the real 

exchange rate. 

This measure actually indicates the price of foreign goods and services in terms of domestic 

goods and services. We must differ between real exchange rate and nominal exchange rate, 

which could be defined as the price (value) of domestic currency in terms of foreign 

currency. To count real exchange rate we need to adjust the nominal exchange rate for the 

domestic and foreign prices of goods. 

We can express the real exchange rate, R, by following equation: 

R 

= 

eP 

P 

f 

The equation defines the real exchange rate as the ratio of foreign to domestic price 

levels, measured in the same currency. R is the real exchange rate whereas e is the 

nominal exchange rate. P is the domestic price level and P f is the price level abroad. The 

currencies are at the purchasing power parity, when the real exchange rate equals 1. Real 

exchange rate actually measures a country’s competitiveness in international trade. For 

example, if the real exchange rate overreaches 1 (a real depreciation), it means that goods 

abroad are more expensive than goods at home. A real exchange rate less 1 is the opposite. 

In real, it is difficult to reach PPP among currencies. The main reasons are that there are 

many barriers to the movement of goods between countries and that the market basket 

differs across countries. In addition to that many goods are so called “non-tradable” and 

cannot be exported or imported. 

14.6. The Balance of Trade 

In a close economy all the domestic output is sold t domestic residents. In this case the 

aggregate demand would equal to total spending of domestic residents. However, in an 

open economy part of spending by domestic residents escapes from the economy as 

expenditures for imports. On the contrary, a part of domestic output is purchased by 

foreigners. This part of GDP is exported. If we define A as a total spending by domestic 

residents, we can write: 

A = C + I + G 

Accordingly, total expenditures in domestic goods would equal: 

A + NX = (C + I + G) + (X – Q) = (C + I + G) + NX 

where X is the level of exports, Q is imports, and NX ≡ X – Q is the net exports or trade 

(goods and services) surplus. 



The determinants of net exports include domestic and foreign incomes and the real 

exchange rate. Domestic income, Y, influences expenditures for imports, foreign income, 

Y f , affects foreign demand for our exports and the real exchange rate, R, sets 

competitiveness of the domestic goods abroad. 

NX = X(Y f ,R) – Q(Y,R) = NX(Y,Y f ,R) 

We can summarise the relations influencing the trade balance as follows (under the ceteris 

paribus assumption): 

• An increase in domestic income increases expenditures on imports and therefore 

worsens the trade balance. 

• A rise in foreign income raises the expenditures on exports and thus raises 

domestic aggregate demand and improves the home country’s trade balance. 

• A real appreciation by the domestic country worsens the trade balance and 

therefore decreases aggregate demand. 

14.7. Capital Mobility, the Balance of Payments and 

Capital Flows 

Some of the well-known and influential economic models (e.g. Mundell-Fleming Model) 

work under assumption that capital is perfectly mobile. We consider capital perfectly 

mobile internationally when investors can buy assets freely in any country they want 

to, without obstructions, in whatever amounts, and with low transaction costs. In case 

of perfect capital mobility, asset holders are willing and able to shift large funds in order to 

seek for highest profit and lowest cost. 

However, such high degree of capital market integration implies, that the interest rates 

(interest yields of similar kind of assets) tend to similar level. With no barriers for capital 

mobility every deviation from a world’s interest rate will bring large (infinite) capital 

movements towards the highest yield. In terms of balance of payments perspective, a 

decline in domestic interest rate relative to that in foreign economies will cause a capital 

outflow. The domestic residents will be lending abroad the foreign investors will prefer 

buying financial assets abroad and this will accordingly lead to worsening the balance of 

payment. 

Looking again from the balance of payments perspective, the overall balance of payment 

surplus is equal to sum of the trade surplus, NX and the capital account surplus, CF: 

BP = NX (Y, Y f , R) + CF (i – i f ) 

To conclude we can summarise domestic and foreign income and the real exchange rate as 

the determinants of the trade balance and the interest differential as the determinant of a 

balance on capital account. Under the perfect capital mobility assumption, we can state that 

a rise in domestic income worsening the trade balance could be offset by an increase in 

domestic interest rates in order to ensure an overall balance-of-payment equilibrium.

134 

Chapter 14

Money Market, Money Supply, Money Demand 57 

7. Money Market, Money Demand, Money 

Supply 

Contents: 

7. MONEY MARKET, MONEY DEMAND, MONEY SUPPLY, 57 

7.1. MEANING OF MONEY 58 

7.2. EVOLUTION OF MONEY 58 

7.3. NARROW AND BROADER DEFINITION OF MONEY: MONETARY AGGREGATES 59 

7.3.1. A Narrow Definition of Money 60 

7.3.2. Broader Aggregates 60 

7.4. THE FUNCTIONS OF MONEY 61 

7.5. DEMAND FOR MONEY 62 

7.5.1. Transaction Demand for Money 62 

7.5.2. Asset Demand for Money 63 

7.5.3. Total Money Demand 63 

7.6. SUPPLY OF MONEY, BANKING SYSTEM AND MONEY CREATION 64 

7.6.1. Roles of Central and Commercial Banks in Money Creation Process 65 

7.6.1.1. Central Bank and Monetary Base 65 

7.6.1.2. Commercial Banks and Money Creation Process 65 

100 Percent-Reserve Banking 65 

Fractional-Reserve Banking 66 

7.6.2. Simplified Money Multiplier Formula 68 

7.7. THE MONEY MARKET 70 

7.8. THE QUANTITY THEORY 72

58 

Chapter 7 

7.1. Meaning of Money 

In the modern age it is not as easy to find the proper definition of money. Developed 

payment systems using cash and credit cards and computer and Internet revolution in recent 

times induced the need for specification and precise definition of the matter of money. 

Today, money doesn’t include solely banknote, coins or silver and gold. The use of sight 

deposits or e-money is on rise. People have become more familiar with plastic cards, 

Internet banking and with using so called near-monies. Accordingly the proper definition of 

money must be based on the specific enduring characteristics of money that give the true 

picture about the function and role of money in the human society. 

Let’s start with the definition of money as commonly accepted means of payment or 

medium of exchange. 

7.2. Evolution of Money 

At the beginning of the money story there was no money. People made the transactions 

through barter, which is the exchange of goods for other goods. Barter contrasts with 

monetary economy, in which people traded through money as the commonly accepted 

medium of exchange. 

The earliest kind of money was the commodity money. Chosen commodities such as 

copper, cattle, salt, wine, hides (pelts), gold, silver, diamonds, rings etc. were widely 

accepted mediums of exchange and therefore ensured the trade transactions. The 

disadvantages of the most of commodity money, which included difficult handling, 

storing, dividing into small changes, forced people to use selected commodities without 

those disadvantages. 

Accordingly, by the nineteenth century, the accepted commodities involved mostly the 

scarce and precious metals such as gold, silver or copper. The common character of these 

kinds of money is their intrinsic value denoting that they had use value in themselves. 

Hence, the quantity of money was determined by the market through the supply and 

demand for the precious metals and no monarch, ruler, crowned head or government had 

to guarantee their value in exchange. However, there are also disadvantages with using 

metallic money. Dealing and handling with large amounts of gold or silver was difficult 

and uncomfortable. In addition to that the accidental discoveries of ore deposits might 

influence scarcity and value of metallic money. 

The commodity money was replaced by the paper money. The kinds of paper money 

don’t have the intrinsic value resulting from their value in use themselves. The value of 

paper money, which made it wanted, results from things it can purchase. Money is not 

consumed. Money is used as a means of payment. The fact that we can spend money 

immediately or keep it and use it later on emphasised the function of money as a store of 

value. The scarcity of money is ensured by a ban on private or individual money creation. 

The paper money must be also protected from counterfeiting. People consider the paper


money a convenient medium of exchange therefore it has become widespread and widely 

accepted across nations. 

In today’s modern age the bank money are on rise. These kinds of money include checks 

written on funds deposited in banks or other financial institution. The modern bank systems 

also allow using plastic cash and credit cards, which reduce the use of the paper money. 

With developing Internet payment systems the e-money becomes more familiar to use in 

making e-transactions through the Internet. 

The evolution of money pointed out the fact that people considered money to be anything 

that served as a commonly accepted medium of exchange or means of payments. 

7.3. Narrow and Broader Definition of Money: Monetary 

Aggregates 

The broader meaning of money covers a vast variety of financial assets in economy. It 

includes currency, bank money or some complicated claims on other financial assets. All 

these kinds of money could be classified into four main monetary aggregates: currency, 

M1, M2, M3, and L. We usually consider currency or M1 as money, nevertheless the 

economists deal with all the monetary aggregates. 

The aggregates are aligned according to liquidity. We consider an asset liquid if we can 

use it instantly, directly, conveniently, and without larger costs to make payments. M1 

cover the most liquid assets whereas M3 includes the less liquid ones. 

The aggregate M1 is associated most closely with the traditional definition of money as the 

means of payment. M1 covers those claims that can be used directly, immediately, and 

without restrictions to make payments. The claims included in M1 are liquid. M2 includes 

M1 plus the not instantly liquid assets such as time deposits or saving deposits, which 

might require some notice to bank or other depository institution some time in advance. M3 

comprises, in addition, the repurchase agreements and large negotiable deposits. Such 

assets are mostly held by corporations or financial institutions. The aggregate L includes 

several liquid assets such as savings bonds, short-term government securities, etc. 

Shifting from M1 to M3, the interest yields of the assets increase whereas the liquidity 

decreases. The saving deposit accounts bears higher interest than the checking accounts. 

Currency bears no interest yield. The central banks and the economic public use M1 or M2 

as the most convenient measure for examining the effects of monetary policy or money in 

general on the economy.

60 

Chapter 7 

7.3.1. A Narrow Definition of Money 

Money in a form of currency including banknote, coins or the metallic money (in the past) 

has been considered the most trustworthy means of payment. Today, the use of such 

currency is rather limited because of using the bank deposit instead. So, the narrow 

definition of money covers currency holding by the public (households, firms, and 

government) plus the checkable or sight deposits (demand deposits or checkable accounts 

that are payable on demand). Accordingly, currency and sight deposits (as the generally 

accepted means of payment and the most liquid asset) are denominated as monetary 

aggregate M1. 

M1 = currency in circulation + sight deposits (checkable accounts). 

7.3.2. Broader Aggregates 

Banks often offer more attractive accounts than the sight or checkable deposits. The 

deposits included in M1 bear no or very low interest yield and cheques can be written or 

transfers can be made against them. The aggregate M2 includes, in addition, the savings 

(time) deposits with small time of maturity. Such funds can be very easily transferred into 

regular sight deposits – through a series of keystrokes on a telephone handset, an Internet 

connection or simply through a phone call. M2 is considered the second and a bit broader 

definition of money: 

M2 = M1 + time (or savings) deposits at banks with unrestricted access. 

The time of maturity, size of the assets and the access differ the aggregate M3 from M2. 

The aggregate M3 covers M2 plus the assets such as time deposits with a longer term of 

maturity and possibly restricted access, deposits denominated in foreign currency, large 

certificates of deposits, and deposits in non-bank institutions. The time of maturity and size 

of an asset, which differ M3 from M2, depend on local rules or conventions. In general, we 

can say that the aggregate M3 covers less liquid assets (that are costly and difficult to 

convert into currency or checkable deposits). On the contrary, such assets bear higher 

interest yield. 

M3 = M2 + larger, fixed-term deposits + accounts at non-bank institutions.


Table 7.1 The measures of money: money aggregates 1 

Symbol 

C 

M1 

M2 

M3 

L 

Assets included 

Currency in circulation 

Sum of currency in circulation + sight (or checkable) deposits (demand 

deposits, traveller’s checks, and other checkable deposits) 

M1 + small 2 time (or savings) deposits (including also money market 

deposit accounts, Eurodolars, and overnight repurchase agreements) 

Sum of M2 + larger time (or savings) deposits and term repurchase 

agreements 

Sum of M3 + savings bonds, short-term government securities, and 

other liquid assets 

7.4. The Functions of Money 

We can name three traditional functions of money in general. The first one and is the 

medium of exchange, which makes money inimitable and matchless comparing to other 

assets. The other two include the unit of account and store of value. 

1) Medium of exchange. In the barter economy people exchanged goods for other 

goods instead of using money. However there were a plethora of difficulties with 

this type of trading. The teacher of dance wanting new clothes would have to find a 

tailor wanting to be taught to dance. The modern economies couldn’t operate 

without a widely accepted medium of exchange. Money eliminated the need for the 

coincidence of wants among people operating in barter. 

2) Unit of account. Money serves also as a unit of account. It means, that people use 

units of money as a yardstick for measuring the relative worth of the vast variety of 

resources, goods and services. Using money, we don’t need to set the value of each 

product in terms of other products that are the subjects of exchange. Instead, money 

serves as an instant denominator, which means that the prices of all products are set 

only in terms of money units, which allow buyers and suppliers to instantly and 

easily compare the prices of whatever products and resources. 

3) Store of value. This function makes money an asset keeping its value. Money 

serves as a store of value, because it is the most liquid and generally accepted asset 

allowing the owner to make purchases today or in the future. Thus, money is a 

convenient way to keep individual’s wealth. This function is a necessary condition 

for the wide acceptance of money as a medium of exchange. If money didn’t keep 

its value. It wouldn’t be accepted as a medium of exchange. To be precise there are 

more assets such as bonds, stocks, and houses serving also as stores of value. 

1 To find more about the components of money stock see Mankiw [9], McConnel – Brue [10], or Samuelson – 

Nordhaus [11]. 

2 Small savings deposits are usually less than $100 000 whereas the larger deposits exceed that level.

62 

Chapter 7 

However such assets are not money because they don’t serve as a mediums of 

exchange or units of account due to their low liquidity. 

7.5. Demand for Money 

Before we start examining the demand for money we must make a clear distinction among 

money as the most liquid asset (including cash, checking accounts and closely related 

assets) and the other less liquid assets bearing interest such as bonds. The demand for 

money describes wants of people to held money instead of other assets bearing higher 

interest yield. To explain the demand for money, we must ask why people want to hold 

money. In general, there are two reasons for holding money: to make purchases with 

money and keep money as an asset. 

7.5.1. Transaction Demand for Money 

Money serves as a medium of exchange, which makes it convenient for purchasing goods, 

services or resources. Households hold money to pay for their daily needs – to buy food, 

clothes, pay for services. Firms must hold enough money to pay for all resources engaged 

in production process (such as labour, power, materials etc.). All these purchases for 

holding money forms the transaction demand for money. 

Figure 7.1 describes the transaction demand for money as a relation between the total 

amount of money demanded (M) and the interest rate (i). The vertical curve depicts the 

independence of transaction demand for money on the interest rate. The basic determinant 

of the transaction demand for money is nominal GDP. The amount of money demanded 

for transactions varies directly with the level of nominal GDP, because the larger 

nominal GDP implies larger money value of goods and services exchanged in the 

economy. Accordingly, the larger amount of money is needed to deal with these 

transactions. Rising nominal GDP shifts the curve of the transaction demand for money to 

the right. 

i 

D t 

M 

Figure 7.1 Transaction demand for money. Vertical curve of transaction demand for money reflect its 

independence on interest rates. It shifts with changes in nominal GDP.


7.5.2. Asset Demand for Money 

People also want to hold money as a form of their wealth. This reason for holding money 

results from the money’s function as a store of value. However, the public can decide in 

what form to keep its wealth. There are many other financial assets keeping the value such 

as private or government bonds, corporate stocks, state securities etc. Accordingly, the 

money’s function as a store of value implies an assets demand for money. 

The curve of an asset demand for money describes negative (inverse) relationship between 

amount of money demanded for asset reasons and the interest rate. The level of interest rate 

indicates the average interest yield of other less liquid financial assets, and thus, the 

opportunity cost of holding money. If this interest rate is high, people would prefer holding 

other financial assets, such as bonds, because the opportunity costs of holding money 

would be too high. In that case the asset demand for money would be small. The low 

interest rate induces people to hold money, as assets and the asset demand for money 

would be large. 

i 

D m 

Figure 7.2 Asset demand for money. Negatively sloped curve M of the asset demand for money describes the 

inverse relationship between demand for money and interest rates. 

7.5.3. Total Money Demand 

Figure 7. describes the curve of total demand for money, formed by horizontal adding the 

assets demand to the transaction demand. The total money demand curve represents the 

total amount of money people demand to make purchases and hold as an assets at each 

given interest rate. 

The negative slope of the curve reflects the inverse relationship among the total money 

demanded and the interest rate. The higher interest rate, the higher opportunity cost of 

holding money and the lower willingness of people to hold money as an assets. The low 

level of interest rate indicates higher demand for money as an asset. The position of the 

curve is influenced by the total nominal GDP. A rise in nominal GDP shifts the total money 

demand curve to the right, whereas a decline in demand for money shifts it to the left.

64 

Chapter 7 

i 

MD 

M 

Figure 7.3 Demand for money. People want to hold money so that they could make transactions (buy goods 

and services) and to keep money as a store of value (assets purposes). Accordingly, the total demand for 

money is the sum of the transactions and asset demands. It is depicted as a negatively sloped curve reflecting 

the inverse relationship between the interest rate and the quantity of money demanded. 

7.6. Supply of Money, Banking System and Money 

Creation 

The money supply refers to the quantity of money available in the economy. In the 

monetary economy based on using coins, paper money and bank money, the government 

(or the central bank) controls the supply of money. The government has got a monopoly on 

printing and regulating bank notes, which make money scarce and accepted. Altering the 

money supply belongs to the policy instruments such as the taxation or government 

expenditures. 

The central (national) banks control money supply in the majority of modern economies. 

The central bank is usually more or less independent institution controlling the money 

supply in a frame of its national monetary policy. Central banks alter the money supply 

through the open-market operations including the sales and purchases of government 

bonds 3 . To increase the quantity of money in circulation, the central bank purchases 

government bonds from the public. Conversely, the money supply is reduced by selling 

bond to the public. 

3 The instruments and the goals of central banks are described in details in Chapter 13 explaining the 

fundamentals of monetary policy.


7.6.1. Roles of Central and Commercial Banks in Money Creation 

Process 

7.6.1.1. Central Bank and Monetary Base 

The central bank represents the highest monetary authority in a country. It is usually a 

public or quasi-public agency, independent or partially dependent on government in terms 

of policy making. The exclusive legal mandate of the central bank to control money and 

credit conditions and keep the stable price level is in most cases explicitly set down in the 

nation’s legal constitution. It serves as the ‘banker’s bank’ providing funds to the 

commercial banks, controls the credit conditions or deals with claims of the commercial 

banks settled against each other. The most important function of the central bank is to 

ensure the price stability in the economy and to guarantee the value of the currency in 

terms of foreign linkages. To reach that aim, the central bank uses its instruments such us 

issuing currency (component of M1) or creating bank reserves. These represents the claims 

on the central bank held by commercial banks. The total sum of commercial bank reserves 

and currency in circulation is called the monetary base or high-powered money (M0). 

7.6.1.2. Commercial Banks and Money Creation Process 

The traditional function of commercial banks is to serve as the financial intermediaries. 

They link the supply of temporarily free funds of savers (by collecting funds from 

depositors) with the demand for these funds by borrowers. In addition, the commercial 

banks ensure the payment-clearing process among their customers. However, their main 

acquisition is their role in the money-creation (supply-creation) process. In real, a large part 

of the money supply consists of the bank deposits created by the commercial bank system 

within the money-creation process. The other financial institution such as brokers, saving 

banks or various types of the thrift institutions cannot legally lend more then they obtained 

in deposits, which prevent them from contributing to money-creation. The commercial 

banks have the right to keep just a fraction of deposits in reserves therefore they have the 

money-creating function. 

The explanation of the difference between the 100-Percent-reserve banking and fractionalreserve 

banking 4 will help us understand the essence of the money-creation process. In a 

nutshell, the condition of that process is that the commercial banks lend money that they do 

not directly possess. 

100 Percent-Reserve Banking 

Let’s start like G. Mankiw [8] by imagine of the world without bank. The only form of 

money is the currency, and the total amount of money holding by the public is the total 

quantity of money in such economy. 

Now, let’s introduce banks. Let’s assume that the banks do not provide loans and hold all 

the received deposits in reserves. Part of the reserves is kept in the banks’ vaults and the 

rest is held at a central bank. Such system is called 100-percent-reserve banking, because 

4 See Mankiw [8]

66 

Chapter 7 

all deposits are held as reserves until the depositor makes a withdrawal or writes a check 

against the balance. 

Suppose that is the total quantity of money in the economy is $1,000 and that people 

deposit this entire amount in Firstbank. The balance sheet consisting of the assets and 

liabilities of Firstbank is depicted in Figure 7.4. Reserves on the assets side equal the 

$1,000; the liabilities of the bank are the same amount of $1,000. First bank must keep 100- 

percent reserves therefore it makes no loans. The only profit is likely a small charge for 

using the bank’s vaults by the depositors. The intention for using the bank by a depositor is 

the safety of money kept in Firstbank. 

Fisrtbank's Balance Sheet 

Assets 

Liabilities 

Reserves $1,000 Deposits $1,000 

Figure 7.4 A Balance Sheet Under 100- 

Percent-Reserve Banking. A bank’s balance 

sheet shows its assets and liabilities. Under 

100-percent-reserve banking, banks hold all 

deposits as reserves. 

Let’s examine the impact of that process on the money supply. Before using Firstbank, the 

supply of money was $1,000 of currency. Recall the money supply consists of currency and 

bank deposits. Using Firstbank by a depositor reduced currency by the $1,000 and raised 

the demand deposits by $1,000. Thus, the money supply remained unchanged. To 

conclude, the banking system has no influence on the supply of money, if banks keep all 

its deposits (100 percent) in reserves. 

Fractional-Reserve Banking 

Now, let’s start with an assumption that banks use some of their deposits to make loans. 

Such banks can charge the interest on the loans provided - for example to firms for 

investing new equipment or to families buying new house or garden. The banks must hold 

some reserves to provide cash whenever depositors want to make withdrawals. However, 

as long as the amount of new deposits approximately equals the amount of withdrawals, a 

bank need not to keep all of its deposits to reserve. That’s why the bankers are motivated to 

make loans. Under the fractional-reserve banking the banks hold only a part of all their 

deposits in reserves. Assuming that the reserve-deposit-ratio (the fraction of deposits hold 

in reserves) is 20 percent. The balance sheet of Firstbank providing a loan is depicted in 

Figure 7.4. The asset side consists of $200 kept in reserves and remaining $800 as a loan. 

The initial deposit of the $1,000 is on the liability side.


A. Firstbank's Balance Sheet 

Assets 

Liabilities 

Reserves $200 Deposits $1,000 

Loans $800 

C. Thirdbank's Balance Sheet 

Assets 

Liabilities 

Reserves $128 Deposits $640 

Loans $512 

B. Secondbank's Balance Sheet 

Assets 

Liabilities 

Reserves $160 Deposits $800 

Loans $640 

Figure 7.4 Balance Sheets Under Fractional- 

Reserve Banking. This figure shows how $1,000 in 

reserves leads to a much greater quantity of deposits. 

Thus, under a fractional-reserve system, banks create 

money. 

Examining the impact on the money supply, we can see that Firstbank increases the supply 

of money by $800 when it makes this loan. Initially the money supply was $1,000, which is 

the total amount of deposits in Firstbank. This sum increased to $1,800 after the loan is 

made. The money supply consists now of the depositor’s demand deposit of $1,000 and 

$800 of currency holding by the borrower. Accordingly, under a system of fractionalreserve 

banking, banks create money. 

The money creation process does not stop with the Firstbank. The process continues as 

long as the borrower pays to someone who deposits the $800 in another bank or the 

borrower deposits the whole sum to a bank himself. Figure 7.4 shows also the balance sheet 

of Secondbank. The sum of $800 obtained in deposit is divided into $160, (20 percent of 

deposit, which must be kept in reserves) and $640, which could be used also as a loan. 

Assume Thirdbank receiving this deposit, it holds 20percent, or $128, in reserve and 

provides a loan of $512, and so on. Every additional deposit and loan create new money 

and increase money supply. 

By how much does the money supply increase? The process could evoke a false conviction 

that the possible infinite amount of bank could produce an infinite amount of money. 

Assuming reserve-deposit ratio as rr = 0,2 (20 percent in our example), the initial $1,000 of 

deposit create following increase in money supply:

68 

Chapter 7 

Original Deposit = $1,000 

Firstbank Lending = (1 – rr) x $1,000 

Secondbank Lending = (1 – rr) 2 x $1,000 

Thirdbank Lending = (1 – rr) 3 x $1,000 

. . 

. . 

. . 

Total Money Supply = [1 + (1 – rr) + (1 – rr) 2 + (1 – rr) 3 + …1 x $1,000 = (1 / rr) x $1,000 

Accordingly, each rise in reserves by $1 generates $ (1 / rr) of created money. In our 

example, rr = 0,2, so the original $1,000 generates $5,000 of money 5 . 

7.6.2. Simplified Money Multiplier Formula 

The relation between an excess reserves and required reserve ratio, rr (or m), described 

above, is known as the so-called “money multiplier”. It indicates that an injection of $1of 

excess reserves into the banking system can result in creation of $1 / rr (or $1 / m) in new 

money. The effect of money multiplier on monetary base (high-powered money) is 

depicted in Figure 7.5. 

Currency Reserves 

High-powered money(H) 

Currency 

Deposits 

Money stock (M) 

Change in money supply = (1/m) x Change in excess reserves. 

Figure 7.5 Relation between high-powered money and the money stock 

5 See Mankiw [8]


High-powered money (or the monetary base) consists of currency (notes and coins) and 

banks’ deposits at the central bank. 

The money multiplier is the ratio of the stock of money (M1) to the stock of high-powered 

money (M0 or H). 

i 

MS 

M 

Figure 7.6 Supply of money. The money supply consists of the amount of currency in circulation and the 

demand deposit. The vertical curve of money supply indicates that supply of money in the economy is 

independent (not sensitive) to the level of interest rate.

70 

Chapter 7 

7.7. The Money Market 

The money market consists of the demand for money and the supply of money. The point 

of intersection of the curves determines the equilibrium interest rate. 

i 

MS 

i 0 

M* 

MD 

M 

Figure 7.7 Equilibrium in the money market. 

Figure 7.7 shows the equilibrium situation in the money market. The money supply curve 

is vertical, showing its independence on the interest rate. The position of this curve is 

determined by changes in money stock, which are exogenous. The total quantity of money 

and altering money supply (such as M1) is in the option of the central bank. The position 

and the slope of the money demand curve are determined by the transaction and asset 

demand for money. The point of intersection determines the equilibrium rate of interest i 0 . 

Let’s examine the changes in equilibrium in the money market. The left part of Figure 7.8 

portrays the influence of increasing economic activity on the money market equilibrium. 

Assuming the supply of money unchanged. A rise in GDP will induce rise in demand for 

money. The money demand curve shifts to the right until the new point of equilibrium E’ is 

reached. As a result the equilibrium interest rate rises. With money supply unchanged a rise 

in demand for money, cannot increase in equilibrium. The interest rate must rise until its 

effect on demand exactly offsets the positive effect of rising GDP. In the right part of the 

figure, the effect of an exogenous increase in money supply is depicted. The curve of 

money supply shifts to the right until the new point of equilibrium E’. It lowers the 

equilibrium interest rate.


i 

MS 

i 

MS 

MS‘ 

E‘ 

E 

E 

MD 

E‘ 

MD 

M 

MD 

M 

Figure 7.8 Changing equilibrium in the money market. A rise in nominal GDP induces a rising interest 

rate until the equilibrium is restored. A rise in the money stock reflecting an expansionary monetary policy 

shifts the curve of money supply to the right. An equilibrium interest rate must decline to clear the money 

market. 

In examining the changes in equilibrium in the money market a question can emerge - how does the money 

market clear? A decline in the money supply creates temporary shortage of money; because with money 

demand unchanged the public (households and firms) demand more money than they hold (money supply). 

To gain more money people sell bonds. The excess supply of bonds lowers the bond prices, which push up 

the interest yields. With higher interest rates people reduces their demand for money – the amount of money 

they want to hold – until the supply of money matches the demand for money. The equilibrium interest rate 

clears the money market. 

i 

MS 

Surplus of 

money 

i e ‘‘ 

Shortage 

of money 

i e 

i e ‘ 

MD 

M 

Figure 7.9 Process of restoring equilibrium in the money market.

72 

Chapter 7 

A rise in the money supply is the opposite case. People hold more money than they wish, 

which results in increased demand for bonds. The excess demand for bonds raises the bond 

prices and reduces interest yields. Decreasing interest rate increases demand for money 

until the equilibrium is restored. The equilibrium interest rate clears the money market 

again. 

7.8. The Quantity Theory 

The quantity theory of money resulted from the old question of what is the relation among 

money, prices and output. Many centuries ago people were interested how the amount of 

money influences the total production in a country. The modern result of that interest is the 

quantity theory of money expressed by the famous quantity equation. 

M × V = P × Y 

The quantity equation provides a very simple link among the price level, the level of output 

and the money stock. Assumptions that both V 6 (the income velocity of money) and Y (real 

output, also labelled as Q) are fixed made this theory the classical quantity theory of 

money. In real, the classical assumptions of output remaining at the potential level and 

fixed velocity of money do not always hold. In spite of that fact, holding these 

assumptions, it is interesting to conclude that the price level is proportional to the supply of 

money. Accordingly, the classical version of quantity theory of money was, in fact, the 

theory of inflation. 

The classical version of quantity theory of money suggests that the price level is 

proportional to the money stock: 

P 

= 

V 

× M 

Y 

Assuming constant V, changes in the money supply lead to proportional changes in 

nominal GDP, P× Y . Under the classical assumptions, Y is fixed at the potential level. 

Thus, changes in the money supply cause the proportional changes in the overall price 

level, P. 

6 The income velocity of money refers to the number of times the stock of money is turned over per year in 

financing the annual flow of income. It is equal to the ratio of nominal GDP to the nominal money stock. 

P × Y Y 

V = = 

M M P

The Phillips Curve 97 

10. The Phillips Curve 

Contents: 

10. THE PHILLIPS CURVE................................................................................................. 97 

10.1. INTERPRETATION OF THE PHILLIPS CURVE ................................................................... 99 

10.2. NATURAL RATE OF UNEMPLOYMENT......................................................................... 100 

10.3. MOVING PHILLIPS CURVE .......................................................................................... 101

98 

Chapter 10 

A famous and influential economist A. W. Phillips developed and quantified the 

determinants of wage inflation and came up with a useful way of representing the process 

of inflation. He analysed more than a century’s worth of data on unemployment and money 

wages in the United Kingdom and found an inverse relationship between unemployment 

and the changes in money wages. He founded that wages have a tendency to increase 

during low unemployment periods and vice versa. The rationale of such process, when high 

unemployment lowers the growth in money wages, is that workers would claim less 

strongly for wage rises when firm’s demand for labour is low. In that cases firms would 

also resist wage claims more firmly to retain profits. 

According to the results of that research A.W. Phillips suggested a curve related to the 

inverse relationship between unemployment and rise in money wages. The Phillips curve 

presents a useful way for analysing short run movements of unemployment and inflation. 

The simple version of that curve is depicted in Figure 10.1. Rate of unemployment is set on 

the diagram’s horizontal axis. The annual rate of price inflation is on the left-hand vertical 

scale. The right-hand vertical scale portrays the rate of money-wage inflation. 

Moving leftward alongside the Phillips curve by reducing unemployment, the rate of price 

and wage increase indicated by the curve becomes higher. 

To move from wage inflation to price inflation, we need to explore the relationship 

between wages and labour productivity. Let’s assume that labour productivity (output per 

worker) rises at a steady rate of 2 percent each year. Another assumption is that firms set 

prices on the basis of average labour costs per unit of output. If there is a rise in 

productivity at 2 percent and wages are rising at 6 percent in the economy, then average 

labour costs will increase at 4 percent, and thus, the price level will rise at the same rate, 

which is 4 percent. 

Rate 

Rate 

Rate of 

of 

inflation 

= 

of wage 

growth 

– 

productivity 

growth 

This inflation arithmetic helps us to understand the relation between wage and price 

increases shown in Figure 10.1. The left-hand side shows the rate of price inflation whereas 

the right-hand side portrays the scale of percentage change in money wage rates. The 

assumed rate of productivity growth is the only difference between these two scales in our 

simple model (assuming that the prices rise at the same rate as the average labour costs). 

The Phillips curve depicts the “trade-off” between rate of inflation and rate of 

unemployment. This theory states that a country can obtain lower level of 

unemployment if it is willing and able to withstand the higher price of inflation. Such 

trade-off relationship is described by the Phillips curve.


∆P/P 

∆W/W 

Price inflation (percent per year) 

8 

7 

6 

5 

4 

3 

2 

1 

Phillips curve 

10 

9 

8 

7 

6 

5 

4 

3 

Annual wage rise (percent per year) 

0 

2 

1 2 3 4 5 6 7 8 9 10 

Unemployment rate 

Figure 10.1 The Phillips curve illustrates the trade-off between inflation and unemployment 1 . The 

inverse relationship between inflation and unemployment is depicted by the Phillips curve. The scale on the 

right-hand vertical axis differs from the left-hand inflation scale by the assumed 2 percent rate of growth of 

average labour productivity. 

10.1. Interpretation of the Phillips Curve 

Let’s put the Phillips curve into a context of AS-AD model and explain the relationship 

between inflation and unemployment through moving AS and AD curves. We will explain 

this relationship comparing Figure 9.3 (in chapter 9) describing process of inertial inflation 

and Figure 10.1. 

Consider potential output corresponding to 6 percent rate of unemployment. At this point, 

output equals its potential; unemployment remains at 6 percent, and price-level keeps in 

rise at 4 percent per year. Assume, that a shift in aggregate demand occurs in the third 

period, so the equilibrium is at point E’’’ rather then E’’ in Figure 9.3. Accordingly 

unemployment will rise above 6 percent as output falls below potential and inflation will 

also decrease. Compare the process with the Figure 10.1 to be clear. 

The Phillips curve depicted in Figure 10.1 is only a short run curve; however, it might shift 

in the long run. Unforeseen inflation (inflation shock) will change expectations of people 

and accordingly changes wages and costs. A new rate of inertial inflation will be set, as 

changing aggregate supply will reflect all these changes. This process will result in shifting 

Phillips curve. 

1 See Samuelson-Nordhaus [11]

100 

Chapter 10 

10.2. Natural Rate of Unemployment 

The theoretical works by Edmund Phelps and Milton Friedman, based on numerous 

econometric studies, suggest distinguishing strictly between the long-run Phillips curve 

and the short-run Phillips curve. According to that approach the downward sloping 

Phillips curve depicted in Figure 10.1 is valid only in the short run. There is only one 

unemployment rate that is consistent with steady inflation in the long run - natural rate of 

unemployment. This natural rate theory concludes that the long-run Phillips curve is 

vertical. 

We must properly define the term of natural rate of unemployment to understand this 

natural rate theory. Samuelson and Nordhaus [11] define the natural rate of 

unemployment as a rate at which upward and downward forces on price and wage 

inflation are in balance. At the natural rate, inflation is stable, with no tendency to 

show either accelerating or declining inflation. In an economy concerned with 

preventing high inflation rates, the natural rate of unemployment is the lowest level 

that can be sustained; it thus represents the highest sustainable level of employment 

and corresponds to a nation’s potential output. 

Samuelson and Nordhaus [11] explain further the theory in the following way: At any point 

in time, the economy has inherited a given inertial or expected rate of inflation. If (a) there 

is no excess demand and if (b) there are no supply shocks, then actual inflation will 

continue at the inertial rate. What do these conditions signify? Condition (a) means that 

unemployment is at that level – the natural rate of unemployment – at which the upward 

pressure on wages from vacancies just matches the downward wage pressure from 

unemployment. Condition (b) denotes the absence of unusual changes in the costs of 

materials like oil and imports, so that the aggregate supply curve is rising at the inertial rate 

of inflation. Putting conditions (a) and (b) together leads to a state in which inflation can 

continue to rise at its inertial or expected rate. 

What would happen if there were either demand or cost shocks? At very low 

unemployment inflation will be pushed above its inertial rate as we move along the shortrun 

Phillips curve. By contrast, if unemployment rises to levels far in excess of the natural 

rate, inflation will decline below its inertial rate as we move down the short-run Phillips 

curve. 

But the story does not end here. Once actual inflation rises above its inertial or 

expected level, people begin to adjust to the new level of inflation and to expect higher 

inflation. The inertial rate of inflation then adjusts to the new reality. And the shortrun 

Phillips curve shifts. 

Thus brief narrative makes a crucial point about inflation: the trade-off between inflation 

and unemployment remains stable only as long as the inertial or expected inflation remains 

unchanged. But when the inertial inflation rate changes, the short-run Phillips curve will 

shift.


10.3. Moving Phillips Curve 

The process, where shocks move the Phillips curve could be explained by the cycle of 

following steps described in Figure 10.2. 

1) Unemployment is at the natural rate in the first phase. There are no shocks in demand or 

supply and the economy corresponds to the point A on the lower short-run Phillips curve 

(SRPC) depicted in Figure 10.2. 

2) During the second phase an economic expansion increases output rapidly and lowers the 

unemployment rate. With decreasing unemployment, firms demand more workers, and 

some corporations decided to increase wages more rapidly than they did in the previous 

period. As output overreaches its potential level, capacity utilisation rises and price markups 

rise. Wages and prices begin to accelerate. Considering the depiction in the figure, the 

economy shifts upwards and leftwards to point B on its short-run Phillips curve (alongside 

SRPC in Figure 10.2). Inflation expectations have not yet changed, but the lower 

unemployment rate increases inflation during the second phase. 

3) As the wage and price inflation increases, firms and workers adjust their expectations 

and begin to expect higher inflation. Such higher expected rate of inflation is incorporated 

into wage and price decisions. Accordingly, the inertial or expected rate of inflation rises. 

In the Phillips-curve framework the short-run Phillips curve shifts upward. The new 

Phillips curve (labelled SRPC’ in Figure 10.2.) reflects the higher rate of inflation and 

changes its position above the original Phillips curve. 

Long-run Phillips curve 

Inflation rate 

SRPC‘ 

C 

SRPC 

B 

D 

Short-run Phillips 

Curve (periods 3 and 4) 

A 

Short-run Phillips 

Curve (periods 1 and 2) 

U* (natural rate) 

Unemployment rate 

Figure 10.2 Shifting Phillips curve due to economic shocks.

102 

Chapter 10 

4) The economy gets into contraction in economic activity, which brings aggregate output 

back to its potential, and the unemployment rate returns to the natural rate in the final 

phase. Inflation decreases as the unemployment rises. 

Let’s compare now the situations in the initial and final phase of the process. The rate of 

inflation at the natural rate is higher in phase 4 than in phase 1, because the expected or 

inertial inflation rate has increased. Even though aggregate supply and demand are in 

balance, firms and workers can have to expect a higher inflation rate. The economy will 

experience the same real GDP and unemployment levels as it did in phase 1, even though 

the nominal magnitudes (prices and nominal GDP) are now growing more rapidly than they 

did before the expansion raised the expected rate of inflation. 

The Vertical Long-Run Phillips Curve 

The conclusion of the natural-rate theory is that the natural rate of unemployment is the 

only level of unemployment consistent with a stable inflation rate. Accordingly the longrun 

Phillips curve is depicted as a vertical line, rising straight up at the natural 

unemployment rate. (See Figure 10.2)

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