Model worker

While I remember, I want to jot down a couple of points about the two macroeconomic models I have found to be of the most practical use in looking at policy and performance in emerging economies: the full Keynesian domestic economy model, which brings in flexible prices and depends on particular view of how firms are likely to respond to changes set off by a change in demand; and the Keynesian open economy model in the short run, which is for economies in which international trade is significant component. It assesses the likely impact and effectiveness of monetary and fiscal policies—the two main levers of policy control—when the exchange rate of a country’s currency is kept artificially fixed against the currencies of the outside world and when it is allowed to float. These models are best "applied" separately, even to the same economy, in order to simplify the analysis of the expected lines of causation.

ISLMAS(K)AD. In contrast to the situation when we are looking at the knock-on effects of demand changes on the goods and financial markets of the domestic economy only, the introduction of the possibility of changes in the price level produces two new effects for policymakers to consider. In the first, [and in addition to the feedback loops set off between the goods and money markets through changes in interest rates and national income,] a price change caused by a rise in demand in the goods market, reflecting perhaps a fiscal expansion, erodes the real money supply, altering the equilibrium conditions in the money market—that is, its shifts the LM curve down, wiping out some or all of the gain in output from the original change in demand. The second is the effect of a change in the price level on the labour market, understood as working in a particular way. The key features of this model, which give rise to its distinctive results, are the assumptions of flexible prices in combination with "sticky wages"—that is, when nominal wages take time to adjust to changes in the price level, either up or down. Assuming that there is spare capacity in the economy, a boost in government spending or a cut is taxes will push up demand for goods and services, but it will also push up price growth. If the nominal wage fails to adjust upwards to compensate for inflation, the real wage falls, inducing a rise in labour demand (ie firms find it profitable to employ more staff) and a fall off in labour supply (people want on average to work less). This divergence of labour demand and supply temporarily boosts the level of employment and so, as conditioned by a definite level of technological development, economic output and income. At the same time, it reduces the level of involuntary unemployment. In modern economies, at least until the great economic crisis of 2007-09, this was the direction of price movements that interested economists, as it matched, for a time, the broad empirical trends of the economies in which they found themselves. However, I think I'm right in saying that Keynes emphasised the "downward stickiness" of wages, as, writing in the 1930s on the events of the Great Depression, what interested him was, understandably, the impact of deflation, which he identified as a trigger of the intractable and socially damaging problem of high and enduring unemployment. This was because institutional and legal factors prevented money wages from adjusting to a fall in prices by falling themselves, as predicted in classical economic theory. In turn, this tended to boost the real wage and so induce a fall in labour demand from firms and a rise in labour supply, at once reducing both employment and output, and amplifying "involuntary" unemployment.

Because the model sets out systematically the relationships between a large number of variables, it is a helpful framework for looking at a wide range of phenomena relevant to assessing the health and stability of economies, from demand-pull inflation and hyperinflation, overheating, soft and hard landings, to the co-ordination of policy with economic recoveries and slumps.

ISLMBOP. In an open economy, which incorporates the impact of inward and outward/net currency flows on the financial and goods markets, fiscal policy is powerful when the country’s currency is set at a specific rate, whereas monetary policy is relatively ineffective. If the authorities allow their currency to find its own level, however, without interfering by buying or selling on the currency market, then the reverse is true: the impact on monetary policy in enhanced and that of fiscal policy weakened. The reason for this is that

Looking both ways

Question: How does a closed economy adjust to shocks from the outside or to economic policy changes in the short run? Why is using the ISLM a more sophisticated and useful approach than looking at the real and financial sectors separately?

ISLM: internal macroeconomic adjustment in the short run

An alarming slowdown in economic growth gnaws away at business confidence, so that increasing numbers of firms lose faith in their ability to hit next year's sales targets, leading them to hold off on investments that would otherwise have gone ahead, depressing economic growth still further. Or instability in the financial markets sees more investors cashing in financial holdings so as to avoid the chance of a fall in their value. It is the macroeconomic implications of scenarios like these that the forbiddingly named ISLM framework helps us to analyse systematically. By selecting the most relevant economic indicators and sketching the expected relationships between them, this framework helps us to trace through the rest of the economy the knock-on effects of destabilising economic developments, such as the ones above, and to work out the kinds of results that we might expect from policy responses to them. The most important variables include the rates of growth of government spending, household consumption, private investment expenditure, and the national output of goods and services. Important, too, are changes in tax rates, money holdings and interest rates. Over a longer period, changes in the price level would be included on this list. When looking at imbalances in the goods and the money markets taken separately or together, the crucial difference is that, in the second case, there are feedback loops between them, going in both directions. The key link by which imbalances in the real economy are transmitted to the financial sector is between the economic activity (or output) and money demand. Imbalances originating in the money market affect the production of goods and services by way of changes in short-term interest rates. And just as we conventionally show the main relationship as between output (Y) and the price level (P) in graphical form when looking at aggregate demand (“PY space”), so it is useful to illustrate the two-way links between the goods and money markets as a relationship between output and short-term interest rates (“IY space”), because these, as I have said, are the main channels through which changes in one market are transmitted to the other. Thus, the IS schedule (the letters stand for “investment” and “savings”) is simply a graphical summary of all possible combinations of interest rates and national output in which goods demand and supply just balance. It incorporates much the same information as in the PY or aggregate demand diagram—since aggregate demand is affected by changes in both the goods and the money markets—but is examined from a different angle so as to bring out the interlinks between the domestic economy’s component markets. As lower interest rates encourage borrowing by firms and households for investment and consumer purchases—and thus also higher levels of economic output—the IS curve is negatively sloped: as interest rates rise, investment, and so economic output, falls. Likewise, the LM schedule (standing for “liquidity preference”, or money demand, and “money”, or money supply) represents all the combinations of interest rates and output in which money supply and demand are in balance. In contrast with the IS line, the LM schedule is positively sloped: as output rises, it takes higher interest rates at every level to equate money demand with a (nominal) money supply that is centrally fixed. Movement along the curve can be read as showing that higher money demand is associated with increased rates of growth in national income—that is, to facilitate the rise in the number of transactions—but that higher rates of interest are required to maintain balance with the fixed money supply. The point of crossover of the two schedules thus represents the unique rates of interest and output growth needed to keep both markets in balance at the same time.

By goods alone: IS

One way to proceed is to contrast the results to be expected following the combined and separate adjustment to developments that upset balance in either market. In the real domestic economy, the kinds of changes that could affect the level of demand for goods and services include alterations in the pace of growth of private investment, household disposable income or government spending. It would also include changes in tax or savings rates, or in the responsiveness of private investment to changes in interest rates. (Reforms of public spending or of the rates of taxation—fiscal policy—are the main policy instruments used by the government to influence activity in the real sector.) Changes in the first set of factors would affect the position of the IS curve, shifting it up or down, boosting or sapping demand for goods and services—and thus the growth rate of national output—at all interest rates. Changes in the second set would tilt the IS curve so that it becomes flatter or steeper. A flatter IS curve implies that only small changes in interest rates are needed to induce a relatively large increase in investment demand. A steeper curve means that even large changes in the interest rate are able to induce only a small change in desired investment. (The slope of the IS curve might be said to reflect the level of development or friendliness of the business environment.) In the short run, changes in domestic spending mean that some combination of firms, households and the government together plan to buy more or fewer goods and services than are currently being supplied. Such a change tells domestic producers whether to make more or fewer products. In this relatively simple model of the domestic economy, firms are assumed to be able to respond unproblematically to imbalances in the goods market by adjusting production for the inputs they need: they supply just as much or as little as is desired.

Money alone: LM

In the financial sector, three factors are typically cited as capable of igniting disturbances. In each case, any imbalance in the money market triggers changes in interest rates, which ensure that a new equilibrium level, higher or lower than the initial one, is achieved. The first factor is a change in the pace of growth of economic activity. For example, a splurge in consumer spending—say, in the run up to Christmas, or ahead of a rise in value-added tax (VAT)—boosts aggregate demand and hence the rate of growth of national income, simultaneously pushing up the demand for money to carry out these additional buys. The LM curve shifts up and left. A second important destabilising factor would be any trend towards holding more private wealth as money. Such a rise in "liquidity preference"—say, in response to high volatility in bond markets, as in my opening paragraph—would likewise shift the LM curve leftwards and up, also by setting off by unbalancing rise in monetary demand. A third important factor that can produce money market imbalance is a change in the growth of the real money supply. In the short run, when prices are fixed, this is identical with the growth or contraction of the nominal money stock, which is controlled by the central authorities as a tool of (monetary) policy to influence other economic indicators, such as the short-term interest rate, or, over the longer term, the pace of growth of the general price level. Typically, it does this by buying or selling government securities (bonds and bills), which increases or decreases amount of cash in the financial sector, pushing interest rates down or up. The excess money supply linked to faster growth in the stock of money in the economy disturbs equilibrium in the money market, triggering a shift in the LM curve, this time rightwards and down, so that money market balance is restored: a reduction in the interest rate induces a switch from less attractive interest-bearing bonds to cash, so that money demand rises to the point where it just offsets the increase in the money supply, restoring money market balance.

Both together: ISLM

Probably the clearest example of the distinct result of the interaction of the goods and money markets can be seen by working through the knock-on effects of a change in demand. From such a change, the main conclusion is that impact of the multiplier, whether positive or negative, is dampened by the interaction with the financial sector, because of the two-way feedback loops between the goods and money markets.

Causes. A rise in demand could be the result either of putting more money into the circular flow of income or of withdrawing less from it. In a closed economy, this might result, for instance, from an increase in government spending, or a tax cut (which would leave households with a larger slice of their income to divide between spending and saving, in this way, assuming that the ratio between them stays the same, boosting consumption demand). Such measures featured heavily in the many "fiscal stimulus packages" that have been implemented by governments around the world since 2008 in an attempt to counter the impact of a sharp drop in foreign demand set off by the global economic crisis. A boost to domestic demand might also stem from an improvement in business or consumer confidence, lifting investment and consumption demand, perhaps because the outlook for economic growth has substantially brightened, or because the latest figures show employment growing more briskly than expected.

Mechanism. An increase in spending and/or confidence boosts aggregate demand, though the rise in output is larger than the original impetus because, along the way, the original sum becomes someone’s income and they, in turn, spend a proportion of it, creating additional goods demand. In the short run, however, with prices relatively rigid, the rise in demand induces only an increase in economic output and the IS curve shifts right: output is higher at all interest rates. But that's not the end of it because the expansion of economic activity shows up in the money market as an increase in demand for money, which is needed to cope with the increased number of transactions. With wealth split, for analytical purposes, between money and bonds, saying that there is an excess of demand for money is the same as saying that there is an excess supply of bonds. With bond offerings exceeding planned new bond purchases, bond prices fall and the yield on bonds moves in the opposite direction—ie the interest rate rises. (Another way or seeing it is that interest rates rise because, in the case of bond-financed government spending, government borrowing bids up the cost of borrowing by creating additional demand for the supply of loanable funds.) This restores balance in the money market by choking off the increase in money demand to equate it to the nominal money supply, which is fixed by the central monetary authorities. At the same time, some business projects are rendered unattractive by the rise in interest rates. This discourages some private investment demand ("crowding out"), reducing aggregate spending and shifting the IS curve somewhat back left. Thus the conclusion is that the full impact of the multiplier on national output is dampened by the feedback loop in the financial sector. This also works the other way, so that the same mechanism will ameliorate the impact on the real economy of a drop in demand. The result contrasts not only with the outcome expected in the goods market taken in isolation, where the impact on the multiplier unfolds fully, but also, looking ahead, with the expected outcome of macroeconomic adjustment over the longer term, once the effect of the inclusion of the domestic labour market is taken into account where fully flexible wages and prices ensure that a boost to government spending produces no increase in output or employment at all (at least, with the classical or monetarist versions of the supply curve). Instead, all of the adjustment takes place in the form of faster price growth and the complete crowding out of private investment. From the point of view of disturbances originating in the financial sector, such as a loosening of monetary policy to try to “jump start” the economy to offset an economic slowdown, or a change in the pattern of distributing assets between money and other forms of wealth, in the first case would see the LM curve shift right, reducing interest rates and pushing up investment demand, which in turn pushes the curve back in the direction it came from.

Practical application

Under what circumstances might such a model be of practical use? A practical use of such a model would be when the international context is either a small or negligible factor for the economy in question, or the international trading environment is stable. This would include countries with economies characterised by a relatively low level of trade of integration with international financial markets. In countries in which the capital or debt markets are underdeveloped, the feedback loop between goods and financial markets is inhibited and the financial sector is an ineffective medium for transmitting official interest rate policy.

AD-AS & IS-LM-BoP 2

The money market
As with the analysis of any other kind of market, that of the money market focuses on theories of the main factors affecting (money) demand and (money) supply, and on the self-correcting chain of economic adjustments that could be set off when these are out of balance. As the supply of money is often taken to be more of a practical, institutional policy question of monetary control, bound up with the money-creating function of modern banking systems, the theory of money markets tends to focus more on the issue of money demand.

Why have money? To buy things or "just in case"
The theory of money demand comes down to this: since one of the main reasons for having money is to carry out transactions (ie to pay for things), when the volume of activity in the economy rises, and/or the prices of goods and services rise, a larger sum of money will be needed to accommodate this. That is, the transactions demand for money is a positive function of changes in economic income (like consumption in the goods market) and of the price level. This is only one source of monetary demand, however—money conceived as the oil that keeps running smoothly the process of purchasing production so that production itself can continue.

Why have money? For safety
A second source, which is a bit more complex to grasp, sees money as the asset that wealth-holders will favour to avoid capital losses when they anticipate changes in interest rates. Bonds—which promise to pay a specified sum of money at regular intervals—stand in for "all other kinds of assets except money", such as the ownership of property, or of shares in firms. Thus, money is conceived one of the two possible assets in which wealth can be held. This ingenious step greatly simplifies the analysis of the financial sector for the purposes of assessing the likely outcomes of real-world economic policies.
Bonds are sold by companies and governments to raise finance for investment projects. They come with a "face value" (the capital value) and a coupon (the interest rate, or return on the capital value), and can be sold on by the original purchaser to raise cash. For example, a bond with a face value of $100 and an annual coupon of 10% would bring to its owner an income of $10 per year. But if the market interest rises above 10%, a bond with a coupon of 10% will be worth less than its face value of $100. On the other hand, if the market interest rate falls below 10%, a bond with a coupon of 10% will be worth more than its face value of $100. Thus, bond prices move in the opposite direction to interest rates. From this point of view, the advantage of keeping your wealth in money is that its value is certain, uninfluenced by changes in interest rates, even if it is not earning its holder any additional income. In contrast, bonds come with a definite income stream attached—as indicated by the face value and coupon—but are more risky, since the market interest rate could change unfavourably, inflicting a capital loss.
To understand what's supposed to be going on, a very important distinction must be made between what happens on average in the money market when interest rates are expected to change and when they actually change. As more wealth-holders expect interest rates to rise (perhaps because inflation is starting to rise too rapidly and the government is signaling its intention to take remedial measures), more of them will begin to sell their bonds, forgoing the return in order to avoid a capital loss implied by a fall in bond prices. The selling of bonds implies an increasing the demand for money. However, as the market interest rate actually rises, creeping further above the norm for more people, larger numbers of wealth-holders will be tempted to switch back to bonds by the prospect of holding an interest-bearing asset and of making a capital gain. The movement back into bonds implies a corresponding reduction in the demand for money. This is the same as saying that speculative demand for money is a negative function of interest rate changes (like investment in the goods market).
Because people are thought to be concerned about the quantity of goods and services they can obtain for their money, rather than merely the volume of cash they hold, money demand is always conceived of as a wish for real money balances. In contrast, money supply is assumed initially to be a nominal variable, and hence is affected by changes in the prices level: if average prices rise and the nominal money supply stays fixed, its real value—the quantity of goods and services that it can command—falls. Additionally, the money supply is one of the policy variables that governments and central banks use to influence interest rates, and hence other key macroeconomic indicators, such as output, employment and inflation.

Balance and imbalance
In a money market in which the price level and income are fixed—two assumptions that can hold only for a short time—any adjustment because of a mismatch in money supply and money demand takes place by means of changes in the composition of speculative money holdings in response to changes in interest rates. If the interest rate is too low to equate the two, there is an excess demand for money and an excess supply of bonds, meaning that some wealth-holders want to convert bonds into money and some hold back from buying bonds. The glut of bonds pushes their price down and interest rates go up.

Loosening the two assumptions on prices and income—as we move the frame of reference to a slightly longer time period—a rise in prices, taken on its own, will reduce the real money supply, pushing up the interest rate, whereas a fall in prices will increases the real money supply, bringing interest rates down.
A factor that could shift the demand for money is a change in economic income, implying that there are different possible combinations of national income and interest rates in which the money market is in equilibrium. And in fact, this how, on the basis of this outline of the workings of the money market, we construct of the LM curve.

AD-AS & IS-LM-BoP

The goods market
Mainstream macroeconomic models make simplifying assumptions to look at the behaviour of the participants in a number of markets, at first imagined and understood discretely. These are the goods market (in fact, the market for goods and services) and the factors market, the money market (representing the workings of the domestic financial sector), the foreign-exchange market, and the labour market. How they work in combination is then investigated systematically. One of the main purposes of this is to try to assess the likely impact of policies in addressing specific economic problems, such as unemployment, or inflation, or destabilising shocks to economic growth.
An important concept in mainstream economic modelling is that of aggregate demand (AD), which is a summation of the spending plans faced by firms, and is itself the outcome of the myriad spending decisions of different groups of "economic actors". When firms are willing to supply all the goods and services that households (C), other domestic companies (I), government institutions (G) and foreigners (X) want to buy, the goods market is said to be in balance. In short-run, demand-side models, this is assumed always to be the case—ie firms will always have spare capacity to raise production, or the freedom to cut it back, when faced with changes in aggregate demand.
However, market balance need not correspond to a level of sales that ensures that everyone who wants to work is employed. In fact, finding a way to close the gap between the two (the so-called deflationary gap) was the motivation for the generation of Keynes's economics as a whole, since mass unemployment was the specific problem that he set out to address in the 1930s. He thought that firms' production plans depended in large part on the demand they expect for their products, itself conditioned by their recent sales experience. In order to influence company behaviour, therefore—and so the level of aggregate supply and employment—it is necessary to understand both how aggregate demand is composed and what the knock-on effects of changes in the components of aggregate demand might be. These components, of consumer demand (goods and services wanted by households), investment demand (goods and services desired by domestic companies), government spending and net exports (foreign demand for domestic goods less domestic demand for foreign ones) are conventionally given the letters of C, I, G and (X – Z).

AD = C + I + G + X – Z

For the two most important components—consumer demand (C) and investment demand (I)—I'm going to start at the end result, missing out the stage of building them up from their simpler to their more complicated versions.
Consumer demand, often the largest demand component of any economy, is the only one that is held to be conditioned by changes in the income of the economy overall, whereas the factors affecting the other three lie outside the model of income determination. Not all of the income received by households (in the form of wages for labour, interest for capital and rent for land) is available for spending, since some portion of it will usually be saved. This portion tends to decline with rising individual household incomes. For economies as a whole, the share of an increase in income that goes on consumption spending (the marginal propensity to consume) is historically and culturally conditioned, slow to change, and can vary between groups, generations and regions. Since the share of income that households have available to spend—their disposable income—has the most bearing on buying decisions, this is what interests economists most. It is affected by the level of net taxes (taxes minus benefits), which is the link through which governments can influence the level of private consumption demand.
However, some part of consumer spending is taken to be independent of changes in income. This component, sometimes called autonomous consumption, takes account of the impact to changes in consumer preferences or taste, for example. Importantly, it is also taken as a proxy for consumer expectations and confidence, which can be lifted or depressed by perceptions of the economic outlook, or by more specific factors, such as the prospect of a tax increase or of rising unemployment.
One final factor that can help to explain changes in observed patterns of private consumption demand is changes in the value of household property or financial holdings—ie their wealth. The proportionate change in consumer spending linked to a change in wealth—the so called wealth effect—is usually much smaller than for the corresponding relation to income, perhaps because changes in wealth can vary. This is something to look at when property booms or busts are prominent features of the economic scene, or when economically significant numbers of households own stocks or shares.

C = a + bY +dW