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Summary Macroeconomics - N. Gregory Mankiw

Macroeconomics 1 (University of New South Wales)

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Summary
Macroeconomics

N. Gregory Mankiw
8th Edition

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Contents

Epilogue. What We Know, What We Dont............................................................................................. 5


1. The Science of Macroeconomics ......................................................................................................... 7
1.1. What Macroeconomists study ..................................................................................................... 7
1.2. How Economists Think ................................................................................................................. 8
1.3. How This Book Proceeds .............................................................................................................. 9
2. The Data of Macroeconomics ........................................................................................................... 10
2.1. Measuring the Value of Economic Activity: Gross Domestic Product........................................ 10
2.2. Measuring the Cost of Living: The Consumer Price Index .......................................................... 12
2.3. Measuring Joblessness: The Unemployment Rate..................................................................... 14
2.4. Conclusion: From Economic Statistics to Economic Models ...................................................... 15
3. National Income: Where it comes from and where it goes .............................................................. 16
3.1. What Determines the Total Production of Goods and Services? ............................................... 17
3.2. How Is National Income Distributed to the Factors of Production? .......................................... 18
3.3. What Determines the Demand for Goods and Services?........................................................... 21
3.4. What Brings the Supply and Demand for Goods and Services Into Equilibrium? ...................... 22
3.5. Conclusion .................................................................................................................................. 25
4. The Monetary System: What It Is and How It Works ........................................................................ 26
4.1. What Is Money? ......................................................................................................................... 26
4.2. The Role of Banks in the Monetary System ............................................................................... 27
4.3. How Central Banks Influence the Money Supply ....................................................................... 28
4.4. Conclusion .................................................................................................................................. 29
5. Inflation: Its Causes, Effects, and Social Costs ................................................................................... 30
5.1. The Quantity Theory of Money .................................................................................................. 30
5.2. Seigniorage: The Revenue from Printing Money ....................................................................... 31
5.3. Inflation and Interest Rates ........................................................................................................ 31
5.4. The Nominal Interest Rate and the Demand for Money............................................................ 32
5.5. The Social Costs of Inflation ....................................................................................................... 32
5.6. Hyperinflation............................................................................................................................. 34
5.7. Conclusion: The Classical Dichotomy ......................................................................................... 34
6. The Open Economy ........................................................................................................................... 35
6.1. The International Flows of Capital and Goods ........................................................................... 35
6.2. Saving and Investment in a Small Open Economy ..................................................................... 36
6.3. Exchange Rates ........................................................................................................................... 37
6.4. Conclusion: The United States as a Large Open Economy ......................................................... 39

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7. Unemployment.................................................................................................................................. 41
7.1. Job Loss, Job Finding, and the Natural Rate of Unemployment ................................................ 41
7.2. Job Search and Frictional Unemployment ................................................................................. 42
7.3. Real-Wage Rigidity and Structural Unemployment ................................................................... 42
7.4. Labour-Market Experience: The United States .......................................................................... 43
7.5. Labour-Market Experience: Europe ........................................................................................... 43
7.6. Conclusion .................................................................................................................................. 44
8. Economic Growth I: Capital Accumulation and Population Growth ................................................. 45
8.1. The Accumulation of Capital ...................................................................................................... 45
8.2. The Golden Rule Level of Capital................................................................................................ 47
8.3. Population Growth ..................................................................................................................... 49
8.4. Conclusion .................................................................................................................................. 50
9. Economic Growth II: Technology, Empirics, and Policy..................................................................... 51
9.1. Technological Progress in the Solow Model .............................................................................. 51
9.2. From Growth Theory to Growth Empirics .................................................................................. 52
9.3. Policies to Promote Growth ....................................................................................................... 52
9.4. Beyond the Solow Model: Endogenous Growth Theory ............................................................ 54
10. Introduction to Economic Fluctuations ........................................................................................... 56
10.1. The Facts about the Business Cycle.......................................................................................... 56
10.2. Time Horizons in Macroeconomics .......................................................................................... 58
10.3. Aggregate Demand ................................................................................................................... 59
10.4. Aggregate Supply...................................................................................................................... 60
10.5. Stabilization Policy.................................................................................................................... 61
10.6. Conclusion ................................................................................................................................ 62
11. Aggregate Demand I: Building the ISLM Model ............................................................................ 63
11.1. The Goods Market and the IS Curve ........................................................................................ 63
11.2. The Money Market and the LM Curve ..................................................................................... 66
11.3. Conclusion: The Short-Run Equilibrium ................................................................................... 68
12. Aggregate Demand II: Applying the ISLM Model .......................................................................... 69
12.1. Explaining Fluctuations With the ISLM Model ....................................................................... 69
12.2. ISLM as a Theory of Aggregate Demand ................................................................................ 71
12.3. The Great Depression ............................................................................................................... 73
12.4. Conclusion ................................................................................................................................ 74
13. The Open Economy Revisited: The MundellFleming Model and the Exchange-Rate Regime ...... 75
13.1. The MundellFleming Model ................................................................................................... 75
13.2. The Small Open Economy Under Floating Exchange Rates ...................................................... 76

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13.3. The Small Open Economy Under Fixed Exchange Rates .......................................................... 76
13.4. Interest Rate Differentials ........................................................................................................ 77
13.5. Should Exchange Rates Be Floating or Fixed? .......................................................................... 78
13.6. From the Short Run to the Long Run: The MundellFleming Model With a Changing Price
Level .................................................................................................................................................. 80
13.7. A Concluding Reminder ............................................................................................................ 80
14. Aggregate Supply and the Short- Run Trade-off between Inflation and Unemployment .............. 81
14.1. The Basic Theory of Aggregate Supply ..................................................................................... 81
14.2. Inflation, Unemployment, and the Phillips Curve .................................................................... 82
14.3. Conclusion ................................................................................................................................ 84
15. A Dynamic Model of Aggregate Demand and Aggregate Supply .................................................... 85
15.1. Elements of the Model ............................................................................................................. 85
15.2. Solving the Model..................................................................................................................... 87
15.3. Using the Model ....................................................................................................................... 88
15.4. Two Applications: Lessons for Monetary Policy ....................................................................... 90
15.5. Conclusion: Toward DSGE Models ........................................................................................... 91
16. Understanding Consumer Behaviour .............................................................................................. 92
16.1. John Maynard Keynes and the Consumption Function ........................................................... 92
16.2. Irving Fisher and Intertemporal Choice .................................................................................... 92
16.3. Franco Modigliani and the Life-Cycle Hypothesis .................................................................... 95
16.4. Milton Friedman and the Permanent-Income Hypothesis ...................................................... 95
16.5. Robert Hall and the Random-Walk Hypothesis ........................................................................ 96
16.6. David Laibson and the Pull of Instant Gratification.................................................................. 96
16.7. Conclusion ................................................................................................................................ 97
17. The Theory of Investment ............................................................................................................... 98
17.1. Business Fixed Investment ....................................................................................................... 98
17.2. Residential Investment ........................................................................................................... 101
17.3. Inventory Investment ............................................................................................................. 101
17.4. Conclusion .............................................................................................................................. 102
18. Alternative Perspectives on Stabilization Policy ........................................................................... 103
18.1. Should Policy Be Active or Passive? ....................................................................................... 103
18.2. Should Policy Be Conducted by Rule or by Discretion?.......................................................... 104
18.3. Conclusion: Making Policy in an Uncertain World ................................................................. 106
19. Government Debt and Budget Deficits ......................................................................................... 107
19.1. The Size of the Government Debt .......................................................................................... 107
19.2. Problems in Measurement ..................................................................................................... 107

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19.3. The Traditional View of Government Debt ............................................................................ 108


19.4. The Ricardian View of Government Debt............................................................................... 109
19.5. Other Perspectives on Government Debt .............................................................................. 110
19.6. Conclusion .............................................................................................................................. 111
20. The Financial System: Opportunities and Dangers ....................................................................... 112
20.1. What Does the Financial System Do?..................................................................................... 112
20.2. Financial Crises ....................................................................................................................... 114
20.3. Conclusion .............................................................................................................................. 116

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Epilogue. What We Know, What We


Dont
There are things in economics that we know, but there are also unresolved questions
that are still heavily debated.

This book has given an introduction into the field of macroeconomics. There are some
important insights contained in the theories to which this book gives an introduction,
but the field of macroeconomics is far from complete. Here we outline the four most
important lessons of macroeconomics, and the four most important unanswered
questions.

The four most important lessons of Macroeconomics

1. In the long run, a countrys capacity to produce goods and services determines the
standard of living of its citizens. The most important question policymakers can
answer is what promotes long run economic growth.
2. In the short run, aggregate demand influences the amount of goods and services
that a country produces. Supply may be the sole determinant of GDP in the long
run, in the short run it is demand that determines the level of GDP.
3. In the long run, the rate of money growth determines the rate of inflation, but it
does not affect the rate of unemployment. There is no such trade-off in the long
run between inflation and unemployment, as is consistent with the classical
dichotomy.
4. In the short run, policymakers who control monetary and fiscal policy face a trade-
off between inflation and unemployment. Although this trade-off does not exist
in the long run, it does exist in the short run.

The four most important unresolved questions in Macroeconomics

1. How should policymakers try to promote growth in the economys natural level of
output? Should the government only focus on a high savings rate? Or focus on
stimulating technological progress? Or leave everything to the market? How
should it do these things?
2. Should policymakers try to stabilize the economy? If so, how? Is it possible for
policymakers to predict economic fluctuations and respond accordingly? Do
current policymakers have the necessary tools to do so? Even if they could, do
the benefits outweigh the costs?
3. How costly is inflation, and how costly is reducing inflation? When policymakers
are faced with a situation of rising inflation, they are faced with a choice.

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Should they try to reduce inflation, or is the resulting unemployment not worth
it? How quickly should they try to reduce it?
4. How big a problem are government budget deficits? Will budget deficits be
balanced by consumer saving, as Ricardian equivalence suggests? Or will it
cause a skyrocketing public debt that puts the burdens of todays consumption
in the hands of future generations?

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1. The Science of Macroeconomics


Macroeconomics is the branch of economics that studies the economy as a whole.

1.1. What Macroeconomists study

Macroeconomics is the study of the economy as a whole. Macroeconomists attempt


to explain the macro-variables that affect the lives of all individuals in an economy,
most importantly, Real GDP, the inflation rate, and the unemployment rate. They are
different from micro economists and from economic policymakers.

Most people are casually introduced to the subject of macroeconomics through


political debates, news events and debates. They are thereby informed of the large-
scale economic events and processes that influence every individual in the economy.
Everyone has some understanding, even if it is vague and rudimentary, of the
questions that are related to the economy as a whole, and it is the discipline of
macroeconomics in which these questions are rigorously studied: What explains the
vast differences in wealth between rich and poor countries? What explains the
periodic recessions and depressions that all countries are affected by? What explains
inflation? And what can the government do to improve these issues?

Macroeconomics is the systematic study of these phenomena, of everything related


to the economy as a whole. It is contrasted to microeconomics, which is the study of
individual firms and markets within the larger economy. It is also contrasted with
economic policy, which is the job of politicians, not necessarily of macroeconomists.
The difference is that macroeconomists try to explain and understand the economy,
but they do not necessarily have the political power to form policies.

On the one hand, macroeconomists use models to attempt to understand and predict
the economy. These models are simplified mathematical simulations of the real
economy that try to capture the essence of particular macroeconomic processes. On
the other hand, macroeconomists also study actual historical events and processes in
all their complexity, using these models. For example, macroeconomists are still trying
to understand the causes of the economic crisis of 2008, a historical event, by using
various macroeconomic models.

There are many macroeconomic variables, too many to name them, but they all
revolve around the three most important variables: Real GDP, The total level of
income in an economy, the inflation rate, the rate at which prices are rising on
average, and the unemployment rate, the amount of workers that dont have a job as
a percentage of the amount of workers (also called the labour force). Most of

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macroeconomics is about explaining the long-term and short-term movement of these


variables.

1.2. How Economists Think

Macroeconomists attempt to explain the economy objectively. The predominant


approach to economic theory is the building of models. Models are collections of
endogenous and exogenous variables and relations between them that attempt to
explain aspects of the complex economy in a simplified manner.

Economists address issues that are often politically and ideologically charged, but
attempt to do so in an objective way. The predominant way that economists build
theories of the economy, is by building models. A model is a collection of endogenous
variables and exogenous variables, and a relationship between them. Endogenous
variables are the variables that an economists tries to explain, for example the short
term fluctuation of GDP during an economic crisis. Exogenous variables are the
variables that are thought to explain the changes in the endogenous variables, for
example consumer confidence. In other words, changes in the exogenous variables
are assumed to be the causes of changes in the endogenous variables. In this example
model, a change in consumer confidence is assumed to result in a change in GDP, but
not the other way around. A simpler way of putting it is: Exogenous variables go into
the model, and endogenous variables come out.

The most famous economic model is the supply-demand model. The supply function
of a good is given by the equation

Qs = S(P,Pm).

Where P is the price of the good, and Pm is the price of the materials used to make the
good. The demand function is given by the equation

Qd = D(P, Y)

Where Y is the aggregate/national income. The final part of the model is the
assumption of market clearing: that the price of the good adjusts so that supply equals
demand:

Q = Qs = Qd

Where Q is the amount of that good produced after the market clears. This is called
the equilibrium quantity, and the price at which the market clears is the equilibrium
price. In this model, Q and P are the endogenous variables, and Y and Pm are the
exogenous variables.

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However, there is most often not one model that completely explains a
macroeconomic phenomenon, so economists usually use multiple models. The models
then differ in the assumptions that they make about the relationships between the
variables. For example, some models assume that markets do not always clear
because prices are sticky, meaning that prices tend to change only slowly after a
change in an exogenous variable (a change in an exogenous variable is also called a
shock), whereas other models assume continuous market clearing and flexible prices.

1.3. How This Book Proceeds

An overview of the structure of the book.

The outline of this book is as follows:

Part one: Introduction

Chapter 1 and 2

Part Two: Classical Theory: The Economy in the Long Run

Chapters 3 to 7

Part Three: Growth Theory: The Economy in the Very Long Run

Chapters 8 and 9

Part Four: Business Cycle Theory: The Economy in the Short Run

Chapters 10 to 14

Part Five: Topics in Macroeconomic Theory.

Chapters 15 to 17

Part Six: Topics in Macroeconomic Policy

Chapters 18 to 20

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2. The Data of Macroeconomics


The three most important statistics in macroeconomics are GDP, the inflation rate,
and the unemployment rate.

2.1. Measuring the Value of Economic Activity: Gross Domestic Product

Gross Domestic Product (GDP) is the measure of the total income in the economy, or
equivalently, the total expenditures on goods in the economy. It is derived from the
circular flow of economic activity and measured within the framework of the
national income accounts. We make the distinction between Real- and Nominal
GDP, and the GDP-Deflator, a measure of inflation, is derived from the two. The
components of GDP are consumption, investment, government expenditure and net
exports. GDP is always adjusted for seasonal cycles.

Economists use economic theories to explain and understand the economy, but a
theory that is not based on empirical data is likely not valid. Data is used to 1) build
theories, and 2) test their validity. In other words, data is the evidence used to test
theories. Economists have become better and better over time at systematically
collecting data relating to the economy. This chapter focuses on the three most
important macroeconomic statistics on which data is being collected: GDP, the
inflation rate, and the unemployment rate

Income, Expenditure and the Circular Flow

GDP is measured by combining a large amount of primary data sources:


administrative data such as data of tax collection, data from government programs,
regulatory programs, and statistical surveys of firms. These are then used to estimate
the value of GDP.

There are two interpretations of the GDP statistic: 1) The total income of everyone in
the economy, and 2) the total expenditure of goods and services in the economy.
These quantities are the same, because every time a good is purchased, the
expenditure on that good by the buyer is exactly the same as the income provided by
that good for the seller.

The system that is built to categorize and relate all the components of GDP is called
national income accounting, and is based on the circular flow model of the economy.

The circular flow model consists of two actors: Firms, and Households. There are two
flows in this model: 1) the flow of goods and services. Households provide labour to
firms that are used to produce goods. And firms provide these goods to households.

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2) The flow of currency (e.g. Dollars/euros). Firms provide income payments to


households in exchange for their labour, and households provide expenditure
payments to firms in exchange for their produced goods. The two measurements of
GDP correspond to the total income and total expenditure respectively.

The values of goods measured in the national income accounts come from the market
price of that good. If there is no market for a good, an estimate is made of its value
(called its imputed value). The underground economy, or black market, is not included
in GDP.

Real GDP versus Nominal GDP

There are two different measurements of GDP: Real GDP and Nominal GDP. The
Nominal GDP of year 2012 is measure by using the amounts produced of all goods
and services and their prices in the year 2012. The problem with this measurement, is
that because the price level changes over time, sometimes to a very great extent
(inflation), this makes the comparison of nominal GDP in year 2000 with nominal GDP
in year 2010 rather meaningless. It could be possible that the economy did not
produce any more goods in 2010 than in 2000, but if prices have risen, there will
nevertheless be a growth in nominal GDP. To correct for inflation, the Real GDP
statistic was created. It measures the GDP using constant prices for all years. The
value of this constant price level is the price level in the so called base-year. For
example, if the base year is 2000, then the real GDP of 2012 is formed from the
amount of goods produced in 2012 and the price level from the year 2000:

Real GDP in year 2012 = (2000-price of apples X 2012 quantity of apples) +)


2000-price of oranges X 2012 Quantity of oranges)

One measure of the inflation rate, the rate at which prices are increasing, is called the
GDP deflator, and can be calculated from real and nominal GDP:

GDP Deflator = Nominal GDP/Real GDP

It is the price of output in a year relative to its price in the base-year.

The Components of Expenditure

GDP is divided into four broad categories within the national income accounts:

Consumption. The goods and services bought by consumers/households for


immediate use.

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Investment. The goods and services bought for future use. They include
business fixed investment, residential fixed investment, and inventory
investment. This generally refers to expenditure on goods that can be used in
future production.
Government Purchases. Goods and services purchased by all levels of
government (e.g. federal, national, local, etc..)
Net exports. The export of goods and services to other countries minus the
imports from other countries. This accounts for trade between countries.

The national income accounts identity summarizes these components of expenditure:

Y = C + I + G + NX

Besides GDP, there are a number of other very similar but subtly different measures
of income. Gross national product (GNP), which corrects for cross-border factor
payments, net national product (NNP) which accounts of the tearing down of goods
over time (depreciation), and a number of other measure.

Seasonal Adjustment

GDP is always measured over a time interval. This is equivalent to saying that it is a
flow variable, and not a stock variable. A stock variable is measured at a specific
point in time. An analogy for this is the example of a river that moves to a lake. The
river consists of a flow variable, because it consists of a certain amount of water that
moves into the lake over a certain time interval (for example 1000 litres per second),
but the lake consists of a stock variable, because it contains a certain amount of water
at a certain point in time. So GDP is always income per year/month/day (usually
measured as per year). However, the actual GDP changes vastly at different parts of
the year. During the summer holidays, GDP is relatively low. Economists are much
more interested in the average GDP over the whole year, than in the predictable but
un-interesting seasonal differences. This is why GDP is usually seasonally adjusted,
which means that that the GDP measured during a quarter of a year is not the actual
income during that time interval, but what that income would be on average over the
entire year. In this way, GDP over time is smoothed. GDP statistics are almost
always seasonally adjusted.

2.2. Measuring the Cost of Living: The Consumer Price Index

Inflation is the gradual increase in the price level of an economy, the


weighted average level of prices of all goods in an economy. There are multiple
measures of the inflation rate, of which the CPI is the most commonly used, and it is
a Laspeyres index. Another is the GDP deflator, which is a Paasche index. Neither of

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these measures are perfect estimates of inflation, and all measures either understate
or overstate inflation.

Inflation is the process that the price level rises over time. The price level is a kind of
average of all the prices of all the goods in the economy. There are multiple
measures of the price level, and the most commonly used measure is the Consumer
Price Index (CPI), that measures the price level of a large number of consumer goods.
Another example is the GDP deflator (explained in the preceding subchapter). The CPI
and other price indexes are always measured with respect to some base-year.

If the base year is 2000, then the CPI in year 2012 is:

CPI = (2012-quantity of apples X 2012-price of apples) + (2012-quantity of


oranges X 2012- price of oranges)/ (2012 quantity of apples 2000 price of
apples) + (2012 quantity of oranges 2000price of oranges)

There are a number of key differences between CPI and GDP-deflator measures of
inflation.

1. The GDP-deflator measures the prices of all goods, whereas the CPI measures
the prices only of consumer goods.
2. 2. The GDP deflator includes only domestically produced goods, whereas the
CPI includes also imported goods. For example, an increase in the price of oil
has no impact on the GDP deflator of a non-oil producing country, but it will
likely strongly influence the CPI.
3. GDP-deflator is a Paasche index, whereas the CPI is a Laspeyres index. A
Paasche index is an index with a changing basket of goods (quantities of the
good are different in the base year than in the year being measured), whereas a
Laspeyres index is an index with a fixed basket of goods. The significance of
this is that a Laspeyres index overstates inflation, whereas a Paasche index
understates inflation. The actual level of inflation is not directly measurable,
but for this reason, economists sometimes take the average of a Laspeyres and
Paasche index to more accurately estimate the level of inflation.

Besides the inherent bias of Laspeyres indexes to overstate inflation, there are other
reasons why the CPI allegedly overstates inflation:

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1. The introduction of new goods. This will increase the purchasing power of
consumers, because new goods are often also better, yet it is not reflected in a
lower CPI
2. Unmeasured increases in quality. Goods are often improved in subtle ways.
(E.g. computers have become better over the last decades), but these
improvements are not measured into the CPI. Therefore, if the price of a
computer rises over time, the CPI will consider this to contribute to inflation,
even if this rise in price might be a reflection of an increase in its technological
qualities.

2.3. Measuring Joblessness: The Unemployment Rate

The unemployment rate is the fraction of unemployed workers as a percentage of


the labour force. It is related to but distinct from the labour-force participation rate,
the number of people willing and able to work as a percentage of the adult
population in a country. The unemployment rate is measured using a household
survey.

The unemployment rate is an important economic measure because a high


unemployment rate suggests that the economy is not using its resources to its fullest
extent, and because high unemployment means a large number of people who are
unsatisfied.

The unemployment rate is estimated by a government agency (e.g. the U.S. Bureau of
Labour Statistics), using a large survey of households. People are categorized into one
of three categories:

Employed
Unemployed
Not in the Labor Force

The labour force equals the amount of employed workers plus the amount of
unemployed workers (L = E + U), and it refers to the number of people that are able
and willing to work. People not in the labour force include those who would want a
job but have given up looking for one, or those who cannot work or do not want to
because they are disabled retired, or students.

The unemployment rate is the number of unemployed as a percentage of the labour


force (u = U/L). Similar but distinct statistic is the labour force participation rate, the
number of people in the labour force as a percentage of the adult population.
In most western economies the labour force participation rates among men have
decreased slightly, whereas that of women has increased steeply over the last 60
years.

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2.4. Conclusion: From Economic Statistics to Economic Models

The three statistics of GDP, inflation rate, and unemployment rate are quantified
measures of the performance of the economy. They are used as policy information
by practical decision makers, but also as empirical data for economic scientists, who
use them to build and test their models. One key lesson learnt from this chapter is
that all macroeconomic statistics are only imperfect estimates.

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3. National Income: Where it comes from


and where it goes
GDP is the measure of national income. This chapter addresses where GDP comes
from, how income and output are distributed, and what determines the supply and
demand for goods and services.

The circular flow model introduced in chapter 2, consisting of firms and households, is
a bit too simple. A more expanded version of the circular flow model also includes the
government, and three key markets: The markets for goods and services, the markets
for the factors of production, and the financial markets.

This chapter will develop a basic classical model that explains the interactions depicted
in this figure, thereby answering four basic questions about GDP:

What determines a nations total income (GDP)?


How is this income distributed among workers and owners of capital?
How is the output of production distributed among households and firms?
How is equilibrium between demand and supply of goods and services
achieved?

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3.1. What Determines the Total Production of Goods and Services?

The production function and factors of production together determine the level of
output.

In the classical theory, GDP is determined by two things:


1) The factors of production of an economy
2) The production function of an economy

The current consensus of economists is that the classical theory is a theory of the long
run, and therefore does not explain short run fluctuations in GDP, nor the very long
run development of the economy. For this, see chapter 10 and 8 respectively.

Factors of production
Factors of production are inputs used by firms to produce goods and services. There
are two main factors of production, Labour (L) and Capital (K). Sometimes Land is also
included as a factor of production, but it is omitted in this book.
We make the simplifying assumption in this chapter that the factors of production are
fixed, i.e. they do not change over time. This is depicted symbolically by an overbar as
follows:

K =K, L = L

We also make the simplifying assumption that all factors are fully utilized in
production at all times, which effectively means zero unemployment, and zero idle
capital.

Production function
the production function is a function of form:

Y = F (K, L)

It reflects, among other things, the available technology in an economy that allows it
to use the factors of production to produce goods and services. This means for
example that an economy with a very highly educated and skilled labour force will
have a different production function than a country with a lowly educated and
unskilled labour force. The former country will produce more with the same amount
of labour and capital than the latter, which is represented by a higher value of the
production function given the same K and L.

One possible property of a production function is constant returns to scale. This


means that increasing the amount of labour and capital by 10% will also increase
production, and therefore GDP, by 10%. This is depicted mathematically as follows:

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zY = F(zK,zL)

Production functions can also have increasing and decreasing returns to scale.
We also assume that the production function is fixed over time.

The supply of goods and services


the production function and the factors of production together determine the supply
of goods and services in the classical model. Because both the factors and the
production function are fixed, GDP is also fixed in the classical theory:

Y = F(K,L) = Y (WITH OVERBARS)

Growth in GDP is addressed in chapters 8 and 9

3.2. How Is National Income Distributed to the Factors of Production?

National income is distributed among the different factors of production, labour and
capital. This chapter addresses how this distribution arises.

This subchapter explains the so called neoclassical theory of distribution, a neoclassical


theory that predicts how the income is distributed among the factors of production.
The theory is a synthesis between classical (18th century) theory of supply and
demand, and the 19th century theory of marginal productivity.

Factor prices
Factor prices are the amounts paid to the factors of production per time interval (it is
therefore a flow-variable). The factor price of labour is the hourly, daily, weekly,
monthly, or yearly wage. The factor price of capital is the hourly, weekly, monthly, or
yearly rental price of that capital good (for example the monthly rental price of renting
an office building, or of a factory machine).
In the classical (long term) theory, the factor price is determined by the equilibrium
between the supply and demand of that factor.

The Decisions Facing a Competitive Firm

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The classical theory assumes that all firms are competitive firms. A competitive firm is
so small that it has negligible influence on the market prices in which it trades. This is
equivalent to the assumption of perfect competition.
We assume that the goal of all firms is to maximize profit. Profit is determined as
follows:
Profit = Revenue Costs.
Where Costs = Labour Costs Capital Costs.
And Revenue = Good price * F(K,L)
Where F(K,L) is the individual production function of the firm, and gives the amount
of its good produced.
Therefore:
Profit = P*F(K,L) WL RK
Where W is the wage rate of labour, and R is the rental rate of capital.
A firm must decide how much Labour and Capital to employ in order to maximize
profit.

The Firms Demand for Factors


the demand for the factors of production is the amount that all firms would like to
employ of those factors. Firms will want to employ such an amount that they
maximize their profits. According to the classical theory, they will employ such that
the Marginal product of that factor equals the price of that factor, and this can be
explained as follows.
The marginal product of labour (or capital) is the extra production created by
employing an extra unit of that factor.
So MPL = F(K,L+1)-F(K,L)
the marginal product of a factor can also be calculated by taking the mathematical
derivative of the production function with respect to that factor.
Most production functions have a property called diminishing marginal product. This
means that, while keeping all other factors constant, increasing the amount of a factor
will yield less and less results per unit. E.g. employing 1 worker instead of 0 workers
will yield far greater results for a firm than employing 101 workers instead of 100.

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Because firms maximize profits, they keep employing a factor of production until
doing so would no longer increase profits. In other words, they stop employing it as
soon as marginal revenue equals marginal cost (i.e. until the extra revenue of
employing 1 unit of a factor equals the extra cost of employing it):

Profit = Revenue cost = 0

For Labour this is

P * MPL W = 0

And for Capital it is

P * MPK R = 0

From this we can derive the wage rate and the rental rate of capital:

W = P * MPL

R = P * MPK

Alternatively we can write the real wage and real rental rate instead of their nominal
values (just like deriving real GDP from nominal GDP):

W/P = MPL

R/P = MPK

So the firms demand each factor of production until marginal product falls to their real
factor price.

The Division of National Income

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The income is distributed between the owners of the firm, the owners of capital and
the workers (labour). However the economic profit of the firms in the neoclassical
theory, is zero. This is because the neoclassical theory assumes a production function
with constant returns to scale, and therefore when marginal products equal the real
price of the factors, revenue equals costs, and profit is zero.
Here we must distinguish between economic profit and accounting profit. In the real
world, the owners of the firm are usually also the owners of capital, and accounting
profit therefore also equals the return to capital. Economic profit only equals the
profit that remains after having paid the owners of capital.
We conclude that total income is distributed among labour according to the marginal
productivity of labour, and to capital according to the marginal productivity of capital.

The Cobb-Douglas production function


one commonly used production function is the cob-douglas production function.
It has the following form:

F(K,L) = AKL1-, Where 0<<1

It has two important characteristics:

1. It has constant returns to scale


2. A constant percentage of economic output is distributed to the factors of
production, namely its power.

The second means that a share of goes to the owners of capital, and a share of 1-
goes to labour. The cob-douglas function is often used, because it has been shown
empirically that the share of income that goes to labour and capital is indeed very
constant.

3.3. What Determines the Demand for Goods and Services?

Demand for goods and services is determined by those who are willing to purchase
its output: consumers, investors and the government.

The previous subchapter explains the distribution of income (GDP). This subchapter
explains the distribution of expenditures on the goods produced (also GDP).
WE make the simplifying assumption of a closed economy meaning that there is no
trade with other countries, so that net exports are zero. This means that GDP
becomes:

Y=C+I+G

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Consumption
Consumption is done by households, and is thus based on the income of households,
Y. However, households have to pay taxes T to the government, so the amount that
they consume is not based on income, but on disposable income Y T:
C = C(Y-T)
This function is called the consumption function, and its derivative is the Marginal
propensity to consume.

Investment
Investment is expenditure on goods used for the future. The interest rate is the major
determinant of the quantity of investment goods demanded. The interest rate is the
cost of funds used to finance investment. However, just as there is real and nominal
GDP, there is a real and a nominal interest rate. The real interest rate (r) is the nominal
interest rate (i) corrected for the effect of inflation ():

r=i

Investment is a function of the real interest rate:

I = I(r)

Note: there are in fact an enormous number of different interest rates, but since they
are all strongly related, we simplify this by speaking of the interest rate.

Government purchases
Government purchases or government expenditures are all expenditures by all layers
of government (local, state, federal/national).
Government purchases are not the same as government spending. Government
spending also includes income transfers, such as social security programs, and
retirement programs, but this is not included in government purchases.
If government expenditures equal taxes, then the government is running a balanced
budget. If G is less than T, it runs a surplus, and if T is less than G it runs a deficit. Both
T and G are fixed variables in the classical theory.

3.4. What Brings the Supply and Demand for Goods and Services Into
Equilibrium?

In the classical model, equilibrium between supply and demand of goods and services
is determined by the interest rate, which is determined by the market for loanable
funds.

In this model, the exogenous variables are Taxes and Government expenditure, and
the endogenous variables are consumption, investment and the interest rate. The

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question is, what brings supply and demand for output in equilibrium?

Equilibrium in the supply and demand for goods and services


the supply of the goods and services in the economy is determined by the production
function
Supply of Y = F(K,L) = Y- WITH OVERBARS
the demand for goods and services is

Y = C+I+G, Where C = C(Y-T)

I = I(r)
G=G
T=T

So because the economy is in equilibrium:

Y = C(Y-T) + I(r)+G

The interest rate r is the only variable that is not determined. It is the interest rate
that changes in order to equilibrate supply and demand for goods and services. When
supply equals demand, we speak of the equilibrium interest rate.

Equilibrium in the financial markets


Why is it the interest rate that equilibrates the supply and demand of goods and
services? To understand this we turn to the financial market, and its role in the
circular flow.
Households do not spend all their disposable income. They allocate their disposable
income to consumption and private saving. The government also does not necessarily
spend all their tax revenue, or more than it. The budget surplus is equal to public
saving. National saving is the sum of public and private saving, and is fixed because all
its constituent elements are fixed:

S = Y-T-C(Y-T) + T-G

Saving is equal to the supply of loanable funds in the financial markets. The financial
markets serve the function of redirecting national saving to investment. Loanable
funds can be seen as just another good, where the interest rate equilibrates the two:

S = I(r)

The interest rate adjusts until the amount that firms want to invest equals the amount
that households and the government want to save, so that the quantity of loanable
funds supplied and demanded are equal.

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Changes in Saving: The Effect of fiscal policy


From the equation of the market for loanable funds, it can be seen that if government
purchases increases, saving decreases. So the interest rate must increase, and
therefore investment decreases.
Because the level of income is assumed to be constant in the classical model, the
increase in government purchases is offset exactly by a decrease in investment.
Therefore we say that government purchases crowd out investment.
A decrease in taxes has a similar effect, but also influences saving by increasing
disposable income, so the effect of a decrease in taxes on saving is smaller than an
equal increase in government expenditures.

Changes in investment Demand


It is possible that investment demand increases, because for example there is
technological innovation, or because the government encourages investment through
its tax or regulatory laws. In this case the investment function I(r) shifts to the right.
However because saving is fixed, this has no effect on investment, only on the
interest rate.

There are also models that assume that saving and consumption depends on the

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interest rate, so that saving is not fixed. However we do not address such models in
this book.

3.5. Conclusion

This chapter has explained the classical model, but this model only described the
economy in the long run. It neglects the short run and very long.

This chapter has explained the classical long run model that assumes that prices adjust
to equilibrate supply and demand. We will address more expanded models in later
chapters by focusing on different aspects of the economy:

This model does not address the role of money. This is addressed in chapters 4
and 5
It does not address trade. This is addressed in chapter 6
It does not address unemployment, which is addressed in chapter 7
It assumes that the capital stock, labour force and production technology is
fixed. This assumption is dropped in chapter 8 and 9 which addresses the very
long run, the growth of an economy.
It does not address the fact that in the short run, prices are sticky. Chapters 10
to 14 explain the short run business cycle.

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4. The Monetary System: What It Is and


How It Works
The two main types of macroeconomic policy are fiscal policy and monetary policy,
and this chapter discusses the basics needed to understand monetary policy,
inflation and the banking system. It discusses the role of money, banks and the
central bank in the economy.

4.1. What Is Money?

The way economists use the word money is different from the way it is used in
everyday life. There are different types of money, and this chapter introduces the
concept of the money supply.

The word money has a specific meaning in the field of economics that is different
than its meaning in everyday use. It is the stock of assets that can be readily used to
make transactions. It does not refer to the wealth of an individual. It nevertheless
includes certain instruments not usually regarded as money, such as money market
assets.

Functions of Money
There are three functions of money

A store of Value. It allows people to transfer purchasing power from the


present to the future
Unit of account. It allows us to compare the value of different items, such as
cars and apples, which would otherwise be very difficult to compare
Medium of exchange. It allows us to exchange goods and services with each
other without having to find a set of individuals who happen to have exactly
what the others want.

Types of Money
Over history there have been different types of money. Today the most commonplace
form of money is fiat money, money that has no intrinsic value as a good. Another
type is commodity money. In this case a certain commodity that also has an intrinsic
value is used as money, such as copper which is much used in industries. Using gold as
money, or paper money that is officially backed by gold, is called a gold standard. Fiat
money is generally considered efficient because it is lightweight (lower transaction
costs). The value in money is not actually in the intrinsic value of the item, but in the
fact that it is a social convention.

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How the Quantity of Money is controlled.


The quantity of money of a certain currency is called the money supply. Monetary
policy is the control of the government over the money supply. Monetary policy is
delegated to a central bank in most countries. The central bank of the United States is
called the Federal Reserve. Central banks control the money supply primarily by open-
market operations, which is the purchasing and sale of government bonds. A sale of a
bond in exchange for money reduces the money supply (because the money used to
purchase the bond from the central bank, is now no longer in the economy but in the
central banks vaults), and the purchase of a bond increases the money supply.

How the Quantity of Money is measured.


There is not just one measure of the money supply, because what counts as money is
somewhat vague. What is always included is currency, the total paper money and
coins in an economy. Also included are demand deposits. In another measure, savings
deposits are also included. M1 equals Currency + demand deposits. M2 equals M1 +
money market mutual fund balances + savings deposits.
4.2. The Role of Banks in the Monetary System

The role of the banking system in the monetary system is that in fractional-reserve
banking, the money supply is in part determined by banks.

The central bank does not actually directly control the money supply, because the
money supply is not just currency. The money supply is determined by both the
central bank, and the banking system, and in order to understand the money supply
we must understand fractional reserve banking. Throughout the book we assume that
M = M1.

100-percent-reserve banking
In a world with 100-percent-reserve banking, banks do not lend out the money that
people deposit. This means that if one puts money on the bank, the deposits on that
bank will increase just as much as the currency will decrease (because the currency is
now in the banks vaults, and no longer in the economy).
The balance sheet of a bank thus looks like this

In this type of banking system the banking system does not affect the money supply.

Fractional Reserve banking


For the last centuries, the banking system has been a fractional-reserve
banking system. This means that banks only keep a fraction of their deposits as

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reserves and give out the rest as loans. The balance sheet of the bank now looks like
this:

The amount that is loaned out is now held either as currency or it is put back into a
bank. Therefore the same dollar is counted twice, because it is counted as a deposit
by the person who went to the bank, but also as a deposit by the person who loaned
from the bank. This in turn is again lent out, and so forth. We say that banks create
money. They do this by transferring funds from savers to borrowers, and this process
is called financial intermediation.

Bank Capital, Leverage and Capital Requirements


In the previous examples, a bank only has bank deposits, but in reality, banks also
have their own capital. The fact that banks use deposited funds besides their capital
to invest is called leverage. The leverage ratio is the ratio of the banks total assets to
its capital (owners equity). One of the regulatory restrictions on banks is capital
requirement. This means that the leverage ratio is not allowed to be higher than a
certain amount (i.e. the capital to asset ratio must be higher than a certain amount).

4.3. How Central Banks Influence the Money Supply

The central bank determines the monetary base, and the banking system determines
the money multiplier. Together they determine the money supply.

We now combine the model of the banking system and the central bank to build a
model of the money supply.

A Model of the money supply


The model has three exogenous variables:

Monetary base B. The total number of Currency C and Reserves R. B = C + R.


Reserve-deposit ratio rr. The fraction of deposits held by banks in reserve. It is
determined by bank policy and regulatory laws. Rr = R/D
Currency-deposit ratio cr. The ratio of currency C that people hold to the
demand deposits D. cr = C/D.

We use M = M1, which is C + D.


Dividing the money supply by Monetary Base gives
M/B = (C+D)/(C+R)

Dividing top and bottom of the fraction by D gives

M/B = (C/D + 1)/(C/D + R/D) = (cr +1)/(cr + rr)

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We call m = (cr +1)/(cr + rr), the money multiplier.


Therefore, M = m * B
The monetary base is for this reason sometimes called high powered money,

The Instruments of Monetary Policy


The Central bank has multiple ways to change the monetary base. The main one as
described earlier is open market operations. The CB can also lend directly to banks at
the so called discount rate (the interest rate on these loans).
The Central bank can also influence the reserve-deposit ratio by multiple means. The
main instrument of doing so is the reserve requirements, a regulation that imposes a
minimum on the reserve-deposit ration of each bank. This tool has become less
effective because banks have started to hold excess reserves. Another tool is that the
CB can pay interest on reserves at the CB. This means that if banks hold reserves, the
CB pays those banks an interest on them.

Although the CB has multiple instruments by which it can effectively change the
money supply, it is not straightforward for the CB to actually control the money
supply, because it often does not have the necessary information to predict how the
money multiplier will change. One example where this went wrong is the banking
crisis during the 1930s; the Federal Reserve is often blamed here for not increasing
the money supply.

4.4. Conclusion

We have now seen how the central bank can control the money supply, but this is
only interesting if we know how the money supply influences the economy, which is
the subject of the next chapter.

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5. Inflation: Its Causes, Effects, and Social


Costs
This chapter addresses the causes, effects, and social costs of inflation and its
relation to the money supply within the classical theory. Inflation is the overall
increases in prices.

Inflation can sometimes take such proportions that we speak of hyperinflation,


periods of extraordinarily high inflation, such as the 500 percent inflation per month
in Germany in 1923. Normal levels of inflation are between 2 and 20 percent.

5.1. The Quantity Theory of Money

The quantity theory of money describes the effect of the money supply on inflation
in the long run.

This subchapter explains the Quantity theory of money, the dominant (classical)
theory of the effect of the money supply on the economy (in the long run).
The theory consists of the quantity equation:
Money X Velocity = Price X Transactions

MXV=PXT

Where V is the transactions velocity of money, the number of times a


dollar/euro/yen changes owner during a given period of time. T is the total amount of
transactions done during that period of time. The quantity equation is an identity (it is
by definition true, due to how the variables are defined).
However, the amount of transactions is hard to measure and not very meaningful, so
therefore we change the equation to

M X V = PXY

Where Y is output, or income (GDP). Output is not the same as the amount of
transactions, but they are roughly proportional, so that the equation still reasonably
holds. Within this equation, V becomes the income velocity of money.

The money demand function and the quantity equation.


We can express the money supply in terms of how much goods and services it can
purchase. This gives us the real money balances, M/P. We can then write the money
demand function, the demand for real money balances:

(M/P)d = kY

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By assuming that money demand must equal money supply, we can rewrite this to
M(1/k) = PY, so that we see that V = 1/k. We conclude that the money demand and
money velocity are two sides of the same coin.

Using these definitions, we now formulate the quantity theory of money by assuming
that money velocity remains constant: MVUPBAR = PY. Since Y is fixed in the
classical theory, there is a direct linear relation between the money supply and the
price level.
According to this theory therefore, the central bank has ultimate control over
inflation. Again, this classical theory works well in the long run, but not so well in the
short run.

5.2. Seigniorage: The Revenue from Printing Money

Seignorage is government revenue caused by increasing the money supply.

Inflation is not the only direct consequence of increasing the money supply. The most
important motivator for the government to increase the money supply is to earn
revenue that is received by printing money. This source of government revenue is
called seignorage. This is effectively a hidden inflation tax, because printing money
causes inflation over time, while households income stays the same, thereby
decreasing real household income. In history, wars have often been financed by
seignorage revenue, and are often accompanied by higher inflation. An example is the
American Revolution.

5.3. Inflation and Interest Rates

The real interest rate can be derived from the nominal interest rate and the rate of
inflation.

There is an important relation between inflation and the interest rate. Just like many
economic variables, there is both a nominal interest rate and a real interest rate. The
nominal interest rate is the actual interest rate paid (e.g. by government bonds). The
real interest rate is corrected for inflation:

r=i

Thus the real interest rate is a theoretical variable not actually observed, but derived
from the nominal interest rate and inflation. However, if we write it in its opposite
form, and assume that the real interest rate remains relatively constant, we get the
Fisher equation:

i=r+

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We can see that the nominal interest rate can change either because the real interest
rate changes, or because the inflation rate changes. The one for one relation between
the nominal interest rate and the inflation rate is called the fisher effect.

Two Real interest rates: Ex Ante and Ex Post


We distinguish between two types of real interest rate:

Ex Ante r = i E, where E is the expected level of inflation at the time that


the contract of a loan is signed. It is the real interest rate expected beforehand.
Ex Post r = i . It is the real interest rate actually realized afterwards.

Because the nominal interest rate does not actually adjust to inflation after the
contract is signed, the more precise version of the fisher equation is
i = r E.

5.4. The Nominal Interest Rate and the Demand for Money

There is a relation between the interest rate and the demand for money.

The money demand function in the quantity theory is based on the assumption that
money demand is proportional to income (addressed in 5.1). However in reality
money demand is also dependent on the nominal interest rate. The nominal interest
rate is effectively the price of holding money, because it is an opportunity cost of
foregoing the income of saving. Therefore we introduce the more complete money
demand function:

(M/P)d = L(i, Y)

This can also be written as

(M/P)d = L(r + E, Y)

This shows us that the current money demand depends on the expected future price
level. Therefore the demand for money depends on the money supply growth, which
complicates the earlier quantity theory of money.

5.5. The Social Costs of Inflation

Economists point to specific costs associated with inflation that are different than
what laymen tend to consider. There is also a possible benefit of inflation.

Most non-economists believe that there are certain social costs associated with
inflation. Economists certainly agree that such costs exist, but the laymans view of
the costs of inflation is different from the costs of inflation described by the classical

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view.
Laymans view: Inflation is bad because it diminishes the real purchasing power of
peoples income.
The classical response to this is that nominal incomes also rise with inflation, so that
inflation does not cause a diminishing real purchasing power.
The actual costs of inflation according to the classical view can be put in two
categories: expected and unexpected inflation.

The Costs of Expected Inflation


There are a number of costs associated with inflation that people saw coming.

It being an inflation tax has a distorting effect on the amount of money people
hold. This creates so called shoeleather costs, costs that are created by having
to go to the bank more often.
Firms have to change their prices more often. This creates so called menu
costs, because changing a price often has a cost.
High levels of inflation mean that there is higher variability in relative prices in
cases where prices havent changed yet due to menu costs.
Many provisions in the tax codes do not take inflation into account, causing
microeconomic inefficiencies if inflation is high.
An always changing price level is inconvenient for people, because it makes it
harder to use money to compare the value of things.

The Costs of Unexpected inflation


Economists generally think that unexpected inflation, inflation that the public didnt
see coming, is more harmful than expected inflation.

It arbitrarily reallocates wealth from creditors to debtors


It diminishes the incomes of individuals on fixed pensions

Therefore highly variable inflation, which has a larger element of unexpected inflation,
is relatively damaging. It is an empirical regularity that higher inflation is also
associated with higher variability of inflation.

One Benefit of Inflation


An inflation of 2 to 3 percent is a good thing according to some economists.
According to this argument, nominal wage cuts dont happen often, and inflation is a
way of allowing a reduction of real wages in case this is necessary to equilibrate the
labour market.

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5.6. Hyperinflation

Hyperinflation is an extreme level of inflation.

Hyperinflation is extraordinarily high inflation and this is usually defined as inflation


larger than 50 % per month. The costs of hyperinflation are the same as the costs of
expected inflation, but these costs rise to extreme and unmaintainable levels.
The causes of hyperinflation boil down to an extreme growth in the money supply.
Most often this growth is necessary to finance government spending. The
government doesnt have enough other sources of revenue, so uses seignorage
revenue. However due to the costs of high inflation, this is a downward spiral, so that
the government is eventually trapped in a policy of hyperinflation. A famous
example of this is Germany from 1922 to 1924, where inflation reached 100 percent
per month, until a new central bank was installed that was banned from buying
government bonds. This hyperinflation started because of Germanys fiscal problems
after WWI, leading it to turn to seignorage revenue. Another famous example is
Zimbabwe, where in 2008 inflation reached 231 million percent.

5.7. Conclusion: The Classical Dichotomy

The classical dichotomy is one of the fundamental theoretical propositions in


classical theory.

One important conclusion of the classical theory is that although inflation has certain
effects by itself, in the long run money is neutral. This gave rise to the classical
dichotomy, the distinction that has already been made earlier, between real and
nominal variables. Real variables correct for the price level and inflation, because in
the long run, inflation has approximately no effect on economic activity (e.g. doubling
the price level will double nominal GDP, but it will not double actual physical
production). This phenomenon is called monetary neutrality, and it is approximately
correct in the long run. In chapter 10 we study how monetary neutrality breaks down
in the short run.

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6. The Open Economy


Previous chapters have discussed a closed economy. This chapter introduces the
open economy, an economy that conducts international trade.

6.1. The International Flows of Capital and Goods

International capital flows and the flows of goods and services always balance out.

When we include international trade in our analysis the national income accounts
identity of an open economy needs to be expanded:

Y = C + I + G + X IM

Where X is exports and IM is imports. Imports need to be subtracted from GDP,


because imports are not produced in the domestic economy, but they are included in
consumption, investment and government expenditures. Equivalently, they have to be
subtracted because people expend income on imports but nobody in the domestic
economy earns income from those expenditures. We define net exports as exports
minus imports: NX = X- IM. Now the identity becomes:

Y= C + I +G + NX

International capital flows and the Trade Balance.


In chapter 3 we derived the equation S = I for a closed economy, but in an open
economy we have to take into account net exports. Saving S is still equal to Y C G,
and rewriting the open economy income identity now gives: S = I + NX. This can be
rewritten as S-I = NX.
This gives us the relation between capital flows and the trade balance. The trade
balance is simply another word for net exports (because it shows the balance of
inward and outward trade). Net capital outflow is the outflow of loanable funds minus
the inflow, and since saving is the total domestic amount of loanable funds available,
and these funds are expended on investment, S-I is the net capital outflow. So the
trade balance must by definition equal net capital outflow. If NX and S-I are positive,
the domestic economy is in a trade surplus, if they are negative it is in a trade deficit,
and if they are zero, it is running balanced trade.

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In summary:

6.2. Saving and Investment in a Small Open Economy

Saving and investment in a small open economy do not determine the interest rate as
they did in a closed economy. Instead, they determine net exports and net outflow of
capital.

We now use this identity (an equation that is by definition true and therefore is not a
theory, because it has no empirical content), and build a theory for a small open
economy with perfect capital mobility. A small open economy is an open economy
whose GDP is so small that it has no effect on the world interest rate r*. Perfect
capital mobility means that there are no barriers between the financial markets of the
domestic economy and the world economy. Because of this assumption, the domestic
interest rate must equal the world interest rate:

r = r*

r* is determined by global demand and supply of loanable funds, but since we describe
a small open economy, the domestic economy has no influence on r*. We assume a
small open economy because it simplifies the analysis.

The Model
We use three assumptions from the model for a closed economy:

Y = Y = F(K,L)
C = C(Y-T)
I = I(r)

We can now write the accounting identity as NX = S I(r*).


Therefore, Net exports are determined solely by saving, and investment at the world
interest rate.

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How Policies influence the Trade Balance.

Domestic fiscal policy.


Increasing G reduces S, shifting the Savings curve to the left, thereby
decreasing net exports.
Fiscal policy abroad.
Foreign fiscal expansion (increasing G or decreasing T) decreases global saving,
and this increases r*
Shifts in Investment Demand.
This shifts the investment curve to the right, and since r* stays the same, net
exports decreases.

Evaluating Economic Policy


The difference between an open and a closed economy is that in a closed economy,
reducing saving will reduce investment, whereas in a small open economy, reducing
saving will reduce net exports, increase capital inflow and thereby increase the
nations debt to foreigners. This is usually seen as a bad thing, but it is not necessarily.
Some countries, such as South Korea, have ran large trade deficits for an extended
period of time, but this capital inflow went into investment, allowing its economy to
grow very rapidly.
6.3. Exchange Rates

The exchange rate is the rate at which two currencies can be traded. It determines
the level of net exports.

This section introduces a new key variable in macroeconomics, one specific to open
economies, namely the exchange rate. The nominal exchange rate e is the rate at
which two currencies can be exchanged. In this book the exchange rate is always
expressed as units of foreign currency per unit of domestic currency. So if the
domestic currency is the Euro, and 1 euro can be exchanged for 2 dollars then the
exchange rate between euro and dollar is 2.

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The real exchange rate is the relative price of goods of the two economies. It is the
nominal exchange rate adjusted for the price levels:

= e * P/P*

Where P is the domestic-, and P* the foreign price level.

Because peoples willingness to trade with a country depends on the real exchange
rate, we write Net exports as a function of the real exchange rate:

NX = NX()

The determinants of the real exchange rate.


We know two things about net exports:

It must equal saving minus investment


It is related to the real exchange rate

This model combines the two by saying that the real exchange rate is determined by
both these things being true. In other words, the equilibrium real exchange rate is the
rate at which the supply of domestic currency from net capital outflow is equal to the
demand of domestic currency for net exports.

How Policies Inflience the Real Exchange Rate.

Fiscal Policy at Home. Increasing G or lowering T shifts the S-I curve to the left,
thereby increasing the real exchange rate.
Fiscal Policy abroad. Foreign countries increasing G or lowering T increases the
world interest rate. This decreases investment so shifts S I to the right.

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Shifts in investment demand. If investment demand increases, investment also


increases because r* stays the same. This shifts S-I to the left, and increases the
real exchange rate.
Effects of trade policies. Trade policies try to increase net exports by increasing
export supply or decreasing import demand. However we see from the figure
that this will not actually increase net exports, as this is determined by S-I. It
will only increase the real exchange rate.

The Determinants of the Nominal Exchange Rate.


We can rewrite the relation between real and nominal exchange rate as follows:
e = *(P*/P)

And we can now derive what would be the change in e given a change in one of the
other three variables:

% change in e = % change in + % change in P* - % change in P

This can be rewritten as

% change in e = % change in + (*-)

Where * is foreign inflation and is domestic inflation.


So we see that the nominal exchange rate over time changes due to 1) a change in the
real exchange rate 2) differences in levels of inflation.

The Special Case of Purchasing-Power Parity.


There is an important hypothesis in economics called the law of one price. This entails
that two identical goods in different locations must have the same price, because if
one were cheaper than the other, buyers would flock to that good instead of the more
expensive one. This law applied to the international marketplace is called purchasing-
power parity (PPP). It refers to the situation where all goods in the economy have the
same real price in each country. In our model it is described by the situation where the
Net Exports curve is very sensitive to changes in the real exchange rate, so that the
real exchange rate maintains purchasing-power parity. This entails that 1) changes in
saving or investment do not change the real exchange rate, and 2) the nominal
exchange rate is only changed by changes in the price levels.

There is some evidence that PPP works as an approximation in the long run, but it is
not a perfect description of exchange rates.

6.4. Conclusion: The United States as a Large Open Economy

The assumption of a small open economy is only a simplification in most cases.

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The assumption of a small open economy is not realistic for large countries such as
the United States. The United States should be seen as a large open economy. It is
important to realize that this simplifying assumption is not realistic, and that countries
like the United States actually behave in a way that is a little bit in between a closed
economy and a small open economy.

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7. Unemployment
Unemployment in the long term is determined by the rate of job separation and job
finding, and policies aimed at reducing long term unemployment should target those
variables.

There is always some unemployment in all market economies. Economists distinguish


between long term unemployment and short term fluctuations in unemployment.
Short term fluctuations are only addressed in the theories of the Business cycle,
chapter 10 to 14. In this chapter we discuss the natural rate of unemployment, the
average rate of unemployment around which it fluctuates.

7.1. Job Loss, Job Finding, and the Natural Rate of Unemployment
A basic model of unemployment is introduced.

We introduce here a model of labour-force dynamics that shows the determinants of


the natural rate of unemployment. We start with the definition of the rate of
unemployment

L=E+U

Where L is the labour force, E is the employed labour force, and U is the unemployed
labour force. The unemployment rate here is U/L
We assume that the labour force is fixed, and that a fraction of the employed E loses
their job each month, and that a fraction of the unemployed find a job. We denote the
rate of job separation (the rate at which employed people lose their job each month)
as s, and the rate of job finding (the rate at which unemployed find a job each month)
as f.
We now find the condition of steady state to determine the natural rate of
unemployment. In the steady state, the amount of people that lose a job must equal
the amount of people that find a job so that

fU = sE

Substituting L U for E, and rewriting, we find

U/L = s/(s+f) or equivalently, U/L = 1/(1+f/s)

This shows how the natural rate of unemployment depends on the rate of job
separation and the rate of job finding, and that a policy aimed at reducing the natural
rate of unemployment must either make it easier for people to find jobs, or decrease
the rate at which people lose their job. There are underlying reasons for why the rate

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of job separation and the rate of job finding are the way they are, and the next two
sections discuss two of them.

7.2. Job Search and Frictional Unemployment

Frictional unemployment is one of the two main categories of natural


unemployment.

One important element of natural unemployment is frictional unemployment. This is


unemployment that is caused by the fact that it takes time for workers to find a new
job. Workers are not all the same, so it usually takes time and effort to match a
worker to the job that suits him or her.
Frictional unemployment is inevitable, because there are always shifts in demand and
shifts in production technologies for goods. If such a shift occurs, there is also a shift
in the demand for labour needed to produce those goods, so certain jobs will
disappear and new jobs will be created. Such a shift is called a sectoral shift, and they
will cause both job separation and job finding. Another cause of frictional
unemployment is the failure and creation of firms.

Public Policy and Frictional Unemployment


The government often tries to decrease frictional unemployment using for example
employment agencies to match workers and jobs more quickly. However they
inadvertently also create frictional unemployment sometimes, for example
with unemployment insurance. This is insurance by the government to unemployed
workers, which tends to increase the time spent unemployed. However this need not
necessarily be a bad thing, because the longer time spent unemployed may result in a
more efficient allocation of workers to jobs.

7.3. Real-Wage Rigidity and Structural Unemployment

Structural unemployment is one of the two main categories of natural


unemployment.

Wage rigidity is a second reason for natural unemployment. It is the tendency that
wages do not adjust to a level that equilibrates supply and demand. Unemployment
that results from wage rigidity is called structural unemployment.

This book describes three main causes of wage rigidity:

Minimum wage laws. The government forbids firms to hire workers for a lower
wage than the minimum wage. If there are workers that want to work but are
not skilled enough to be hired for minimum wage, they will remain unemployed

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Unions and collective bargaining. Unions bargain with firms for a wage that
suits the insiders of the union: the workers that are already employed by the
firm. The outsiders, the workers that would like to work for the firm, but are
unemployed, are not at the bargaining table, so that the wage is set higher than
they would like (because the high wage stops them from being
employed).Unions do not necessarily cause wage rigidity, and countries in
which outsiders have more influence in unions tend to have lower
unemployment
Efficiency wages. According to efficiency wage theories, increasing the wage
of workers also increases their efficiency, for example because they are more
motivated, or in underdeveloped economies, because it allows them to be
more healthy. Another reason is that it reduces the incentive for workers to
leave the firm. Another reason is that it attracts better skilled workers.
Efficiency wages cause the firm to employ less workers than the labour supply.

7.4. Labour-Market Experience: The United States

The U.S. labour market is used as a case study of unemployment.

Using the U.S. labour market we now discuss some additional facts about
unemployment

The Duration of Unemployment


Not all unemployed workers are unemployed for an equal amount of time. If workers
are employed for a long time, this is a signal that the worker may be part of the
structurally unemployed, rather than the frictionally unemployed. Information about
the distribution of unemployment duration among the unemployed is an important
indicator for policymakers, as frictional unemployment and structural unemployment
require very different policy solutions. It is a matter of contention in the United States
what the causes are of long term unemployment. Some say the government
unemployment insurance is the problem, others say it has to do with the economic
downturn of the beginning of the 21st century.
Another fact that becomes clear by looking at the U.S. situation is that the labour
force, unlike in the model of this chapter, is not fixed. The crisis of 2008 has caused
many people to become discouraged workers, workers who have given up looking for
a job. They are not counted in the labour force.

7.5. Labour-Market Experience: Europe

Europe is used as a casy study of unemployment.

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Looking at Europe, we see that unemployment has risen steadily since 1960. There
has during the same period also been a pattern that workers are working less and less
hours per week. Europeans now work a smaller amount of hours per week on average
than Americans, and there are multiply hypotheses for this difference

Europeans have more taste for leisure than Americans.


The tax systems of Europe discourage work more than those of the U.S.
because they are higher
Unions push for shorter work weeks, and unions are more important in Europe
than in the U.S.

7.6. Conclusion

Natural unemployment is unemployment in the long run.

Natural unemployment is a permanent phenomenon that cannot be completely


removed. The government can try to reduce structural unemployment, but some
causes of structural unemployment, such as minimum wage laws, are desired.
Frictional unemployment can also be tried to be reduced, but it is a normal part of the
economy that results from the job matching process, which is necessary for a well-
functioning economy.

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8. Economic Growth I: Capital


Accumulation and Population Growth
The Solow Growth model is the basic model that describes long run growth of GDP.

Part II, Chapters 3 to 7, explained the classical theory of macroeconomics. It is a


theory that is now thought to apply to the Long Run of an economy. Part III, chapters
8 and 9 address growth theory, the theory of the Very Long Run. In this theory, GDP
is no longer assumed to be constant. Instead it tries to explain economic growth over
time. This is usually a slow process, 2 to 4% per year, and changes over one year are
not very noticeable, but over decades and centuries has enormous effects on the
productive power and standards of living in an economy.
The model introduced in chapter 8 and 9 is the Solow Growth Model, the basic
standard model used for economic growth in macroeconomics.

8.1. The Accumulation of Capital

The basic elements of the Solow growth model are savings, investment, and the level
of capital.

We introduce the fundamentals of the Solow Growth model

Supply of goods and the production function


The Solow model uses a basic production function for the economy, the same as is
used in the classical model in part II:

Y = F(K,L)

And just as in part II, it is a constant returns to scale production function:

zY = F(zK,zL)

However, in the Solow model, we rewrite the production function into a different
form. Instead of using the standard production function, we use the production per
labour function, and we write quantities per worker in lower letters, so that y = Y/L, k
= K/L, and the production function becomes

Y/L = F(K/L,1) = y = f(k).

We can now derive the marginal product of capital:

MPK = f(k+1)-f(k), or equivalently, MPK = f(k)

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Note that this is not the absolute marginal product of capital, but the marginal product
of capital per labour.

The demand for goods and the consumption function.


We ignore the government and trade in this simplified model, so that the demand for
goods and services is given by

y=c+i

Where c is consumption per worker, and i is investment per worker.


A fraction of the income is saved by households and this is given by s. this means that
a fraction 1 s is consumed. Therefore the consumption function is:

c = (1-s)y

W can plug this into the goods market demand function to obtain investment

y = (1-s)y + i => i = sy

Which is again equivalent to saying that investment equals savings.


These two ingredients, the production function and the consumption function are the
basis of the Solow growth model.

Growth in the Capital Stock and the Steady State.


The purpose of the Solow model is to explain long term growth, and it does so by
analysing the effect of investment on the capital stock k (capital per worker). Besides
investment, the building of new capital equipment, the second force that influences
the capital stock is depreciation, the tearing down of existing capital equipment.
The rate of deprecation each year is given by . So the change in the capital stock is
given by
k = i k, which is written as
k = sf(k) k.
The depreciation of capital goods increases linearly with respect to capital per labour,
but since the production function has constant returns to scale, investment increases
at a decreasing rate with respect to capital per labour. This means that there is a point
at which there is a steady-state, a level of capital per labour that makes that new
production of capital goods equals depreciation of old capital goods. We denote the
steady state level of capital by k*. So the steady state level of capital is defined by the
following equation:
sf(k*) = k*, so that k = 0
For this reason k can also be called the break-even level of investment here.

Two examples of the process of moving towards the steady state level of capital are
Japan and Germany after the war. The war destroyed a very large part of the factories
and other productive machinery in those countries, while the labour force was still

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able to produce the pre-war level of production. This caused investment to be much
bigger than depreciation, so that there was a period of fast capital accumulation.

How Saving Affects Growth


The Solow model predicts that an increase in the savings rate should also increase the
level of capital per labour. A higher saving rate means higher capital stock and
therefore a higher level of output in the steady-state. However a higher saving rate
does not mean higher long term growth. It only means a higher level of output at the
steady-state. Factors that influence the level of long term growth are addressed in
chapter 9.

8.2. The Golden Rule Level of Capital

The golden rule level of capital is the level of capital that maximizes consumption in
the long run.

The previous subchapter addresses the relation between the saving rate and the level
of output, but it does not address the relation to consumption. If the saving rate is 1,
then the highest output is maintained in the steady-state, but none of this output
goes to consumption, so this high level of output does not increase the standard of
living. The question arises, what is the optimal level of capital? I.e. what level of
capital maximizes consumption in the steady state? This level of capital is called
the Golden Rule level of capital, and is denoted by k*gold.
To find it, we can rewrite the demand for goods and services as:

c = y- i

Because in the steady state, investment equals depreciation, and y = f(k*), we rewrite
this as follows

c* = f(k*) k*

Where c* is steady-state consumption, and the golden rule level of capital is the level
of capital that maximizes c*.
Using the First Order Conditions (FOC), of maximization of a function using
derivatives, we conclude that the derivative of f(k*) must equal that of k* (if you do
not understand this, consult a calculus textbook, or simply rote learn the result). This
is written as:

MPK =

When this equation holds, we have reached the golden rule level of capital. For
example if

MPK = 1/(2sqrt(k)),

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We derive that k*gold = 1/(4 2). This is summarized in the following graph:

We can also derive the necessary saving rate to achieve this golden rule level of
capital by equating the steady state level of capital to 1/(4 2) and solving for s.

The Transition to the Golden Rule Steady State


Policymakers can influence the saving rate, so the policymakers problem is to set the
saving rate such, that the golden rule level of capital is achieved. Here are two
graphical depictions of what happens if a policymaker corrects for a situation of
higher than golden rule level and lower level of capital respectively:

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8.3. Population Growth

Population growth has a negative effect on the level of capital per worker in the
steady-state.

The basic Solow model predicts that capital accumulation by itself is not able to
explain sustained long term economic growth. By itself, it can only explain growth
towards the steady-state in cases of low levels of capital, such as the examples of
Japan and Germany show after WWII. There are at least two other elements that
produce growth that must be added to the model. The first is population growth,
which is added here, and the second is technological progress, added in chapter 9.
We introduce the labour force growth rate n. if n = 0.01, this means that the labour
force grows by 1 percent every year.

The Steady State with Population Growth


To reiterate, k is the level of capital per labour. If the labour force grows, then this will
slow down the growth of capital per labour, so that the function of capital
accumulation must be adjusted:

k = i ( + n)k

We see that the rate of population growth effectively functions the same as the rate
of depreciation in its effect on capital accumulation per labour. The study state
consumption now becomes:

c* = f(k*) (+n)k*

And the k*gold is now the k* at which MPK = + n

The effect of an increase in the rate of population growth can be seen here:

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This is an important effect for policymakers, because it means that in order to


increase the steady state level of income per labour in poor countries, population
growth must be decreased.

Alternative Perspectives on Population Growth


The Solow growth model does not capture all the effects of population growth. Two
of those effects are captured by the Malthusian model and the Kremerian model
respectively.

The Malthusian model. According to Malthus, population growth would increase


until the income per worker equals that, just enough to keep him alive. So he
predicted that no real economic growth per worker could be maintained in the
long run, because population growth would always compensate it. This has
turned out not to be realistic, because population growth has been broken by
modern birth control, and because Malthus underestimated the possibilities of
technological advances on food production.
The Kremerian model. According to this model, a large population means more
people who can become scientists, inventors and engineers to contribute to
technological progress, so that high population growth coincides with high
levels of economic growth.

8.4. Conclusion

The currently developed model can explain some aspects of growth, such as why
countries with high saving rates tend to have higher levels of income, and the fast
growth of Japan and Germany after the war, but it does not explain sustained long
term economic growth. To this we must include technological progress, which is
done in the next chapter.

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9. Economic Growth II: Technology,


Empirics, and Policy
In this chapter we introduce technological progress in the model, and we apply the
model to empirical problems.

9.1. Technological Progress in the Solow Model

Here we introduce technological progress in the Solow model.

The Efficiency of Labour


Technological progress is included in the model by the new variable E, efficiency of
labour. It reflects the knowledge and capabilities of production methods. New
available technologies and methods of production increase the efficiency of labour.
The new production function becomes:

Y = F(K,EL)

In this model, E increases at a constant rate g. This way of incorporating technology in


the model is called labour-augmenting technological progress, because it changes the
effect of labour in production. It could also have been capital augmenting, or both
capital and labour augmenting, but this is not done in this book.

The Steady State With Technological Progress.


In the previous chapter, we measured variables as per worker. We now redefine
these variables as per effective worker. This means that k=K/EL now and is called
capital per effective worker. Similarly, y= Y/EL, output per effective worker. This
means that the capital accumulation equation now becomes:

k = sf(k) ( + n+ g)k

So ( + n+ g)k becomes the new break-even level of investment.

In a similar way as in the previous chapter when introducing population growth,


technological progress alters the steady state level of consumption per effective
worker, and the level of capital at which the steady state level of consumption is
maximized (golden rule level of capital k*gold)

c* = f(k*) (+n+g)k*
MPK = + n

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According to the Solow growth model, only technological progress can consistently
increase the standard of living over time. That is the level of consumption per worker.

9.2. From Growth Theory to Growth Empirics

The Solow model is applied to make empirical predictions and comparisons with
evidence.

Balanced Growth
Growth of output per worker and capital stock per worker in the steady state is
caused by technological progress and is called balanced growth. IT predicts that there
is sustained economic growth at the rate of technological progress, and we
approximately see this in the real world.

Convergence
The Solow model predicts that convergence should occur if two economies have a
different capital stock but the same level of technological progress. We also see this
in the examples of Germany and Japan, which had about the same technological
progress as the rest of the western world, but destroyed capital stocks. They quickly
converged to the rest of the western world. However it predicts that convergence
should not occur with countries with different technological progress, and this is
indeed the case, as Africa and the West for example, have not converged yet. In this
case we speak of conditional convergence: countries converge to their own steady-
state, but countries do not have the same steady-state level of output.

Factor Accumulation versus Production Efficiency


An important question is the source of differences in income. It can come from either
1) differences in the factors of production such as physical or human capital, or 2)
differences in the efficiency with which the economies use their factors of
production, that is differences in the production function. On empirical inspection, it
turns out that high levels of the factors of production are correlated with high
efficiency of the use of those factors.

9.3. Policies to Promote Growth

We can now use the Solow model and its empirical application to make some
analyses of the policy decisions that governments face.

Evaluating the Rate of Saving


We take the example of the U.S. and ask the question: is the U.S. above, below, or
approximately at the golden rule level of capital? We obtained three facts about the
U.S. economy:

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1. k is about 250% of GDP: k = 2.5y


2. Capital depreciation is about 10% of GDP: k = 0.1y
3. Capital income is about 30% of GDP: MPK * k = 0.3y (we make this conclusion
from the classical theoretical prediction that the factors earn the share of
income equal to their marginal product derived in chapter 3)

Using these facts we derive that = 0.4, and MPK = 0.12, this means that net
marginal product of capital (MPK ) is 8%. This is much bigger than the U.S.
economys average growth rate (n+g = 3%). This indicates that the U.S. is well below
its golden rule level of capital. In fact all countries in practice are below their golden
rule level of capital, which indicates that in practice, increasing the savings rate is a
good thing.

Changing the Rate of saving


The government can increase the rate of saving directly by increasing public saving,
by either decreasing G or increasing T. The government can also affect saving by
affecting the level of private saving through tax incentives. One possibility is to shift
from income taxes to consumption taxes, but there are disagreements over how
effective this would be

Allocating the Economys Investment


In the Solow model, capital is simplified as being only of one type but in reality there
are many types of capital. This means that capital must be allocated. Some economists
say that the capital allocation process should be left to financial markets. Others say
that the government should invest in infrastructure, a form of public capital, and in
education, a form of human capital. It is also suggested by some economists that
governments should actively encourage particular forms of capital if there are
externalities associated with certain types of investments (for a theory of externalities
look for a microeconomics textbook).

Establishing the Right Institutions


Not all countries have the same institutions guiding the allocation of scarce resources.
Different institutions might have very different effects on production efficiency. An
example of an institution is a legal tradition. Different countries often have very
different levels of development of legal institutions. The development of government
is also an important difference in institution. Some governments do not work
effectively for the development of the domestic economy, or are corrupt. The
development of these institutions is an important necessary element of economic
growth.

Encouraging Technological Progress


The Solow model takes technological progress as exogenous, so does not explain it.

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The drivers of technological progress are not fully understood, but one important
aspect of it is intellectual property rights. If a company can obtain a patent on a piece
of technology, so that other companies are not allowed to use that technology
without permission, this gives a incentive for firms to invest in research and
development.
9.4. Beyond the Solow Model: Endogenous Growth Theory

Endogenous growth theories try to explain technological progress.

The Solow model developed in the previous sub-chapters and chapter 8 does not
explain technological progress, but instead takes it as given (an exogenous variable.
This subchapter introduces four examples of an endogenous growth theory, a theory
where technological progress is explained (i.e. where technology is an endogenous
variable).

The Basic Model


This basic model makes one key assumption different from the Solow model, namely
that there are constant rather than diminishing returns to capital, using the following
production function:

Y = AK

Where A is a constant measuring the output produced per unit of capital. In this
model, unlike in the Solow model, K does not just include physical capital, but also
knowledge. Using a similar capital accumulation equation as in the Solow model:

K = sY K

We can calculate the growth rate of output

Y/Y = sA

This shows that as long as the saving rate is high enough, there will be constant
economic growth. Because K also includes knowledge, it models technological
progress as part of investment.

A Two-Sector Model
This more expanded model is a kind of combination between the Solow model and
the Basic model. It consists of two sectors: Universities that invest in technological
progress, and manufacturing firms, firms that produce output. The addition of
universities is what distinguishes it from the Solow model. The model consists of the
following three equations:

Y = F(K, 1-u)EL) (Production in manufacturing firms


E = g(u)E (University investment in technology)

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K = sY K (Capital accumulation)

Where u is the percentage of workers employed in universities. Just like in the Solow
model, the production function has constant returns to scale. If we include knowledge
E to be a part of capital, then it also has constant returns to capital. For any given
value of u, this model works just like the Solow growth model. As a result, there are
two decision variables in the model, the saving rate, and the percentage of workers
employed in research.

The Microeconomics of Research and Development


These two models do not go into the microeconomic foundations of decision makings
with respect to research. Three key facts show the relevance of this:

1. Much research is done by firms and is driven by profit motive.


2. Research is profitable because it gives rise to temporary monopolies, due to
intellectual property rights and first mover advantages.
3. When one firm innovates, this opens the door to new innovation

The study of the microeconomics of R&D is focused on the positive and negative
externalities generated by private research. In practice, positive externalities
dominate, which is an argument for research subsidies.

The Process of Creative Destruction


The economist Schumpeter came up with the theory of creative destruction, the
process by which entrepreneurs innovate and create new products or new ways of
developing an old product, thereby destroying the markets for old products or
production methods. The theory says that economic progress is always associated
with the destruction of old industries. I.e. there are always losers to economic
progress.

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10. Introduction to Economic Fluctuations


In the short run, the economy fluctuates instead of staying fixed at its natural level.
These fluctuations can be understood within the model of aggregate supply and
demand.

Part IV: Business cycle theory: The economy in the short run contains chapter 10 to
14. The classical theory introduced in part II chapters 3 to 7, addresses the long run of
an economy. However, in the short run many of the relations of the classical theory
break down. Monetary neutrality does not hold and production is not fixed, but
affected by short run fluctuations such as of the money supply and demand for goods
and services. Also, the unemployment rate is not equal to the natural rate of
unemployment but fluctuates in the short run. Part IV introduces the basic Keynesian
theory, an adaptation of the classical theory that is developed to describe short run
fluctuations, or alternatively, the Business Cycle.

10.1. The Facts about the Business Cycle

We start with the basic facts about the business cycle.

GDP and its Components


Taking the U.S. as an example, we can see that GDP growth is not at all steady. A
period in which there is negative real GDP growth is called a recession, and if this is
severe, it is called a depression. The exact line between a recession and a depression
is vague. Moreover, if we look at the components of GDP, we see that investment is
much more volatile than consumption. This is an important fact that needs to be taken
into account in theories of the business cycle.

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Unemployment and Okuns law.


Okuns Law states that there is a negative relationship between unemployment and

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GDP. This means that if there is a recession, unemployment rises. This can be
understood theoretically by the idea that workers produce goods and services and
therefore if they become unemployed economic output should also decline. There is
very strong statistical evidence (A correlation of -0.89) that Okuns law is the case, as
seen in the following graph:

The approximate numerical relation that is taken from empirical research is that the
there is a linear relation between the unemployment rate and GDP with a factor of 2:
Percent change in real GDP = 3% - 2 * Change in unemployment rate

Leading Economic Indicators


Many economists are busy trying to predict short run fluctuations. There are two
reasons why government economists need to do this:

1. The economic environment affects the government e.g. through tax revenue
2. The government wants to stabilize the economy through fiscal and monetary
policy.

To predict short run fluctuations, economists use leading indicators, variables that
tend to fluctuate in advance of the whole economy. A list of ten leading indicators is
used by the Conference Board, a private research group:

Average workweek of production workers in manufacturing


Average initial weekly claims for unemployment insurance
New orders for consumer goods and materials, adjusted for inflation
New orders for nondefense capital goods
Index of supplier deliveries
New building permits issued
Index of stock prices
Money supply (M2) adjusted for inflation
Interest rate spread: the yield spread between 10-year Treasury notes and 3-
month Treasury bills
Index of consumer expectations

This list is far from complete, but contains some of the important leading indicators
10.2. Time Horizons in Macroeconomics

The short and long run is an often used distinction with a specific meaning.

The previous chapters have explained to some extent the difference between short
run, long run, and very long run, but it has not been addressed rigorously, which is

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done in this subchapter.

How the Short Run and Long Run Differ


The predominant view among economists is that there is one main difference
between the short run and the long run, and that is that monetary neutrality works in
the long run, but breaks down in the short run (meaning that money is not neutral in
the short run). The fundamental reason why this is the case, according to this
predominant view, is that prices are flexible in the long run, but sticky in the short run.
This means that it takes time for prices to adjust to equilibrate supply and demand.
For example, in the long run, according to the quantity theory of money, increasing
the money supply will cause an equal increase in the price level. But in the short run,
the price level is not immediately affected. The result is that in the short run, real
variables, such as real GDP, the real interest rate, and unemployment, are affected,
until the price level catches up.

The Model of Aggregate Supply and Aggregate Demand


In the classical model, output is determined by the supply of goods and services,
which is determined by the production function. However, due to short run price
stickiness, in the short run model, aggregate demand also influences output. The next
subchapters develop the basis of this model, which is then fully developed in detail
throughout the next three chapters.

10.3. Aggregate Demand

Aggregate Demand (AD) is the relationship between the aggregate price level, and
the quantity of goods and services demanded.

The Quantity Equation as Aggregate Demand.


We build here a simple theory of Aggregate demand based on the Quantity theory of
Money. This is a simplified version and it will be refined in the subsequent chapters.
The quantity equation is:

MV = PY

This can be rewritten to:

Y = (M/P)*V

Where M/P is real money balances. According to the quantity theory of money,
money velocity stays constant, so that this equation denotes the relationship between
Y and P. If P rises, demand for Y must decline. This gives the following graph for the
AD curve:

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The reason that this curve slopes downward is fully explained in chapter 11, but for
now, a simplified explanation is that it slows downward because if the price level is
high, there is higher demand for real money balances, but since M stays the same and
V stay the same, less of that real money balances are spent, so that expenditures is
lower. This is a highly simplified and not very complete explanation, so if you do not
follow it, dont worry and wait until chapter 11.
We can clearly see from this equation that a reduction in the money supply shifts the
AD curve to the left, and that an increase in the money supply shifts it to the right.

10.4. Aggregate Supply

Aggregate supply (AS) is the relation between the aggregate price level and the
quantity of goods and services supplied.

In the long run, the LRAS (Long run AS) curve is determined by the production
function, and independent of the price level. This means that a decrease in AD
decreases the price level, but leaves output unchanged:

In the short run, the SRAS (Short run AS) curve is horizontal at the price level, because

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prices do not change. This means that a decrease in AD leaves prices unchanged, but
decreases output.

We see here that in the long run, output is determined by AS, and the price level by
AD, but in the short run output is determined by AD and the price level by AS. In
Chapter 14, this statement will be nuanced to an extent.

From the Short Run to the Long Run.


We now have two models, one for the short run, and one for the long run. We can
combine the two to see the transition between the short run and the long run. See the
next figure for this explanation. For example, if an economy is in long run equilibrium
(Point A), and the money supply is decreased, then in the short run this will leave
prices unchanged (point B) and output decreases, but as prices start to adjust over
time, output starts to increase again, and prices start do decrease, so that in the long
run, we are back to the original level of output.

10.5. Stabilization Policy

Stabilization policy are policies enacted by the government with the intent of
stabilizing the economy at its natural rate.

We now turn to the role of the government in stabilizing short run fluctuations. A
short run fluctuation can be caused by a shock, a change in an exogenous variable
caused by some exogenous event. A demand shock is a shock that shifts the demand
curve, and a supply shock is a shock that shifts the supply curve. Policy actions aimed
at reducing the severity of short run fluctuations are called stabilization policy.

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Demand Shock
Suppose that the velocity of money suddenly increases. This shifts the aggregate
demand curve to the right. The central bank could stabilize this by decreasing the
money supply, thereby shifting the AD curve partially back.

Aggregate Supply Shocks


Say that some exogenous event has a short run adverse effect on supply, such as a
drought that destroys the crops in an agricultural economy. This will cause the
Aggregate supply curve to shift upward, threatening a short run decrease in GDP. The
central bank could compensate this by increasing the money supply, shifting the AD
curve to the right:

10.6. Conclusion

This chapter introduced the concepts of Aggregate Demand and Aggregate Supply,
and their role in short run fluctuations.

Chapters 11 and 12 will develop the fundamentals of the Aggregate Demand curve in
far more detail from Keynesian theory. Chapter 13 will develop the small open
economy version of Keynes theory, and chapter 14 develops the Aggregate Supply
curve in more detail.

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11. Aggregate Demand I: Building the IS


LM Model
The IS-LM model is the most widely accepted interpretation of Keynes' theory.

The economist Keynes formulated a theory in which he outlined that it is aggregate


demand that determines output in the short run, not aggregate supply as in the
classical theory. These two opposing views have later been combines into
the neoclassical synthesis. The predominant model that is currently accepted that
captures Keynes theory is called the IS-LM model. It is a model that shows the
determinants of aggregate demand, and therefore replaces the oversimplified AD
curve based on the quantity equation in chapter 10. The IS-LM model consists of
the IS-curve, and the LM-curve. The IS curve is the curve that captures the equilibria
in the goods market, and the LM curve shows the equilibria in the money market. This
will be explained in the following subchapters.

11.1. The Goods Market and the IS Curve

IS-curve stands for Investment-Saving curve. It plots the relation between the
interest rate and the level of income for which the goods market is in equilibrium.

The IS curve is derived from multiple steps which will be explained here.

The Keynesian Cross.


The Keynesian Cross is the first step of deriving the IS-curve. It captures Keynes
basic idea that it is inadequate spending that is the cause of lower output during
recessions. It is based on the distinction between actual expenditure and planned
expenditure. Actual expenditure is what people actually spend on goods and services,
and it is equal to GDP as explained in chapter 3. Planned expenditure is what people
would like to spend on goods and services, given their income. So actual expenditure
is simply

And planned expenditure is the demand for expenditure given the level of income:
PE = C(Y-T) + I + G
The assumption of the Keynesian cross is that the goods market is in equilibrium
when planned expenditure equals actual expenditure:
Y = PE = C(Y-T) + I + G
Note that in the classical theory, this was always the case, because in the classical
theory, the goods market is assumed to always be in equilibrium. The argument why

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the goods market should move to equilibrium, is that if there is too little expenditure,
the inventories of firms will increase (they sell less than they produce), and they will
try to adapt to this. The Keynesian cross is summarized in this graph:

The multiplier effect


We now consider the effect of an increase in government expenditures. We will see
that according to the Keynesian cross, income will rise with more than the increase in
expenditures. That is, Y is bigger than G, and Y/G is the government-purchases
multiplier. If the government expenditures are increased by 1$, then income will rise
by Y/G dollars. This is because due to the increase in income due to extra
government expenditures, there is also more disposable income, so an increase in
consumption as well. Setting the goods market equation given above to equilibrium,
and deriving the effect of an increase in government expenditures on income gives:

Y/G = 1/(1-MPC)

Where MPC is the marginal propensity to consume. Equivalently, the tax multiplier is:
Y/T = -MPC/(1-MPC)

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From these multipliers we see that the short run effect of increasing government
expenditures (or decreasing taxes) is to increase income by a larger amount than the
increase. This is consistent with Keynes proposal that in times of recessions, the
government should stimulate demand. There are many examples in history after
WWII where governments have done precisely that. For example the Obama
spending package tried to stimulate the economy in 2009.

The Interest Rate, Investment, and the IS Curve.


The second element of deriving the IS curve is investment. Investment is negatively
related to the interest rate and also part of planned expenditures, so this means that
an increase in the interest rate will shift the planned expenditures function downward,
thereby decreasing income. The IS-curve is the curve that summarizes this
relationship between the interest rate and income, through the effect of an
increase/decrease in investment through the multiplier effect on income. This
derivation is summarized here:

How Fiscal policy shifts the IS curve


Fiscal policy shifts the planned expenditure function upwards or downwards, and
therefore it also shifts the IS curve (as does any other external planned expenditure
shock that is not the interest rate itself):

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11.2. The Money Market and the LM Curve

The LM-curve stands for Liquidity money curve. It plots the relation between the
interest rate and the level of income for which the money market is in equilibrium.

The LM curve is based on Keynes Theory of Liquidity Preference, which is the first
step of its derivation. This theory states that people prefer to hold money because it
is liquid, that the demand for holding money is based on liquidity preference and that
the interest rate adjusts to equilibrate the demand and supply of real money balances
(explained in chapter 5). The supply of real money balances is determined simply by
the money supply and the price level:
(M/P)s = M/P
Money demand is given by the function of Liquidity preference, which decreases in
the interest rate, because the higher the interest rate, the higher the opportunity cost
of holding money (versus investing in bonds):
(M/P)d = L(r, Y)
We can plot this relation, and see the effect of a decrease in the money supply (which
would be equivalent to an increase in prices):

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Income, Money Demand, and the LM Curve


The second step of its derivation is the relationship between income and liquidity
preference. Liquidity preference is a function of r and of Y. its relation to Y is that if Y
becomes higher, people will need more money in order to cover the larger amount of
transactions they are doing. This means that an increase in income shifts the money
demand function to the right, and this relation is summarized in the LM curve, the
relation between r and Y for which the money market is in equilibrium:

The effect of for example an decrease in the money supply is as follows: it decreases
the supply of real money balances, and therefor increases the interest rate for which
the money market is in equilibrium. Therefore, for the same level of income, a higher
interest rate is needed for money market equilibrium. Therefore the LM curve shifts
upward:

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11.3. Conclusion: The Short-Run Equilibrium

The IS-LM model is the basic model of aggregate demand.

We can now combine the LM curve and the IS curve to find the short run equilibrium
interest rate and level of income. To summarize, the IS-LM model consists of two
equilibrium equations:

IS: Y = C(Y-T) + I(r) + G (Goods market equilibrium)


LM: M/P = L(r,Y) (Money market equilibrium)

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12. Aggregate Demand II: Applying the


ISLM Model
Chapter 11 developed the IS-LM model. In this chapter we first use the IS-LM model
to explain economic fluctuations, then we derived the Aggregate demand function
from the IS-LM model, and finally we use it to study the great depression of the
1930s.

12.1. Explaining Fluctuations With the ISLM Model

Fluctuations in the economy can be explained by shocks in the IS-LM model.

According to the IS-LM model, the equilibrium level of income and the interest rate is
determined by the intersection of the IS and LM curves.

The Effects of Fiscal Policy


As explained using the Keynesian cross in chapter 11, fiscal policy has a multiplier
effect, as an increase in government purchases increases planned expenditure by
more than that increase, because it also increases consumption. This means that an
increase in G shifts the IS curve to the right by G multiplied by the multiplier.
However, this analysis was incomplete, because it neglected the effect of this
expansion on the money market. The expansion increases the demand for money,
thereby increasing the interest rate. This interest rate in turn decreases investment, so
that the extent to which output is increased due to a government stimulus is
somewhat diminished due to its crowding out effect on investment. A similar argument
can be made for a tax cut (however the effect of the tax cut is smaller, because it only
indirectly increases planned expenditure through consumption, contrary to
government purchases which also has the direct effect). This is summarized here:

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The Effects of Monetary Policy


The effect of monetary policy on the level of income happens through the so
called monetary transmission mechanism: An increase in the money supply lowers
the interest rate through the money market. This lower interest rate increases
investment. In the ISLM model, this is summarized by a downward shift of the LM
curve.

The Interaction between Monetary and Fiscal Policy


Monetary and fiscal policy both have effects on the interest rate and income. If the
government or the central bank want to alter course, then it is sometimes desirable
for the other party to coordinate so that income is stabilized.

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Shocks in the IS-LM model


The LM curve and IS curve can also shift due to exogenous shocks, and this is what is
often used to explain recessions. For example, if investors suddenly lose confidence in
the economy, the investment function shifts to the left, and the IS curve shifts to the
left, causing a recession (their prophecy was self-fulfilling). In this case, the
government or central bank can try to compensate this.

12.2. ISLM as a Theory of Aggregate Demand

The IS-LM model is the most widely accepted interpretation of Keynes' theory of
aggregate demand.

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Recall that the AD curve is the relationship between income and the price level. The
price level has a direct effect on the money market, because a higher price level
means a lower supply of real money balances. So inflation is equivalent to decreasing
the supply of real money balances (in the short run). A lower supply of real money
balances shifts the LM curve upward. In other words, increasing the price level shifts
the LM curve upward, increases the interest rate and thereby (through investment)
decreases income. This mechanism is summarized in the AD curve, and it is the reason
that the aggregate demand curve is downward sloping (this is a more complete
explanation than the one given in chapter 10 using the quantity equation). From this
mechanism, we know that any fiscal policy that shifts the IS curve to the right, and
any monetary policy that shifts the LM curve to the right, also shifts the AD curve to
the right. The derivation of the AD curve is summarized here:

The IS-LM model in the Short Run and Long Run


We can now formally explain the difference between the assumptions of the classical
theory and the short run theory within the framework of the IS-LM model. Basically,
both the long run and short run can be captured within the IS-LM model, and they
both have the basic equations:

IS: Y = C(Y-T) + I(r) + G (Goods market equilibrium)


LM: M/P = L(r,Y) (Money market equilibrium)

However the difference between the long and short run is in the final equation
necessary to complete the model. In the Keynesian (short run) model, the third
equation is
P =P
Because prices are fixed in the short run. In the classical theory, the level of income is

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fixed at the production function, and prices are flexible:


Y=Y
12.3. The Great Depression

We can now empirically apply the IS-LM model to the Great Depression to see how
it might explain this downward point on the business cycle.

There are two main hypotheses on what the causes of the great depression were.

The Spending Hypothesis: Shocks to the IS Curve


According to this hypothesis, shocks to demand for goods and services were
responsible. Allegedly, the stock market crash of 1929 caused a large downward shift
in consumer spending (because people suddenly became less wealthy), and that the
residential investment boom of the 1920s suddenly stopped, both causing the IS
curve to shift to the left. Because policymakers at the time were concerned with
balancing the budget rather than stabilizing the business cycle, they further decreased
government expenditure, causing a further shift of the IS curve to the left.

The Money Hypothesis: A Shock to the LM Curve


This hypothesis says that it was a fall in the money supply that caused the depression.
They blame the Federal Reserve for letting the money supply drop by 25% through
1929 to 1933. Allegedly, however the channel through which this happened was not
through the decrease in the supply of real money balances, because there was a
period of deflation as well. Through what is called the Pigou effect, the effect that
deflation causes real money balances to rise thereby increasing peoples wealth and
their spending, some economists would expect the economy to restabilize. However
there are two proposed theories for why the deflation would depress income rather
than stabilize it.

Debt-deflation theory. According to this theory, a decrease in the price level


raises the amount of debt (as analysed in chapter 5). This decreases peoples
wealth, thereby depressing their spending.
The effect of expected deflation on investment. If people expect a high level of
deflation, this means that the ex-ante real interest rate increases. This is not
the nominal interest rate (which is the interest rate studied in the IS-LM
model), so this causes the IS curve to shift downward, and this would be the
explanation of the economic downturn.

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12.4. Conclusion

This chapter addressed the IS-LM model, the dominant short run model for a closed
economy. The next chapter formulates the small open economy version of this
model, the Mundell-Fleming model, by introducing trade and capital flows.

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13. The Open Economy Revisited: The


MundellFleming Model and the
Exchange-Rate Regime
The Mundell-Fleming model is the open economy version of the IS-LM model.

Chapters 11 and 12 introduced the IS-LM model, the closed economy model of the
short run. This chapter introduces the Mundell-Fleming model, the adaptation of the
IS-LM model for a small open economy. It makes the same assumption as the classical
small open economy model introduced in chapter 6: that the domestic economy is a
small open economy with perfect capital mobility.

13.1. The MundellFleming Model

The Mundell Fleming model replaces the IS and LM curves with the IS* and LM*
curves.

The Mundell-Fleming Model takes the same basic form as the IS-LM model: However,
the IS curve is renamed the IS* curve and the LM curve is renamed the LM* curve.
There are two basic differences with the IS-LM model.

The interest rate is fixed at the world interest rate, just like in the classical
model of a small open economy: r = r*
The Planned expenditure function includes a term for net exports: NX(e). Note
that we write Net exports as a function of the nominal instead of the real
exchange rate. This is because we assume prices to be fixed in the short run.

The IS* and LM* curves


In the Mundell-Fleming model, we no longer plot the IS* and LM* curves as a relation
between the interest rate and income, because the interest rate is always fixed at the
world interest rate. Instead, we plot them as a function of the nominal exchange rate.
So it is now the exchange rate that equilibrates the goods market, and the new goods
market equilibrium condition becomes
Y = C(Y-T) + I(r*) + G + NX(e)

The money market equilibrium is still dependent only on income and the interest rate,
and not on the exchange rate, so the LM equilibrium condition remains unchanged,
except that the interest rate is fixed:
(M/P)d = L(r*,Y)

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Therefore, the LM* curve is a straight line in the new graph, because it does not
depend on the nominal exchange rate:

All the effects analysed in chapters 11 and 12 with the IS-LM model can easily be
applied to the Mundell-Fleming model, except that it is net exports that equilibrates
the goods market, the interest rate stays fixed, and the LM curve is vertical. However
there are a number of new issues that can be analysed specifically for an open
economy, which will be done in the next subchapters

13.2. The Small Open Economy Under Floating Exchange Rates

Floating exchange rates are one of the two main exchange rate regimes.

There are roughly two exchange rate regimes: floating exchange rates, addressed in
this subchapter and fixed exchange rates, addressed in the next subchapter. Under
floating exchange rates, the central bank allows the exchange rate to be freely
determined by market forces, and does not intervene to keep it stable. This will mean
that the exchange rate adjusts to keep the goods market and money market in
equilibrium. We can analyse the effects of fiscal policy, monetary policy and trade
policy under floating exchange rates:

Fiscal policy is ineffective under floating exchange rates. Shifting the IS* curve
to the right will only increase the exchange rate, thereby making the domestic
currency more expensive, and depressing net exports. Since the LM curve is
vertical (There is only one value of the level of income for which it is in
equilibrium, given the fixed values of M and r*), the decrease in net exports
must be exactly as big as the increase in government spending.
Monetary policy is effective under floating exchange rates. An increase in the
money supply shifts the LM* curve to the right, thereby lowering the exchange
rate and increasing the level of income.
Trade policy is ineffective under floating exchange rates. Trade policy, for
example policy that tries to restrict imports with the goal of increasing net
exports, will shift the IS* curve. However this shift will not increase income, but
instead change the exchange rate, which decreases NX again. The net result is
lower import and lower export, so that net exports remain the same

13.3. The Small Open Economy Under Fixed Exchange Rates

Fixed exchange rates are one of the two main exchange rate regimes.

Under fixed exchange rates, the central bank keeps the exchange rate fixed at a
certain level by changing the money supply accordingly. It does this by announcing an

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exchange rate and agreeing to always exchange currencies at that rate. By the law of
one price, the market exchange rate will then also shift to that value. The result of this
is that it cannot increase the money supply at will, because if it does, then the demand
for the domestic currency will drop, threatening a lower value of the currency. This
will force it to buy domestic currency, thereby lowering the money supply again.

Note: a fixed exchange regime fixes the nominal exchange rate. In the short run this is
equivalent to fixing the real exchange rate, but this is not so in the long run when
prices are flexible.
We can now evaluate the effectiveness of fiscal, monetary and Trade policy under
fixed exchange rates:

Fiscal policy is effective under fixed exchange rates. Raising government


expenditure will shift the IS* curve to the right. This induces an increase in the
exchange rate, but to keep the exchange rate fixed, the central bank increases
the money supply which shifts the LM curve to the right, so that the exchange
rate is back at its original level. The result is an increase in Y.
Monetary policy is ineffective under fixed exchange rates. As explained
earlier, if the Central bank decides to increase the money supply, this will
induce a decrease in the exchange rate, which will force the CB to decrease the
money supply again, leaving the money supply and Y unchanged.
o However, another type of monetary policy is effective, namely a change
in the value of the fixed exchange rate. If the central bank increases the
value of the fixed exchange rate, it is called a revaluation, and if it
decreases it, it is called a devaluation.
Trade Policy is effective under fixed exchange rates. The reason that trade
policy was ineffective under floating exchange rates is because it altered the
exchange rate such as to undo the effects of the trade policy. However under
fixed exchange rates, the trade policy induces a change in the money supply (a
shift in the LM* curve), which prevents such a change in the exchange rate.

13.4. Interest Rate Differentials

There can be differences in interest rates among countries due to differences in


country risk and expectations of exchange rate changes.

We have assumed throughout chapter 6 and chapter 13 that a small open economy
with perfect capital mobility has an interest rate equal to the world interest rate r*.
However, in reality there are interest rate differentials, for two primary reasons:

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Country risk. Some countries investment are more risky than others, which
makes investors demand a higher interest rate before they want to invest.
Expected changes in the exchange rate. If investors expect a currency to
appreciate (increase in value), then they will invest more heavily, causing the
interest rate in that country to decline.

Differentials in the Mundell-Fleming Model


We can include these differences in interest rates in the Mundell-Fleming Model by
including a risk premium :
r = r* +
The higher the risk premium , the higher the interest rate will be. A strange
prediction is made when we fill this in into the Mundell-Fleming model:

Y = C(Y-T) + I(r* + ) + G + NX(e)


(M/P)d = L(r* + ,Y)

An increase in the risk premium now shifts the LM curve to the right, thereby
increasing income. However, in reality an increase in the risk premium of a country
tends to decrease income. There are two reasons why in reality this happens which
are not taken account of in the Mundell-Fleming model:

The depreciation of the currency may increase the price of imported goods,
thereby increasing the price level.
The risk premium will also affect the liquidity demand of domestic agents,
shifting the LM curve back

The Mexican crisis of 1994-1995 and the Southeast Asian crises of 1997-1998 are
clear examples of crises that started because of an increase in the risk premium.
13.5. Should Exchange Rates Be Floating or Fixed?

A country must choose between floating or fixed exchange rates, and every country
faces the dilemma of the impossible trinity.

Now that we have developed the Mundell-Fleming model, we can use it to address an
important question in international macroeconomics: should a country have a fixed
exchange rate regime or a floating exchange rate regime?

Advantages of floating exchange regimes and disadvantages of fixed exchange


regimes are:

Keeping the currency floating allows the central bank to use monetary policy
for different purposes, such as stabilizing the level of output.

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In a fixed exchange regime, you have to always trade the currency, but if you
run out of foreign currency, your economy is vulnerable to speculative attack.

Advantages of fixed exchange regimes and disadvantages of floating exchange


regimes are:

A fixed exchange rate removes exchange-rate uncertainty, which helps


international trade
A fixed exchange regime disciplines a monetary authority so that it does not
perform excessive inflationary policies

Besides fixing the exchange rate, the euro zone has gone one step further and created
a common currency, which is effectively a permanent fixed exchange rate between
the European countries. There are costs and benefits associated with this move:

Costs

National central banks lose their monetary authority.


Labour is not very mobile in Europe, which increases the costs of not having an
own monetary policy.
There is no European fiscal authority that can engage in stabilization policies.

Benefits

No exchange rate risk


No costs associated with exchanging currencies
Political unification

The Impossible Trinity


The analyses of fixed and floating exchange regimes, and the policy effectiveness
allows us to conclude an important international macroeconomic result, namely that it
is impossible for an open economy to have all three of the following macroeconomic
policies:

Free Capital Flows


Independent monetary Policy
Fixed Exchange Rate

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Every country must choose two of the three of these, and this is called the impossible
trinity.
13.6. From the Short Run to the Long Run: The MundellFleming Model With a
Changing Price Level

The Mundell-Fleming model can be used to show how we move from the short to
long run.

Just like we did in chapter 12 for the IS-LM model, we can look at what happens with
the Mundell-Fleming model as it moves to the long run. To do this we write the Net
export function as a function of the real exchange rate again, as in chapter 6: NX =
NX(). Having done this, the Mundell-Fleming model explains the aggregate demand
curve for an open economy, as is shown in the following graph:

13.7. A Concluding Reminder

The Mundell-Fleming model developed in this chapter is a model for a small open
economy, just like the classical model developed in chapter 6. However, countries
like the United States do not behave completely like a small open economy, because
their policies affect the world interest rate. Such economies should be seen as lying
somewhere between a closed economy and a small open economy.

The Mundell-Fleming model developed in this chapter is a model for a small open
economy, just like the classical model developed in chapter 6. However, countries like
the United States do not behave completely like a small open economy, because their
policies affect the world interest rate. Such economies should be seen as lying
somewhere between a closed economy and a small open economy.

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14. Aggregate Supply and the Short- Run


Trade-off between Inflation and
Unemployment
Chapters 11 to 13 have expanded on chapter 10 by deriving the Aggregate Demand
curve from the IS-LM and Mundell-Fleming models. This chapter expands on chapter
10 by delving deeper into the Aggregate Supply curve.

14.1. The Basic Theory of Aggregate Supply

There are two basic theories of aggregate supply but they come to similar
conclusions.

In this subchapter, we explain two prominent theories that explain the shape of the
Aggregate Supply curve. The Keynesian Aggregate Supply curve was horizontal,
assuming that prices do not alter supply of goods and services at all in the short run.
In this chapter, this assumption is nuanced to an extent, so that the aggregate supply
curve becomes upward sloping, which is in between the classical model and the
Keynesian model. Both theories explained in this subchapter result in the aggregate
supply equation of the following form, but in a different way:

Y = Y + (P EP), > 0

Where EP is expected inflation, and Y = F(K,L) .

Sticky-Price Model
The sticky-price model is the most widely accepted explanation for the upward-
sloping nature of the SRAS curve, and entails that because prices are sticky. The
model begins by assuming that firms have a desired price
p = P + a(Y- Y)
There are firms with sticky prices and firms with flexible prices. Firms with flexible
prices simply set the desired price, but firms with sticky prices set their prices to what
they expect:
p = EP
s is the fraction of firms with sticky prices and 1-s the fraction with flexible prices, so
the price level is:

P = sEP + (1-s)(P+a(Y-Y)

We rearrange this to:

Y = Y + (s/((1-s)a))(P-EP)

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The Imperfect Information Model


A different theory for the upward slope of the aggregate supply curve is
the imperfect-information model. In this model, the aggregate supply curve is upward
sloping because of temporary misperceptions about prices. If producers expect the
price level in the future to be high, then the future value of their profit will be
relatively lower. This means they will work less hard, or invest less, so that supply is
lower. In other words, when actual prices exceed expected prices suppliers have a
higher output than they would if theyd always have perfect information on prices, so
that the aggregate supply curve becomes:

Y = Y + (P EP)

Implications
The two theories of aggregate supply differ in the explanations they give for the
behaviour of aggregate supply, but the form of the AS curve that they generate is the
same, namely a function of the natural rate of output (determined by the production
function), the price level, and the expected price level. We can now complete the
partial analysis of the IS-LM and Mundell-Fleming model (which was only an
aggregate demand analysis and assumed that aggregate supply was completely
determined by the price level). When an unexpected shift to the right of the aggregate
demand curve occurs, this has the immediate effect of causing an economic boom,
because suppliers have not adjusted their prices to the new level of demand yet. The
new price level and income is determined by the intersection between the demand
curve and the short run aggregate supply curve. However, as prices begin to adjust,
the short run aggregate demand curve shifts to the left, because the expected price
level moves towards the actual price level. The intersection between the new short
run AS curve and the AD curve lies on the Long run AS curve again, this time with a
higher price level:

It is important to see that this model captures both short run monetary non-neutrality
and long run monetary neutrality.

14.2. Inflation, Unemployment, and the Phillips Curve

The Phillips curve gives the relation between inflation and unemployment in the
short run.

Two of the goals of macroeconomic policy are keeping inflation low and keeping
unemployment low. These goals, however, conflict in the short run according to the
theory of the Philips curve, the curve that is derived from the AS curve and gives the

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relation between inflation and unemployment. It is derived by combining the AS curve


and Okuns law (see chapter 10). Okuns law can be written as follows:
(1/)(Y-Y) = -(u-un)
If we substitute this in the aggregate supply equation and add a variable v for a supply
shock, we get the equation for the Philips curve:

= E - (u-un) + v

According to this equation, trying to decrease inflation in the short run will increase
unemployment.

Adaptive Expectations and Inflation Inertia


In order to make the Philips curve useful for policymakers, we must know what
determines expected inflation. One often used theory for this is the theory of
adaptive expectations. The theory states that economic agents base their expectation
of inflation on inflation levels in the past. The Philips curve now becomes:

= -1 - (u-un) + v

we see here that the rate of unemployment will be equal to its natural rate, if inflation
stays the same. For this reason the natural rate of unemployment is also sometimes
called the non-accelerating inflation rate of unemployment (NAIRU).

Two causes of Rising and Falling Inflation


There are two types of shocks that can cause inflation

Demand-pull inflation. Inflation caused by high aggregate demand.


Cost-push inflation. Inflation caused by an adverse supply shock (v in the
Philips curve)

Disinflation and the Sacrifice Ratio


For practical policymakers it is not enough to know that there is a relation between
unemployment and inflation. They also want to know how strong the relation is. This

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is captured by the sacrifice ratio, the percentage of GDP that must be forgone to
reduce inflation by 1 percentage point. Typical estimates range around 5%

Rational Expectations and the Possibility of Painless Disinflation


The previous analysis is based on the theory of adaptive expectations, that expected
inflation is based on inflation in the past. However, some economists advocate
rational expectations. The theory states that inflation expectations are based on
peoples analyses of the determinants of inflation, including government policy. A
conclusion of this theory is that if the government can make clear beforehand to
people that they will decrease inflation, then expected inflation will decrease as well,
so that there can be a decrease in inflation, without an increase in unemployment.

Hysteresis and the Challenge to the Natural-Rate Hypothesis


The chapters 10 to 14 have all been based on an assumption called the natural-rate
hypothesis. This is the hypothesis that fluctuations in aggregate demand and supply
only affect the short run levels of unemployment and output, and that in the long run
they will move back to their natural rate, described by the classical model. However,
this hypothesis is not uncontroversial. There is a different hypothesis that there is a
phenomenon called hysteresis, which refers to effects to the natural rate caused by
short run fluctuations. In other words, an economic downturn not only changes
income in the short run, but also in the long run by diminishing the natural rate of
output or increasing the natural rate of unemployment. There are multiple possible
channels for hysteresis:

A recession can move people in a type of permanent unemployment because


them not having a job for a long time causes them to lose skills, or by giving
them a certain stigma that deters employers from hiring them.
A recession may cause high unemployment, which turns more workers into
outsiders, so that unions increase wages, which in turn stop those outsiders
from getting a job again. This may set the wage level at a permanently higher
level, and therefore also unemployment.

14.3. Conclusion

We have developed and applied the AS-AD model. However many aspects of these
theories are still controversial, and the debate about them continues.

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15. A Dynamic Model of Aggregate


Demand and Aggregate Supply
The DAD-DAS model is the dynamic version of the AD-AS model. that is, it explains
how the short run equilibrium moves over time to the long run equilibrium.

Part V expands upon the models in part IV, IS-LM and Mundell-Fleming, in specific
ways. This chapter formulates a dynamic version of the AS-AD model. the next
chapter delves deeper into the consumption function, and chapter 17 delves deeper
into the theory of investment.
The AS-AD model of part IV was a Static model. it showed the short run equilibrium
and the long run equilibrium, but it did not show how the short run equilibrium
changed over time. This chapter introduces the DAS-DAD model (D for dynamic), the
dynamic version of the AS-AD model. It shows how the short run equilibrium moves
over time, and thereby models the movement of output and inflation after exogenous
shocks.

15.1. Elements of the Model

The basic elements of the model are similar to the static model (chapters 10 to 14),
but formulated somewhat differently.

In the dynamic model, the variables are defined for each period, rather than just for
their equilibrium. This means that all the variables have a subscript that denotes the
period which that variable denotes. For example, Yt means income in period t. We
first go through all the constituent elements of the model before we solve the model
and determine the DAD and DAS curves.

Output: The Demand for Goods and Services


The demand for goods and services is given by:
Yt = Yt (rt ) + t
Where t is some demand shock, such as a change in fiscal policy or a change in
consumption demand due to a stock market boom, and where the constant is the
real interest rate for which aggregate demand is equal to natural output. The constant
is the sensitivity of investment demand and consumption demand to a change in the
real interest rate. This equation is similar to the equation for the IS curve, but the
variables of the income identity are simply written less explicitly.

The Real Interest Rate: The Fisher Equation


The real interest rate that we use in this model is the ex-ante real interest rate. This

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should not be controversial, since it is the ex-ante real interest rate that determines
demand. We derive it from the fisher equation:

rt = it Ett+1

Where Ett+1 is the expectation in period t of the level of inflation in period t +1.

Inflation: The Phillips Curve


The supply curve in this dynamic model is derived from the Phillips curve. This form of
the Phillips curve denotes the relation between inflation, output, and supply shocks:
t = Et-1t + (Yt Yt) + vt
Where the constant is the extent to which inflation responds to a change in output
away from its natural level, and where vt is any supply shock, such as one caused by a
drought, or by an oil cartel.

Expected Inflation: Adaptive Expectations


In this model, we simply assume adaptive expectations of inflation (see chapter 14):
Ett+1 = t

The Nominal Interest Rate: The Monetary-Policy Rule


One of the key differences between this model and the static model is that in this
model, monetary policy is inserted more explicitly in the model itself. In the static
model, a monetary expansion would be formulated as a shift in the AD curve to the
right, but in this model we formulate an explicit monetary policy rule: a target for the
interest rate for which the central bank then allows the money supply to change in
order to achieve that interest rate. This interest rate is then inserted in the DAD
curve, so that monetary policy influences the slope of the DAD curve, but does not
move it. The monetary policy rule is a rule that sets the nominal interest rate as a
response to the level of inflation:
it = t + + (t *t) + Y(Yt Yt)
Where is the sensitivity that the central bank gives to staying at the target inflation
*t, and Y is the sensitivity that the central bank gives to staying at the natural level of
output. Note that the central bank is indirectly targeting the real interest rate by
including the current level of inflation in the first part of the equation. One
assignment of values to , and Y is done by the Taylor Rule, formulated by the
economist John Taylor, who said to assign 0.5 to both.

The following table summarizes the equations in this model:

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15.2. Solving the Model

By solving the model we derive the dynamic aggregate demand and dynamic
aggregate supply curves.

It follows from this model that the values in every time period t depend on the values
of some variables in period t-1. Variables in period t-1 are already determined from
the perspective of period t, they happened in the past), and so within period t, they
are called predetermined variables. We can determine the DAD and DAS curves
using this model, and determine the long run equilibrium and the short run equilibrium
in each period.

The Long-Run Equilibrium


The long run equilibrium is reached when output is at its natural level, the real interest
rate is at the rate which sets aggregate demand at natural output given no demand
shocks, inflation is at the central banks target inflation and expected equals inflation,
and when the nominal interest rate is at the natural real interest rate plus the target
level of inflation.

The Dynamic Aggregate Supply Curve


To derive the aggregate demand curve, we simply substitute the equation for adaptive
inflation expectations in the Phillips curve to find:
t = t-1 + (Yt Yt) + vt

The Dynamic Aggregate Demand Curve


To find the dynamic aggregate demand curve we take the equation for the demand
for goods and services and we substitute the Fisher equation in, and in that equation
we substitute the monetary policy rule and the equation for adaptive expectations.
After simplifying, the DAD curve becomes:
Yt = Yt (/(1+ Y))(t *t) + (1/(1+ Y))t
As hinted at before, the DAD curve is similar to the AD curve, but it has two essential
differences:

It is written as a function of inflation rather than the price level, denoting its
dynamic nature.
More importantly, it is drawn for a given monetary policy rule, rather than a
given money supply. Monetary policy thus enters the DAD curve through the
weights the central bank puts on keeping inflation stable and keeping output
stable. A shift in the aggregate demand curve as a result of monetary policy can
only happen by changing the target level of inflation.

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The short-run equilibrium is determined simply by the intersection of the DAS and the
DAD curves. This intersection determines both the level of inflation and the level of
output:

15.3. Using the Model

The DAD-DAS model can be used to analyse movements of the short run equilibrium
to the long run equilibrium.

We can use the model to analyse long run growth, supply shocks, and demand shocks,
in order to predict the movement of variables over time.

Long Run Growth


In order to see the effect of long run growth, we only have to increase the natural rate
of output. If you do this, both the DAD and DAS curves shift to the right, so that
inflation stays the same, and output rises. We conclude that this model predicts that
stable long run economic growth with stable inflation is possible

Aggregate Supply Shocks and Aggregate Demand Shocks


An aggregate supply shock is formulated in this model as a change in vt if there is a
negative supply shock of one period, inflation will rise and output will fall. However
this will not immediately recover, as expected inflation will stick at the new level of
inflation. It will take time for the policy of the central bank of higher interest rates to
take inflation back at its original level. This example denotes a period of stagflation, a
situation of low output and high inflation caused by a negative supply shock. The
movements of all the endogenous values in this model are given here:

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A similar analysis can be done for a demand shock. A sequence of 5 periods of a


demand shock is depicted here:

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A shift in Monetary Policy


A change in the target level of inflation can also be analysed in this model. A reduction
in the target level of inflation would simply shift the DAD curve to the left
permanently. This slowly lowers inflation, so that the DAS curve slowly adjusts as
well, until it is at the long run equilibrium again.

15.4. Two Applications: Lessons for Monetary Policy

The two main lessons of the DAD-DAS model are the trade-off between output
variability and inflation variability, and the Taylor principle.

We can use this model to conclude two lessons for monetary policy. The first has to
do with the weight that the central bank puts on balancing output versus balancing
inflation. The second has to do with the effect that inflation can spiral out of control if
the central bank does not apply the right policies. Both have to do with the values
that the central bank assigns to and Y.

The Trade-off Between Output Variability and Inflation Variability.


The values of and Y determine the slope of the DAD curve. This slope determines
the effect that a supply shock has on inflation and output. If the weight on output is
higher, then the effect on output of a supply shock will be balanced, but the effect on

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inflation less so. This trade-off is an unavoidable choice that the central bank must
make. One example that shows this is that the Fed and the ECB (European Central
Bank) have assigned different weights to them. The ECB is primarily focused on
stabilizing inflation, whereas the Fed has a more balanced weight distribution.

The Taylor Principle.


Besides the trade-off between inflation stabilization and output stabilization there is
also something called the Taylor Principle. This principle states that for inflation to be
stable, the central bank must respond to a percentage change in inflation by
increasing the nominal interest rate by higher than a percentage change. This can be
shown by the DAD-DAS model, but it can also be explained intuitively: If inflation
rises, and the nominal interest rate rises by exactly the same amount, then the real
interest rate has remained the same. Because it is the real interest rate that
determines demand, demand will not change as a result of the central banks policy.
As a result, inflation will stay at a higher level. In order to stabilize it, the rise in the
nominal interest rate must be higher than the rise in inflation. If the rise in the nominal
interest rate is even lower than the rise in inflation, then inflation will spiral out of
control. According to some economists, this is exactly what happened during the
period of high inflation in the 1970s.

15.5. Conclusion: Toward DSGE Models

This chapter has developed the dynamic model of aggregate supply and aggregate
demand. It forms the basis of more advanced macroeconomic models, called dynamic
stochastic general equilibrium models (DSGE). These models are based on micro
foundations (studied in microeconomics courses), and relatively complicated, so will
not be studied in this book, but the model developed in this chapter comes closest to
these models compared to the other models studied.

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16. Understanding Consumer Behaviour


In part IV, chapters 10 to 14 about short run AS-AD theories we have assumed a
consumption function C(Y-T), but we have not looked at the specifics of this
function. There have been many disagreements about the nature of this
consumption function, and in this chapter we look at the different theories that have
been developed about the role of consumption in macroeconomics.

16.1. John Maynard Keynes and the Consumption Function

Keynes hypothesised three conjectures about the consumption function.

Since Keynes, the consumption function has been central in the macroeconomic
debate. Keynes made three basic conjectures about consumption:

1. The marginal propensity to consume is between zero and one.


2. The ratio of consumption to income, the average propensity to consume, falls
as income rises.
3. Income is the primary determinant of consumption; the interest rate does not
play an important role.

These three conjectures are the basis of the Keynesian consumption function used in
this book:
C = C + cY, C > 0 , 0 < c < 1
This consumption function captures the three Keynesian conjectures. These
conjectures were tested using household surveys and at first were upheld. However
there were two empirical tests that the theory did not withstand:

Incomes grew strongly after WWII, but consumption grew at the same rate
Simon Kuznets constructed data dating back to 1869 that showed that the
share consumption remained relatively stable over time.

In other words, Keynes theory held up to short run changes in income, but not to
long run changes. This suggested that there were two consumption functions, one for
the short run and one for the long run. Two theories, one by Modigliani, the other by
Friedman, try to explain this fact. This chapter will explain them both, but first we
must understand the theory of consumer behaviour developed by Irving Fisher, on
which those two theories are based.
16.2. Irving Fisher and Intertemporal Choice

The model of intertemporal choice is the basis for two theories that try to solve
Keynes' consumption puzzle.

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Irving Fisher developed a model to describe how rational individuals make inter-
temporal choices, choices about allocating goods over time. He assumed that
consumers have an inter-temporal budget constraint, a budget that limits what they
can spend during their lifetime. The consumer can choose how much he consumes
today and how much he consumes tomorrow. If he wants to consume more tomorrow
than he earns tomorrow, he will need to save. If he wants to consume more today
than he earns today, he will need to borrow. Both are done for the interest rate. So
we have:
S = Y1 C
Where Y1 is income in period 1. He can consume in period 2 the amount that he earns
in period 2 plus what he saves plus interest:
C2 = (1+r)S + Y2, which can be written as C2 = (1+r)(Y1 C) + Y2
We can rewrite this to find the inter-temporal budget constraint:

C1 + C2/(1+r) = Y1 + Y2/(1+r)

You see that the income and consumption done in period 2 is divided by the factor for
the interest rate. This is because a dollar today is worth more than a dollar in the
future, since a dollar today, if invested in a bond, will give 1+ r dollars in the future.
This process is called discounting. This gives the following budget constraint:

Consumer Preferences
Consumer preferences can be represented by indifference curves, curves that show
the set of allocations between the amounts of two goods for which the consumer is
indifferent (If you dont understand this, see a microeconomics textbook for a full
explanation). The slope along an indifference curve is the marginal rate of
substitution. A rational consumer will chose the allocation of current consumption
and future consumption such that the slope of the inter-temporal budget constraint is
equal to the marginal rate of substitution, as shown here:

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Choosing the optimal consumption given the consumers indifference curves is called
optimization. We can formulate a change in income as a shift of the inter-temporal
budget constraint away from the origin. In this case, as you can see from the graph,
both consumption in period 1 and consumption in period 2 increases. A good that is
consumed more when income increases is called a normal good. The key insight
gained from this model is that both goods are normal goods, and
therefore consumption smoothing occurs. This means that an increase in income,
whether it is in period 1 or in period 2, will increase consumption in both periods.

How Changes in the Real Interest Rate Affect Consumption


The real interest rate determines the relative cost of period 1 consumption and period
2 consumption, and it determines the discount rate of period 2 income. This means
that a rise in the interest rate will make consumption in period 2 less expensive, and
make income in period 2 less valuable. This means that we can analyse the effect of a
change in the interest rate into two effects:

Income effect: the change in consumption in either period that arises from
moving to a higher indifference curve. Another way to understand it is that
income increases.
Substitution effect: the change in consumption in either period that arises from
a change in the relative price of the two consumption periods.

So we conclude from this that depending on the relative sizes of the income and
substitution effects, a change in the interest rate will either depress or stimulate
saving.

Constraints on borrowing
An element that will not be studied in depth here is the notion of borrowing
constraints. The most extreme form of borrowing constraint is a complete
impossibility of borrowing. This effectively means that period 1 consumption cannot

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be higher than period 2 consumption. For these type of consumers that want to
borrow but cannot, consumption is only determined by income.
16.3. Franco Modigliani and the Life-Cycle Hypothesis

the Life-Cycle hypothesis is a possible solution to Keynes' consumption puzzle.

We now turn to one of the two theories of the consumption function. This theory is
called the life-cycle hypothesis, and it means that people would like to have equal
consumption throughout their lives (consumption smoothing). This can be expressed
as follows:
C = (W + RY)/T
Where C is consumption in every period, W is wealth, R is the amount of periods that
the individual works, Y is income in each period, and T is the amount of years that that
person lives. This life-cycle hypothesis can solve the consumption puzzle that Keynes
theory faced. Wealth does not change very quickly as income changes, so that
consumption does not change as fast as income changes in the short run. However, in
the long run, wealth changes with income, so that changes in income result in equal
changes in consumption. This is captured by the following formula:
C/Y = (W/Y) +

There is one empirical problem with the life-cycle hypothesis. The elderly disserve less
than they need to. There are two explanations for this:

Precautionary saving. They want to save money as a precaution in case they


get older than expected, or in case of unexpected (healthcare) expenses.
They want to leave wealth to their children.

16.4. Milton Friedman and the Permanent-Income Hypothesis

The Permanent-Income Hypothesis is a possible solution to Keynes' consumption


puzzle.

We now turn to Milton Friedmans permanent-income hypothesis. This hypothesis


suggests that we can view income as consisting of two components: permanent
income Yp, the part of income that people expect to persist in the future,
and transitory income YT, the income that people expect to be specific to a certain
period, i.e. not to persist.
Y = YP + YT
An example of a change in permanent income is if you get an unexpected job
promotion which you think will persist during your career. An example of a change in
transitory income is a onetime lottery prize. Friedman thought that people want
consumption smoothing, and therefore do not let increases in transitory income affect
their current consumption very much. Rather, they would spread it out over their life

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time. On the other hand a change in permanent income does strongly affect their
consumption. Therefore Friedman made the following consumption function:
C = YP
He derived from this the Average propensity to consume:
APC = YP/Y
Therefore, the effect of income on consumption depended on the share of permanent
income in that income. Just like Modiglianis theory, this can solve Keynes
consumption puzzle.

16.5. Robert Hall and the Random-Walk Hypothesis

the random-walk hypothesis is an extension of Friedman's permanent income


hypothesis.

This subchapter introduces an extension of Friedmans hypothesis, by combining it


with the assumption of rational-expectations. The economist Robert Hall showed that
if the permanent income hypothesis is correct and consumers have rational
expectations, then it is impossible to predict changes in consumption. This is called
a random walk. This has an important implication for policy. It means that a policy will
only change consumption if it is unexpected. An expected policy change will not
influence consumption at the moment it is enacted. Instead the changes will take
effect the moment that consumers can predict they will happen.

16.6. David Laibson and the Pull of Instant Gratification

Behavioural economists have criticized the rational-choice based theories of


consumption on a number of grounds.

The study of consumption after Keynes has focused on models of rational decision
making, and not on psychology. Yet there have been some psychological studies that
contradict this assumption of rational choice and rational expectations. This branch of
economics is called behavioural economics. One result is that 76% of Americans say
that they save less than they should. According to rational choice theory this is
impossible, because consumers always choose that which they find best. Another
example is that consumers preferences may be time-inconsistent. This means that
they change their choices only because time passes. One example of this is that
people are too impatient in the short run to wait for something, even though they
would like it in the long run (likely causing them to save less than they would ideally
want).
A practical application of this is that policymakers looking to behavioural economics
have thought about how to get people to save more. Studies have shown that if tax
plans have an option to not save while saving is the standard choice, rather than an

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option to save while not saving is the standard choice, people will have a stronger
tendency to save.

16.7. Conclusion

The basic conclusion of this chapter is that Keynes consumption function was too
simplistic. He had a consumption function of the form:
Consumption = f(Current Income)
The advances in consumer theory discussed here suggest that the real consumption
function may be closer to the form:
Consumption = f(Current Income, Wealth, Expected Future Income, Interest
rates)

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17. The Theory of Investment


This chapter delves deeper into the determinants of the investment component of
GDP that is so crucial in the models introduced in this book.

Throughout parts II, III, and IV, we have used investments as a part of the models,
without addressing what investment consists of. There are three main categories of
investment:

Business fixed investment is what people usually think of when they think of
investment: expenditures by firms on equipment and structures that they use
in production
Residential investment is the building of new houses.
Inventory investment refers to the goods that businesses produced but that
have not been finished yet or that have not been sold (yet) to customers.

The determinants of these three types of investment differ, so to fully understand


total investment, we must analyse them separately, which we do in this chapter in
that order.
17.1. Business Fixed Investment

The neoclassical model of investment is a model that explains business fixed


investment from the costs and benefits of investing in capital goods.

The predominantly used model of business fixed investment is the neoclassical model
of investment. It is based on an analysis of the costs and benefits for firms of owning
capital goods. The development of this model assumes two types of firms:

Rental firms. These firms buy capital goods and rent them to production firms.
Production firms. These firms rent capital goods and use them to produce goods
and services.

This is a theoretical distinction that is not necessary for the theory but simplifies its
development. We will drop the assumption later.
The Rental Price of Capital
We assume that the production function of production firms is a cobb-douglas
production function. As developed in chapter 3, a firm that maximizes its profits
purchases a capital good until the marginal product of capital equals the real rental
price of capital (in equilibrium):
M/P = A(L/K)1-

The Cost of Capital

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The revenue that rental firms generate by renting out capital goods is the real rental
rate R/P. The rental firm bears three costs of capital:

It must pay interest i on the loan used to buy the capital good.
The price of capital PK can change during the renting out of the capital good
and this could be a loss for the rental firm
The capital good tears down over time, called depreciation, while being rented
out. The rate of depreciation is .

These combine to determine the cost of capital:


Cost of capital = iPK PK + PK
By assuming that the price of the capital good rises with the price of other goods
(inflation), we can write it as a function of the real rather than nominal interest rate.
We then rewrite it as the real cost of capital, the cost of capital measured in a unit of
the economys output.
Real Cost of Capital = (PK/P)(r + )

The Determinants of Investment


Rental firms can decide to buy new capital goods or not. They do this if it is profitable
to do so. Because we earlier derived the relation between the real rental price and the
marginal product of capital for which production firms want to rent capital, we can
substitute this to find the profit rate of rental firms:
Profit Rate = MPK - (PK/P)(r + )
If the profit rate is positive given a level of capital stock, then rental firms will want to
increase the capital stock. We now have the relation between the incentive to invest
(profit rate) and the increase in the capital stock given by the net investment function
In():
K = In(MPK - (PK/P)(r + ))
We now also see that the theoretical separation between rental and production firms
is not necessary, since we only use the cost of capital and the marginal product of
capital. Both can be associated solely with production firms. We now find the
investment function, which is the net investment function adjusted for depreciation
(since the depreciated capital goods also need to be replaced):
I = In + K
We now see why a lower interest rate increases investment: it decreases the cost of
capital. We can also find the steady state level of the capital stock by setting profit to
zero, which is equivalent to setting revenue equal to cost of capital:
MPK = (PK/P)(r + )

Taxes and Investment


Two examples of taxes that are important for investment are:

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Corporate income tax, a tax on corporate profits. If corporate profits are


defined the way we have, then such a tax will not have any effects on the level
of investment.
Investment tax credit, a reduction to the amount of taxes a firm has to pay
based on the amount spent on capital goods.

The Stock Market and Tobins q


A stock is a share in the ownership of a firm, and the stock market is the market of
such shares. Tobins q is defines as follows:
q = Market Value of Installed Capital / Replacement Cost of Installed Capital
It gives information about whether investment is profitable. If q >1 then investment is
profitable, but if q<1, it is not. This is similar to the neoclassical model, because the
stock market value is a representation of profitability (MPK), and the replacement cost
of capital is similar to the cost of capital. Tobins q effectively measures the same
thing. An advantage of Tobins q is that the stock market value is easily measurable,
and is therefore often used as an economic indicator that predicts investment
fluctuations.

Alternative Views of the Stock Market


There is a debate among economists about whether stock market fluctuations are
rational. There are roughly two positions:

The efficient market hypothesis says that because 1) every stock in the stock
exchange is monitored by professional portfolio managers, and 2) the stock is
valued by supply and demand of the market, it must be the case that the stock
is valued fairly, because otherwise, investors would flock to purchase or sell the
stock, correcting its market price. According to this theory the market price
reflects al information in the market.
Keynes on the other hand said that the stock market price does not reflect its
actual value, but what people think other people think is the actual value.
Because this is a very uncertain and hectically changing estimate, the market
price will fluctuate very strongly away from its actual value.

Financing Constraints
If a firm has a profitable investment opportunity, this does not necessarily mean that
it can undertake it, because the firm may face financing constraints, which are limits
on the amount of capital they can raise in financial markets. Financing constraints for
firms are similar to borrowing constrains for consumers.

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17.2. Residential Investment

Residential investment is investment in increasing the stock of houses.

The Stock Equilibrium and the Flow Supply


In order to understand residential investment a model has been developed that
contains two elements:

The (stock) supply and demand for the stock of houses.


The (flow) supply of new housing.

It is the market for the stock of houses that determines the real price of housing PH/P.
However the supply of houses is fixed in the short run. If the real price of houses is
larger than the cost of building houses then firms have an incentive to invest in
housing. We see that if the housing demand shifts upward, then the incentive to
invest in housing will increase. This is summarized in the graph:

The interest rate is a determinant of housing investment, because if the interest rate
is high, the cost of paying a mortgage is higher.
17.3. Inventory Investment

Inventory investments are usually only 1% of GDP, but during a recession it is usually
more than half of the decline in spending. Therefore it is on the one hand
insignificant, but for the study of economic fluctuations it is very important.

There are four reasons for inventory investments:

Production smoothing. There are often fluctuations in sales over time. For
some firms more is sold in weekends than in week days, or more in the summer
than in the winter. However it is often more efficient to produce the same

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amount of a good in each period, so therefore inventory is developed in low-


sale periods, in order to sell them in high-sale periods.
Inventories as a factor of production. For some firms it is more efficient to
hold inventories than to produce just-in-time. For example, it saves
transportation costs for supermarkets to hold large amounts of inventories as
opposed to shipping in new stocks every day.
Stock-out avoidance. The exact level of sales in a given period is uncertain,
therefore it is better for firms to have more in stock than is expected to be
sold, in case sales are unexpectedly high, in order to prevent running out.
Work in process. For some goods, the production process requires that
products are developed in parts. The different components of that good are
often held in stock for a period of time and counted as inventory investment.

The relation between the real interest rate and inventory investment is simple: when
the real interest rate rises, holding inventories becomes more costly, so firms move
more to just-in-time production.
17.4. Conclusion

There are three important conclusions to be made from this chapter.

All three investment types are inversely related to the real interest rate
The investment function depends on a wide range of influences
Investment spending is highly volatile over the business cycle.

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18. Alternative Perspectives on


Stabilization Policy
In Part VI of the book, three different macroeconomic topics will be discussed that
move away from the models developed here, either by critiquing their results or by
approaching different aspects that they omit.
In this chapter, certain perspectives will be outlined that critique the policy advices
developed using the (primarily Keynesian) AS-AD model.

18.1. Should Policy Be Active or Passive?

There is a debate over whether the government should try to actively stabilize the
economy in response to exogenous shocks.

We have assumed throughout chapters 10 and 14 that it is possible for the


government to respond to shocks to the economy, so that if there i.e. a supply shock,
the government should stabilize the shock with fiscal and/or monetary policy. This
idea is a relatively recent idea that started to gain support after the great depression.
However not all economists agree that this should be done, and we address some of
their arguments here.

Lags in the Implementation and Effects of Policies


Some economists argue that stabilization policy is not feasible because there are time
lags associated with these policies, so that stabilization policy will be too slow to
respond to be effective. There are two types of time lag associated with stabilization
policy:

1. Inside lag. This is the time it takes between the exogenous shock to the
economy and the response of the government to enact stabilization policies.
2. Outside lag. This is the time it takes for the policy to take effect in the
economy.

Monetary policy has much shorter inside lag than fiscal policy, at least in the U.S. and
Europe, because the government needs to first pass the policy decision through the
legislature, and go through the political process, whereas the central bank can decide
to change the interest rate/money supply overnight.
However, monetary policy does have an outside lag of about half a year, because it
takes time for firms to respond to the interest rate change by writing new contracts
and setting up new projects.
There are however certain policies, called automatic stabilizers, that dont require an
explicit policy change by the government, but stimulate or depress the economy

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automatically in case of a shock. For example, the income tax system automatically
reduces taxes in a depression because incomes go down.

The Difficult Job of Economic Forecasting


Because of the time lags associated with stabilization policies, it is required to forecast
the economy in order to respond to shocks in time. However, economic forecasting is
incredibly difficult, so one argument against stabilization policy is that the government
should not even try to do it, because it will only do more harm than good.

Ignorance, Expectations, and the Lucas Critique


The economist Robert Lucas formulated what came to be known as the Lucas
critique. The critique is that the models developed in this book make the wrong
predictions about the effects of stabilization policy because they do not take into
account the change in expectations that are the result of these policies. If a policy
tries to stabilize a shock, but people see this policy coming, their expectations will
change such as to reduce the effect of the policy. Some economists conclude from
this critique that policy evaluation is too hard to really make stabilization policy
effective.

The Historical Record


Apart from theoretical arguments about the effectiveness of stabilization policy,
economists have also looked at the effectiveness of specific stabilization policies in
history. However the historical record is not perfectly clear on this, because it is often
too difficult to determine the cause of a recession.
18.2. Should Policy Be Conducted by Rule or by Discretion?

A second debate topic on stabilization policy is about the question whether policy
should be conducted by rules that are stated beforehand, or whether the policy
should be left to the discretion of policymakers.

There are multiple aspects to this debate which we will go through step by step.

Distrust of Policymakers and the Political Process


One question related to this debate is whether policymakers can be trusted with the
discretion of choosing policies at their will, rather than by rule. There are generally
two arguments why they should not be:

They are incompetent. This argument says that politicians do not have the
competence to assess economic problems and their necessary solutions.
They are opportunistic. This argument says that the objectives of policymakers
are not the same as those of the public. For example some say that it is
the political business cycle that determines stabilization policy rather than the

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economic business cycle. This means that politicians choose to stimulate the
economy just before the elections in order to increase their chance of re-
election

The Time Inconsistency of Discretionary Policy


Discretionary policy is more flexible than rule-based policy, but this does mean that it
is subject to the problem of time inconsistency, which goes as follows: The
policymakers will want to announce in advance what their policy is going to be (for
example when stabilizing inflation, they will want to announce this so that it has the
least effect on output), however, when the public has formed these expectations, they
will have an incentive to enact policies that stimulate output in the short run, simply
because the public did not expect it. This however has a long run negative effect
because it will cause the public not to believe the announcements of the
policymakers, which makes the stabilization policy less effective.
This is an argument why the government should enact policy by rule rather than by
discretion, because a policy by rule is not subject to this time inconsistency.

Rules for Monetary Policy


Even if we agree on the idea that there should be a policy rule rather than policy
discretion, there remains the question of what that policy rule should be. There are
three main proposed policy rules for monetary policy:

The monetarist proposal is that the central bank should keep the money supply
growing at a steady rate. This is based on the hypothesis that changes in the
money supply are the cause of most large economic fluctuations.
Another proposal is GDP targeting, which states that the central bank should
target the nominal level of GDP, a target that changes over time to take
account of long-run growth.
A third proposal is inflation targeting, which means that the central bank
announces a target for the level of inflation (usually around 2%), and adjusts
the money supply and interest rate to achieve this target.

All three of these policy rules target nominal variables. This is because it is hard to
measure the true real variable of something and hard to measure for example the
natural rate of unemployment, even though real variables are more indicative of
actual economic performance.

There are two further institutional observations to be made about the practice of
monetary policy.

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In practice, even if central banks use a policy rule, there is also some room for
discretion
There is a relation between central bank independence, the lack of influence
that politicians have over the central bank, and low levels of inflation. This has
caused many economists to propose that central banks should be independent
institutions.

18.3. Conclusion: Making Policy in an Uncertain World

The main conclusion that can be drawn from this chapter is that our knowledge of
what the most effective policies are is still very incomplete. There is not yet a clear
answer to the debates in this chapter.

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19. Government Debt and Budget Deficits


The main theories about government debt are the traditional view, which is
consistent with the models introduced in this book, and the Ricardian view, which
critics this view and reaches a different conclusion. Debt is still a controversial
subject in economics.

This chapter introduces a subject of macroeconomics that has been neglected by our
models: Debt. The models in this book contain the option for the government to run a
fiscal deficit, but do not address the effect this has on the level of sovereign debt. This
issue is addressed in this chapter. First the context and measurement of government
debt is addressed. Then the two most important theories of government debt are
explained, and finally we address some alternative perspectives on debt.

19.1. The Size of the Government Debt

The government debt increases in periods where the government is running a deficit,
and decreases when it is running a surplus.

We begin with the context of government debt, focusing primarily on the U.S. The
government debt is usually expressed as a percentage of GDP. Besides this being
more indicative than the absolute level, this also allows easy comparisons between
countries. Countries have a variety of debt-to-GDP ratios ranging from Switzerland
with 0.4 % to Greece with 133.1 %.
There are two main events that usually cause a significant increase in the level of
government debt:

Wars: They cost a lot of money and the short run consideration of winning the
war usually trumps the long run consideration of keeping debt low.
Economic crises: Taxes decrease as GDP decreases, and government
expenditures sometimes increase as part of stabilization policy, causing a fiscal
deficit and an increase in debt.

The U.S. and Europe also face the future problem of an aging population because this
means more retired workers and therefore a smaller labour force to be used in
production and it means a higher level of social security expenditures. This may cause
a big increase in the level of government debt.
19.2. Problems in Measurement

There are a number of problems with the measurement of government debt, some of
them more controversial than others.

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Before we move on to the theories of debt, we address four problems in measuring


government debt. This is because some economists think that the way government
debt is currently measured does not reflect the extent to which burdens are shifted to
the future or the effect of the debt on the economy.

1. Inflation. This is not a very controversial measurement problem, and it entails


that the nominal level of government debt should be adjusted each year by
inflation to find the real level of debt. This means that if the real level of
government debt is stable, the nominal level should be rising by the rate of
inflation: D = D.
2. Capital Assets. The government does not just expend money for current use,
but it also expends money to purchase capital goods/assets. Therefore some
economists propose that the government uses capital budgeting, a procedure
that takes into account these assets as well. This means that if the government
purchases a capital good, this will be subtracted from the net level of debt
3. Uncounted Liabilities. Some economists argue that the level of debt is
misleading the way it is currently measured because it does not take into
account certain liabilities. For example the pensions of government workers
will have to be paid to them in the future, and therefore are just like debt, but
they are not counted as such.
4. The Business Cycle. Due to automatic stabilizers addressed in chapter 18, the
budget deficit automatically rises during recessions and decreases during
booms. This is not an unrealistic representation of the deficit, because this
deficit cycle actually occurs, but it nevertheless does not represent policy
changes in the budget deficit. Therefore some economists propose to calculate
a cyclically adjusted budget deficit that is based on estimates of what
government spending and tax revenue would be if the level of output would be
at its natural level.

Few economists deny the existence of these four measurement problems, but not
everyone agrees on how severe the problems are.
19.3. The Traditional View of Government Debt

The traditional view of government debt can be deduced from the models
introduced in this book.

Imagine the effect of a decrease in taxes (keeping G constant). The short run and long
run effects of this can be deduced from the theories in this book.

In the short run, a reduced tax level increases consumer spending, thereby
stimulating aggregate demand and employment. However the lower level of

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saving causes an increase in the interest rate, thereby decreasing investment,


and a capital inflow, thereby appreciating the currency and depressing net
exports. The effect on debt is that it will rise
In the long run, the level of saving declines, thereby decreasing the capital
stock, decreasing output and decreasing consumption (since economies are
generally below the golden rule level of capital). The economy would have
larger foreign debt.

19.4. The Ricardian View of Government Debt

The traditional view of debt is criticized by the Ricardian view.

The economist David Ricardo came up with a hypothesis that came to be known
as Ricardian equivalence. It states that consumers are forward-looking and therefore
base their spending not just on current disposable income but also on expected future
disposable income. The consumer reasons that the reduction in todays taxes must be
paid by an increase in future taxes, so that the consumers future income decreases.
The rational forward looking consumer would not respond to the tax cut by increasing
spending, but by increasing saving. This means that net saving is unaffected in both
the short and long run, and that the effects described by the traditional view are not
realized, in short because the traditional view assumes that consumers base their
consumption decision on current income. Note that Ricardian equivalence is a similar
argument to some of those made in chapter 16 about consumer theory.

Consumers and Future Taxes


Defenders of the traditional view argue that consumers are in fact not as forward
looking as the hypothesis of Ricardian equivalence assumes. Here are three
arguments why they are not:

Myopia. This basically means that people are short-sighted and do not fully
understand the effects of a decrease in taxes, so that they do not realize that
they will have to pay the taxes in the future.
Borrowing Constraints. This argument means that consumers cannot always
borrow to smooth their consumption, so that there may be consumers who
would like to spend more, but can only do so after the tax cut. This would
mean that the tax cut still has an effect on consumption.
Future Generations. A third argument is that consumers expect the future taxes
to be paid by future generations rather than by themselves. If we assume that
people are selfish, they will care less about future generations than about
themselves. On the other hand the counter argument to this is that people do
care about future generations, as evidenced by the fact that parents leave
bequests.

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The debate about the validity of the Ricardian view versus the traditional view is
ongoing. At this point there is evidence to support both theories.
19.5. Other Perspectives on Government Debt

With the two theories in mind, we address some debates about government debt.

Balanced Budgets Versus Optimal Fiscal Policy


On the one hand, we would like to run a balanced budget and not have any
government debt, but on the other hand there are three reasons why we would want
to have deficits and surpluses:

Stabilization. The argument for stabilization is clear from chapters 10 to 14.


Tax smoothing. Besides stabilizing output, budget deficits and surpluses can also
be used to smooth taxes so that people dont have large fluctuations in their
disposable income due to the business cycle
Intergenerational Redistribution. A budget deficit causes a shift in the tax burden
from current to future generations. For example, if the current generation
fights a war. It is only fair that future generations share some of the burden of
that war.

Fiscal Effects on Monetary Policy


some economists argue that if the government has a large public debt, the monetary
authority may try to decrease it by stimulating inflation, thereby decreasing the real
public debt. However in practice this does not happen in developed countries,
because central banks are relatively independent, and the fiscal authority knows that
inflation is not a very good solution to fiscal problems.

Debt and the Political Process


some economists think that the possibility of public debt worsens the political
process. They argue that debt is a way to move the negative effects of their policies
to future politicians, so that a true cost-benefit analysis is not done. This has caused
some economists to argue for a constitutional balanced-budget clause, so that
politicians are forced to bear both the costs and benefits of their policies. Others
oppose this because it makes stabilization harder, or because it is impractical.

International Dimensions
the budget deficit and the level of government debt does not just affect the domestic
economy, but also the relation of the economy to foreign economies. The budget
deficit is namely also related to the trade deficit, which has to effects:

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High levels of government debt may have the risk of capital flight. This
happens if there is a fear that the government will default on its debt, causing
international investors to take their capital out of the country.
High levels of debt paid by foreign borrowing may have a negative effect on
the political power of a country in world politics.

19.6. Conclusion

The question of the best policy towards government debt is a complex one that has
many considerations and uncertainties related to it. This is why there are still many
disagreements among economists on what the best policies are.

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20. The Financial System: Opportunities


and Dangers
The financial system is on the one hand a source for economic efficiency, but on the
other hand a possible source for economic instability.

This book has so far neglected to give a complete analysis of the role of the financial
system and instead has focused primarily on the real economy. It has been introduced
in the theories as the market of loanable funds and the money market. For a more
complete study of the financial system you should consult a textbook on that topic,
but here is a brief introduction to the role of the financial system in the macro
economy. We first address the function of the financial system in the economy, and
then we address the macroeconomic ramifications of a crisis in the financial system.

20.1. What Does the Financial System Do?

The financial system has a number of key functions in the economy.

The financial system is a broad term that refers to all the institutions and mechanisms
that channel the loanable funds of savers to the borrowers that need them to invest.

Financing Investment
there is a large variety of mechanisms used to channel funds from savers to
borrowers, and this is one of the most important functions of the financial system.

Financial markets are markets through which savers can directly provide
resources to investment.
o One financial market is the market for bonds, a representation of a loan
given to a firm by the bondholder. The process of raising funds for
investment by firms through the bond market is called debt finance.
o Another financial market is the market for stocks, shares in the
ownership of a firm. The process of raising funds for investment through
stocks is called equity finance.
Financial intermediaries are firms that take loans or equity from savers and
invest them in profitable firms that need finance. They allow savers to invest
without them having to study the investments themselves.

Sharing Risk
Another important function of the financial system is to share risk between individuals
in an efficient way. Some people are more risk averse than others. That is they have a

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stronger aversion to taking financial risks. One way to allocate risk among strongly
risk averse and less risk averse individuals is by letting the risk averse individuals hold
bonds, and letting the more risk-tolerant individuals hold equity. This is because the
income gained from equity is much more volatile.
Another way that the financial system does is reduce risk. It does so by giving
investors the option of diversification, the process of buying equity or bonds in many
different firms, so that the risk of one firm failing is spread out over a larger part of
individuals; on average, the firms will do well, and individuals bear less of the risk. One
way to diversify is a mutual fund, a financial intermediary that finances itself with
equities (stocks), and invests the funds into a large set of firms. This allows even small
savers to own a small part of a very large variety of firms.
However, diversification cannot completely remove risk, because there are two types
of risk:

Systemic risk. These are risks that affect the income of all firms. For example, an
economic recession hurts all firms, not just a specific one. This risk cannot be
removed by diversification.
Idiosyncratic risk. This is risk that is specific to one firm, such as the risk of the
CEO dying in a plane crash. This risk can be removed with diversification.

Dealing with Asymmetric Information


one problem in finance is the problem of asymmetric information, the situation where
one parties in an economic transaction has more information than the other. There
are two main problems that asymmetric information can cause:

Adverse selection. An example of this is that if the owner of a firm wants to


raise finance, he usually knows more about the firm than the investor. The
owner will only accept the financing deal if he thinks it is beneficial to him.
Therefore the investor will be weary of the owner accepting the deal, since
that means the owner is likely getting the better part of the deal. The result is
that investors sometimes do not invest in firms, even if the firm has a profitable
investment opportunity.
Moral hazard. This is the situation when an agent, someone who works for
someone, has more information about his actions than the principal, the person
who the agent works for. In this situation for example, an agent may decide to
spend some of the finance raised on personal consumption rather than
investment.

Fostering Economic Growth


as we saw in the Solow growth model, high saving means high investment, and this
means economic growth. However, the Solow model simplified the analysis by simply
assuming that saving would turn into investment, and that investment would be the

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right type of investment. In fact, unlike in the Solow model, there is more than one
type of capital good; instead there are an uncountable number of possible
investments. One role of the financial system is to look at what the most profitable
investments are and invest in those. Presumably, the financial system does this by
supply and demand which changes different interest rates such that capital moves to
the efficient investments. However the process is not perfect, in part due to the
asymmetric information problems described earlier.
20.2. Financial Crises

Within the AS-AD a financial crisis is one type of exogenous shock.

Chapters 10 to 14 described short run fluctuations by showing the effects of an


exogenous shock. Such an exogenous shock can take many forms. One type of shock
is a financial crisis, a major disruption in the financial system making the process of
moving funds from savers to borrowers less efficient. We first look at how a financial
crisis works, then at possible responses by policymakers, and finally what can be done
to prevent them.

The Anatomy of a Crisis


not all crises are exactly alike, but they all roughly follow the same pattern:

1. Asset-price Booms and Busts. First, there is often a speculative bubble in the
financial markets, an increase in the market price of a financial asset that
doesnt represent its underlying value. At some point investors see that the
market value is too high for the underlying value, so they sell the asset and the
bubble pops.
2. Insolvencies at Financial Institutions. Financial institutions hold such assets on
their balance sheets, so when the bubble pops, they suddenly have fewer
assets than before. Because financial firms often use leverage, borrowing funds
to finance investment (discussed in chapter 4), they may suddenly have more
debt than assets, causing them to go bankrupt.
3. Falling Confidence. Because financial institutions now suddenly are heavily
indebted, investors lose confidence in them and take out their capital. This
forces banks and other institutions to stop lending and sell assets. Because
they are forced to sell these assets, this drives down their price, and they sell
them at lower than value. This is called a fire sale.
4. Credit Crunch. Because many financial institutions fail or heavily hold back on
lending, borrowers find it difficult to obtain investment funds even though they
have profitable investment opportunities, and investment spending is
contracted.

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5. Recession. Due to this credit crunch, the overall demand for goods and services
declines. This can be interpreted simply as an investment demand shock to the
aggregate demand curve in the AS-AD model.
6. Vicious cycle. The decrease in aggregate demand reduces income. Besides
reducing consumption spending through the multiplier effect studied in
chapters 10 to 14, this also reduces profits and asset values, thereby causing a
stock market decline and further insolvencies. Thus we go back to step 1 and 2,
and the cycle starts again.

Policy Responses to a Crisis


There are three broad categories of policy responses

Conventional Monetary and Fiscal Policy. Because one result of a financial crisis
is to shift the investment demand function leftward, a possible response is to
shift the aggregate demand function back to the right by monetary and fiscal
expansions. This is exactly what the U.S. government did after the 2008
recession.
Lender of Last Resort. Because of lost confidence in financial institutions, people
draw their money back, and banks may not have enough reserves to provide
these withdrawals, even though they are solvent. Such a situation is called
a liquidity crisis. In this case the central bank may choose to take the function
of lender of last resort, by lending to solvent banks with liquidity problems, if
there is no one else to lend to them. The central bank can in this way not only
lend to banks but also to shadow banks, financial institutions that serve similar
functions to banks.
Injections of Government Funds. It is also possible for the government to directly
inject funds in failing institutions, for example by buying stocks in those
companies. This can cut down or dampen the process of the financial crisis at
step 2.

Policies to Prevent Crises


Rather than responding to a crisis, it is more desirable to prevent the crisis in the first
place. Here are four current topics of debate on improving regulation to prevent
crises.

Focusing on Shadow Banks. The focus of most regulation of financial firms is on


banks, and less so on other financial institutions, even though some of them
perform similar functions. One proposal is to focus regulation more on these
shadow banks.
Restricting Size. Another proposal is to restrict the size of financial firms. In the
crisis of 2008, certain banks were so big that if they failed, it would cause

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ripple effects that are too large. Such banks were called too big to fail. This
proposal tries to prevent such banks from getting too big, so that the
government can let them fail. A counterargument to this is that it would
prevent banks from taking advantage of economies of scale.
Reducing Excessive Risk Taking. Most financial firms that failed during the 2008
crisis did so because they took excessive risks. Therefore there have been
proposals to prevent banks from taking excessive risks.
Making Regulation Work Better. There have been many proposals, and some of
them executed, to create new regulatory agencies, or to replace old ones, so
that the regulatory process performs in a smoother and more effective way.

20.3. Conclusion

The financial system is a source of economic efficiency and growth, but it can also be
a source of economic instability. It is hard to find a right balance between these two,
and the debate over the structure of the financial system is not over yet.

The financial system is a source of economic efficiency and growth, but it can also be
a source of economic instability. It is hard to find a right balance between these two,
and the debate over the structure of the financial system is not over yet.

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