Difficulty: Intermediate | Prerequisites: Ch. 1–3 notes (national income model, goods market equilibrium).
Source: Mankiw, Macroeconomics, 9th Edition, Chapters 4–7
Tags: money supply, inflation, quantity theory, Fisher effect, seigniorage, open economy, trade balance, net capital outflow, real exchange rate, unemployment, natural rate, frictional, structural, efficiency wages, EC305
These four chapters complete the long-run classical model. Chapters 4–5 explain what determines the price level and inflation: money is neutral in the long run, meaning it affects nominal variables (prices, wages) but not real ones (output, employment). Chapter 6 opens the economy to international trade and capital flows, showing how saving, investment, and the exchange rate are connected. Chapter 7 addresses why unemployment exists even in the long run. Together, these chapters answer the question: what does the economy look like when prices have fully adjusted?
In the long run, the money supply determines the price level and inflation rate (quantity theory of money). Real and nominal interest rates are linked through expected inflation (Fisher effect). In an open economy, the trade balance is the mirror image of net capital outflow, and both are determined by the gap between national saving and domestic investment. Unemployment persists at its "natural rate" because of frictions in job matching, structural mismatches, and wage-setting behaviour.
Money Supply (M)
The total quantity of money available in the economy. Controlled by the central bank. Think of it as the total pool of cash and deposits people can spend.
Velocity of Money (V)
The number of times a typical unit of currency changes hands in a given period. If V = 5 and M = $2 trillion, then $10 trillion of transactions occur. In simple terms, it measures how quickly money circulates.
Quantity Theory of Money
The proposition that changes in the money supply lead to proportional changes in the price level (in the long run). Built on the quantity equation MV = PY with the assumption that V is stable and Y is determined by real factors.
Classical Dichotomy
The theoretical separation of economic variables into real variables (quantities, relative prices) and nominal variables (measured in money units). In the classical model, monetary policy affects only nominal variables.
Neutrality of Money
The idea that changes in the money supply affect nominal variables (P, nominal wages) but not real variables (Y, real wages, real interest rate) in the long run.
Fisher Effect
A one-for-one adjustment of the nominal interest rate to expected inflation: i = r + π^e. If the central bank raises the money growth rate by 2%, inflation rises by 2%, and the nominal interest rate rises by 2%, leaving the real rate unchanged.
Seigniorage
Revenue the government raises by printing money. The inflation that results is sometimes called an "inflation tax" because it erodes the real value of the money people hold.
Shoe-Leather Costs
The real resources wasted when inflation causes people to hold less cash and make more frequent trips to the bank. Named after the wear on shoe leather from walking to the bank.
Menu Costs
The real costs of changing prices, such as reprinting catalogues or menus. Relevant when inflation is high enough that firms must update prices frequently.
Net Exports (NX) / Trade Balance
Exports minus imports. A positive NX means a trade surplus; negative means a trade deficit.
Net Capital Outflow (NCO)
Domestic purchases of foreign assets minus foreign purchases of domestic assets. In simple terms, it is the net flow of funds going abroad to buy assets.
Real Exchange Rate (ε)
The rate at which you can trade the goods of one country for the goods of another. It determines the competitiveness of a country's goods in international markets. A higher ε means domestic goods are more expensive relative to foreign goods.
Nominal Exchange Rate (e)
The rate at which one country's currency trades for another's. For instance, 110 yen per dollar.
Natural Rate of Unemployment
The rate of unemployment that the economy tends toward in the long run, around which actual unemployment fluctuates. It is not zero because of frictional and structural unemployment.
Frictional Unemployment
Unemployment that arises because it takes time for workers to search for and find jobs that match their skills. Think of it as the normal churn of people between jobs.
Structural Unemployment
Unemployment that occurs because the real wage is stuck above the market-clearing level, so there are more workers who want jobs than there are jobs available. Causes include minimum wages, unions, and efficiency wages.
Efficiency Wages
Above-equilibrium wages that firms pay deliberately to boost productivity, reduce turnover, or attract better workers. The higher wage creates unemployment because more people want to work at that wage than firms will hire.
Money serves three functions: medium of exchange, unit of account, store of value
Money supply is controlled by the central bank through open-market operations (buying/selling government bonds)
The money multiplier: when the central bank injects reserves, banks lend them out, creating deposits, which are lent again. If the reserve ratio is rr, the money multiplier is 1/rr.
Broader money aggregates: M1 (cash + checking deposits) and M2 (M1 + savings deposits, money market funds, etc.)
The quantity equation: MV = PY. This is an identity when V is defined as PY/M.
The quantity theory assumes V is roughly constant. Then a change in M leads to a proportional change in P (given that Y is fixed by real factors in the long run).
Inflation is "always and everywhere a monetary phenomenon" (Friedman). In the long run, the inflation rate equals the money growth rate minus the output growth rate.
The classical dichotomy: the real side of the economy (output, real wages, real interest rate) is determined by technology and factor markets. Money determines only the price level and nominal magnitudes.
The nominal interest rate (i) is what the bank quotes. The real interest rate (r) is the nominal rate minus inflation.
The Fisher equation: i = r + π^e (nominal rate = real rate + expected inflation)
The Fisher effect: a 1 percentage-point increase in the inflation rate raises the nominal interest rate by 1 percentage point, leaving the real rate unchanged. This holds well in the long run across countries.
Expected inflation: shoe-leather costs (wasted resources avoiding cash), menu costs (price adjustment costs), relative price distortions, tax distortions (bracket creep, taxation of nominal capital gains), inconvenience of a changing unit of account
Unexpected inflation: arbitrary redistribution between debtors and creditors. Debtors gain, creditors lose when inflation is higher than expected.
Hyperinflation: caused by governments printing money to finance large fiscal deficits (seigniorage). Leads to collapse of the monetary system.
In an open economy: Y = C + I + G + NX
Rearranging: NX = Y - (C + I + G) = S - I. The trade balance equals national saving minus domestic investment.
Net capital outflow (NCO) = NX. This is an accounting identity. A trade surplus means the country is lending abroad; a trade deficit means it is borrowing from abroad.
The model has two markets that determine two prices:
The loanable funds market (S = I + NCO) determines the real interest rate
The foreign exchange market (NCO = NX) determines the real exchange rate
A fiscal expansion (higher G, lower S) raises the real interest rate, reduces NCO, appreciates the real exchange rate, and worsens the trade balance (twin deficits)
Trade policies (tariffs, quotas) shift the NX curve but do not change the trade balance in this model, because they do not change S or I. They only appreciate the real exchange rate.
The labour market always has some unemployment, even in equilibrium. This is the natural rate.
Frictional unemployment: time spent searching for the right match. Reduced by better information, job boards, placement services. Increased by unemployment insurance (which subsidises search).
Structural unemployment: the real wage is above the equilibrium level, so quantity of labour supplied exceeds quantity demanded. Three causes:
Minimum wage laws (most relevant for young, low-skilled workers)
Union bargaining power (insiders get higher wages; outsiders are unemployed)
Efficiency wages: firms pay above-market wages to reduce shirking, lower turnover, improve average worker quality, or boost morale
The steady-state unemployment rate: U/L = s / (s + f), where s = job separation rate and f = job finding rate. Higher separation or lower finding rates raise unemployment.
Quantity Equation
M \times V = P \times YInflation Rate (from the quantity equation, in growth-rate form)
\pi = \text{money growth rate} - \text{real output growth rate}(assuming velocity growth is zero)
Fisher Equation
i = r + \pi^eReal Exchange Rate
\varepsilon = \frac{e \times P}{P^*}where e = nominal exchange rate (foreign currency per unit of domestic currency), P = domestic price level, P* = foreign price level.
Open Economy Identities
NX = S - INCO = NXSteady-State Unemployment Rate
\frac{U}{L} = \frac{s}{s + f}where s = separation rate, f = finding rate.
Money Multiplier
\text{Money multiplier} = \frac{1}{rr}where rr = reserve-deposit ratio.
Key Diagrams
Loanable funds market (open economy): vertical axis = real interest rate, horizontal axis = loanable funds. S curve is vertical (or upward sloping), I + NCO curve slopes down. Intersection gives r.
Foreign exchange market: vertical axis = real exchange rate (ε), horizontal axis = quantity of currency. NCO curve is vertical (determined in the loanable funds market). NX(ε) slopes down. Intersection gives ε.
A fiscal expansion shifts S left, raises r, lowers NCO, appreciates ε (shifts NCO left in the FX market), reduces NX.
The quantity theory explains why countries that print large amounts of money (Zimbabwe in the 2000s, Venezuela in the 2010s) experience hyperinflation. Central banks target a money growth rate consistent with low, stable inflation.
The "twin deficits" result from the open-economy model maps closely onto the United States in the 1980s and 2000s: large fiscal deficits coincided with large trade deficits, just as the model predicts. The mechanism runs through the exchange rate: government borrowing pushes up the interest rate, attracts foreign capital, appreciates the dollar, and makes US exports less competitive.
Efficiency wage theory helps explain why firms in industries like tech or finance pay well above the minimum needed to fill positions. The above-market wage reduces turnover costs and attracts higher-quality applicants, even though it means some qualified workers cannot find jobs in those sectors.
Students often think printing money increases real output. In the classical model, money is neutral: printing more of it raises prices but does not create more goods or services.
Students confuse the real exchange rate with the nominal exchange rate. The nominal rate is just the price of one currency in terms of another. The real rate adjusts for price levels and tells you about competitiveness.
Students often believe tariffs improve the trade balance. In this model, they do not, because NX = S - I and trade policy does not change saving or investment. Tariffs only change the real exchange rate.
Students think zero unemployment is the goal. The natural rate is positive and healthy. Frictional unemployment reflects a dynamic economy where people change jobs to find better matches.
⚠️ Be able to work through the two-market open economy model: show what happens to r, ε, and NX when fiscal policy or trade policy changes.
⚠️ Know the Fisher equation and be able to explain why nominal interest rates rise with inflation in the long run.
⚠️ Be able to use the quantity equation in growth-rate form to link money growth, output growth, and inflation.
⚠️ Understand why tariffs do not improve the trade balance in the classical open-economy model.
⚠️ Know the three causes of structural unemployment (minimum wage, unions, efficiency wages) and be able to explain the mechanism for each.
⚠️ Be able to compute the natural rate of unemployment given separation and finding rates.
True or False: In the long run, a 5% increase in the money supply leads to a 5% increase in real GDP. (False; it leads to a 5% increase in the price level, not real GDP.)
Fill in the blank: The Fisher equation states that the nominal interest rate equals the real interest rate plus ______. (Expected inflation)
True or False: A country running a trade deficit must be borrowing from abroad. (True; NX < 0 means NCO < 0, meaning net foreign borrowing.)
Fill in the blank: Unemployment that arises because wages are set above the equilibrium level is called ______ unemployment. (Structural)
True or False: In the classical open-economy model, imposing a tariff on imports improves the trade balance. (False; it only appreciates the real exchange rate.)
Q: The central bank increases the money supply by 10%. Using the quantity theory, what happens to the price level and real GDP in the long run? Assume velocity is constant.
A: Real GDP is unchanged (determined by factors of production and technology). The price level rises by 10%. This is the neutrality of money: monetary expansion only affects nominal variables in the long run.
Q: Suppose the government runs a large budget deficit. Using the open-economy model, trace through the effects on the real interest rate, net capital outflow, the real exchange rate, and net exports.
A: A budget deficit reduces national saving (S falls). In the loanable funds market, the supply of loanable funds shifts left, raising the real interest rate. The higher r makes domestic assets more attractive, reducing NCO. In the foreign exchange market, lower NCO shifts the supply of currency left, appreciating the real exchange rate (ε rises). A higher ε makes domestic goods more expensive relative to foreign goods, so NX falls. This is the twin deficits story.
Q: Country A has a job separation rate of 2% per month and a job finding rate of 18% per month. What is the natural rate of unemployment?
A: U/L = s / (s + f) = 0.02 / (0.02 + 0.18) = 0.02 / 0.20 = 0.10 = 10%.
Q: Explain why a policy that extends unemployment insurance benefits might increase the natural rate of unemployment.
A: More generous unemployment insurance reduces the cost of being unemployed, which lowers the intensity of job search. This reduces the job finding rate (f). Since U/L = s / (s + f), a lower f raises the natural rate. Workers take longer to accept offers because the financial pressure to find a job quickly is reduced.
Q: Explain the Fisher effect and provide an example.
A: The Fisher effect states that a one-for-one increase in expected inflation raises the nominal interest rate, leaving the real interest rate unchanged. For example, if the real interest rate is 3% and expected inflation rises from 2% to 5%, the nominal interest rate rises from 5% (3 + 2) to 8% (3 + 5). Lenders demand higher nominal returns to compensate for the expected loss of purchasing power.
The money neutrality result from Ch. 4–5 is the long-run benchmark. When the course shifts to the short run (Ch. 10–14), this assumption is relaxed: prices become sticky, and monetary policy has real effects. The open-economy model in Ch. 6 reappears in Ch. 13 (Mundell-Fleming), where exchange rates interact with short-run output fluctuations. The natural rate of unemployment from Ch. 7 becomes the anchor for the Phillips curve and aggregate supply in Ch. 14.
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