MacroEconomics;

Chapter 1; A Tour of The World.

1.1; Europe and the Euro.

In 1957, six European countries decided to form a common market. Since
then, 21 other countries have joined this common market, and together they
form the EU-27. When Macroeconomists study an economy, they first look at
three variables;
- Output; The level of production of the economy as a whole – And the rate of
growth.
- The unemployment rate;
- The inflation rate;

1.2; The economic outlook in the USA.

Between 2007 and 2008 the households in the USA got hit by four
economic shocks; the increase of the oil price; a fall in the price of their homes; a
fall of the stock market; and a restriction of credit. Before these economic shocks,
the economy in the USA did very well. There has been a high output growth rate,
a low unemployment rate, and a low inflation rate.

1.3; The largest emerging economies.

The BRIC countries are now the largest economies outside of the group of the
advanced countries. Note that unemployment rates in the BRIC countries are
typically not very informative, simply because people are more likely to stay in
the agricultural sector than getting unemployed. The economy in China is
booming because of the high accumulation of capital, very fast technological
process, the move from a central planning economy to a market economy.
Chapter 2; A Tour of the Book;

2.1; Aggregate Output;

At the end of the Second World War a System of National Accounts was
put together in a number of European countries.
The measure of aggregate output in the system of national accounts is
called the gross domestic product (GDP). There are several definitions of the
GDP;
- GDP is the value of the final goods and services produced in the economy
during a given period; We only count the final goods, not the intermediate
goods.
- GDP is the sum of value added in the economy during a given period. The
term value added means the value of the production of a firm minus the
value of the intermediate goods.
- GDP is the sum of incomes during a given period; It is the sum of, in the
example given in the book, of the labour income and the profit income.
Nominal GDP (€Yt) is the sum of the quantities of final goods produced
times their current price. The real GDP (Yt) is the sum of quantities of final goods
times constant prices. The increase in the price of the goods gets eliminated.
Nominal GDP is also called GDP at current prices. Real GDP is also called GDP in
terms of goods, GDP at constant prices, or GDP adjusted for inflation.
If a country has twice the real GDP of an other country, in economic terms,
the GDP of anther country is economically twice as big as the other country.
Equally important is the real GDP per capita, the ratio of real GDP to the
population of the country. It gives the average standard of living of the country.
Economists focus on the growth of the GDP. If the growth rate of the GDP is
positive, we face an expansion. If it is negative, we face a recession.

Additional remark; Hedonic pricing is used to estimate changes in the price of

complex and fast changing goods.

2.2; Other Major Macroeconomic Variables;

Employment is the number of people who have a job; unemployment is

the number of people who do not have a job but are looking for one. The labour
force is the sum of employment and unemployment. The unemployment rate is
the number of unemployed people, divided by the number of people in the
labour force.
It is quite hard to determine how many people are unemployed. They do
not have a job, and they need to be looking for one. Only the people that are
registered at unemployment offices are seen as unemployed. This is not a very
good indication, because some people do not see the need to get registered at an
unemployment office.
Today, most rich countries rely on large surveys of households to
compute the unemployment rate. In Europe, this survey is called the Labour
Force Survey (LFS). This is based on interviews with randomly selected
individuals. They get marked as employed when they have worked for at least
one hour in the week before the interview is taken.
 The people who are not looking for a job are counted as not in the labour
force. When unemployment is high, some unemployed people may give up to
look for a job. They are called discouraged workers. A higher unemployment rate
is usually associated with a lower participation rate, defined as the ratio of the
labour force to the total population of working age.
Economists care about the unemployment rate for to reasons. The first
one is because of the effect of the direct welfare of the unemployed people.
Another reason is that it may indicate that the economy may not be using its
resources efficiently. If the unemployment rate is too low, the economy may be
using too much of its resources, and soon will face shortages.
Inflation is a sustained rise in the general level of prices – the price level.
The inflation rate is the rate at which the price level increases. Symmetrically,
deflation is a sustained decline in the price level. It corresponds to a negative
inflation rate. Economists usually use two price indexes to measure the price
level; the GDP deflator, which is defined as the ratio of nominal GDP to real GDP
(Nominal GDP is equal to the GDP deflator times real GDP), and the consumer
price index, which is increase or decrease of the price consumers need to pay for
the goods. Consumers are interested in this, because some goods are not for the
consumer market, and some goods are produced domestically. The average price
of consumption is the same as the cost of living. In Europe, the price index, which
is most frequently used, is the harmonised index of consumer prices, or HCIP. It
gives comparable measures of inflation in different subsets of European
countries.
Both the GDP deflator and the consumer price index are index numbers.
They are both set equal to 100 at a certain moment. The variance is between now
and the moment chosen earlier.
The HCIP and the GDP deflator move together most of the time. In most
years, the two differ by less than 0.5%. Nevertheless, there are clear exceptions
to the first conclusion. This difference arises when the prices of the domestic
goods rise or decrease with a big difference.
Economists care about inflation because there is no such thing as pure
inflation (i.e.; the wage rises with the same percentage as the inflation rate). Not
all prices and wages rises proportionally during periods of inflation.

2.3; Output, Unemployment and the Inflation Rate; Okun’s Law and the Phillips
Curve.

The relation between output and unemployment rates has first been
discovered by economists Arthur Okan, and for this reason it is called Okan’s
Law. It concludes that there is a tight relation between the two variables; higher
output leads to a decrease in unemployment.
In Figure 2.5 the horizontal axis crosses the point where output growth is
equal to 3%. This means that we should have a growth of 3% to keep the
unemployment rate at the same level. The reason for this is that the labour force
increases over time, and because of the fact the employed workers get a higher
productivity.
Pihillips discovered that if unemployment is too low, the economy will
overheat, and this will lead to a much higher unemployment rate. This is
graphically illustrated in the Phillips curve. The Phillips curve suggest that there
is a relationship between the change in inflation and the unemployment rate. It
can be graphically illustrated at which point of unemployment the economy is in
a balance.

2.4; The Short Run, The Medium Run and The Long Run.

There are several factors that determine the level of aggregate output in
an economy. One of them is the demand (determined by the consumer
confidence) for goods. If this increases, people are going to buy more, and so the
aggregated output increases. Another factor is the supply side. When people
demand something, but it cannot be produced, then nothing is sold. The level of
capital, technology and the size and the skills of the labour force determine the
countries level of output, and thus, supply. Another factor is the ability of a
country to innovate and introduce new technologies. Which one is the right one
to choose, depends on the time frame;
- The short run; in the sort run, say 2-3 years, the demand affects the
aggregated output.
- The medium run; in the medium run, say a decade, supply is the leading
factor.
- The long run; this is a period of a few decades or more, factors like education
system, the saving rate and the role of government are the leading factors.
Chapter 3; The Goods Market.

3.1; The Composition of GDP.

The decomposition of GDP consists of the following elements;

- Consumption (C); These are the goods and services purchased by consumers.
Consumption is by far the largest component of the GDP.
- Investment (I), sometimes called fixed investment to distinguish it from
inventory investment. Investment is the sum of non residential investment,
the purchase by firms of new plans, and residential investments, which is
done by consumers buying houses.
- Government Spending (G); This represents the purchases of services and
goods by the national, regional and local government. G does not include
government transfers, like unemployment benefits and pensions.
- The imports (IM) need to be subtracted because these are goods and
services that get bought from the rest of the world.
- We must add the exports (E), because they get bought from the foreigners.
o The difference between both export and import is called the net
exports or the trade balance. If export exceed imports, the country
faces a trade surplus. In case of imports exceeding exports, the
country faces a trade deficit.
o If you want to determine production in a certain year, you also need
to determine the inventory investment. This is basically the difference
between number of goods sols, and number of goods produced. To
determine the total production, you need to add the investment
inventory to the production. To determine the sales, you subtract the
inventory investment from the sales.

3.2; The Demand for Goods.

The total demand for goods is written as Z. The equation

Z ≡C + I + G+ E−ℑ is an identity. To think about the determinants of Z, we need
to add some simplifications; All firms produce the same good; Firms are willing
to supply any amount of the good at a given price P; The economy is closed, so
there will be no import and export.
Consumptions depends on many factors, but the most important one is
the disposable income (Yd), which is the income after the receiving’s of transfers
from the government and tax-payments. The function (C ( Yd ) is called the
consumption function. The consumption function is a behavioural function,
because it describes the behaviour of the person. If his income goes up, he will
consume more.
To describe consumption in a better way, we can see it as a linear relation.
The relation between consumption and disposable income is then characterised
by two parameters; C=c 0+c 1Yd
¿ this case , c 1, is called the propensity to consume. It is also called the marginal
propensity to consume. It describes the effect of one extra dollar income, to its
consumption. The parameter, c 0, describes what people would spend if their
disposable income would be equal to zero. If their disposable income, people will
dissave or borrow money. People can have variable reasons why they should
change the parameter c 0.
Disposable income is given by the income minus the taxes. In a
mathematical form, we can set up the following equation; Yd=( Y −T ) .This will
lead to a change in the original function; C=c 0+c 1(Y −T ).
Models have two types of variables; Some variables depend on other
variables in the model, and therefore explained within the model. Variables like
these are called endogenous. Other variables are not explained in the model, but
they are taken as given. Variables like these are called exogenous. Investment is a
variable that is described in this way. The equation looks as following; I = Í .
The variable government spending describes fiscal policy. We will also
imply government spending as an exogenous factor for two reasons;
Governments do not behave in the same way as people or firms do;
Macroeconomists will think about what happens if a certain factor changes; They
want to see what the effects of a certain fiscal policy are.

3.3; The Determination of Equilibrium Output.

There is an equilibrium in a market when the inventory investment is

exactly what firms want it to be, so production ,Y, is equal to the demand for
goods, Z. In this case there is an equilibrium in the goods market; Y =Z; This is
called an equilibrium condition, which is one of the three types of equations
(behavioural equations and identities). TO find the equilibrium, we need to solve
the equation;

Y =c 0+ c 1 ( Y −T ) + I +G

1
Y= [ c 0+ I + G−c 1T ]
1−c 1

The term [ c 0+ I +G−c 1 T ]is that part of the demand that does not depend
on the output. It is called autonomous spending. The autonomous spending is
positive, due to the fact that the investments and c 0 are always positive. The
only case, in which the autonomous spending could be negative, is when the
taxes are way bigger than the expenses of the government. Although, this still
needs to be a very extreme case.
It is possible to explain graphically where the equilibrium of the market
is. When the equilibrium gets shocked, this can also be explained graphically. We
will face a continuous round of, i.e., increase in demand, increase in production,
increase in income, increase in demand etc. We can set up an equation for this
round, which is called a geometric series.
Following the equation, we should assume that the adjustments take
place at the same time. In real life, this is actually not possible. There will not be
an immediate reaction of a company that faces a little increase in demand.
Writing down the equations for what economists call the dynamics of adjustment
is quite hard to do. That is why it is explained in words; Firms decide about the
level of production each quarter. They determine a production level at the
beginning level of the quarter, and it cannot be adjusted during the quarter. Now,
lets assume that consumers demand more during the quarter. Production cannot
be changed, so income will also stay the same. The following quarter, the firm
will adjusts its production, which leads to more income, and this will lead to
more demand and so on.
Decreases will lead to decreases in output. It works the same way as in
the increasing example.

3.4; Investment Equals Saving; An Alternative Way of Thinking About the Goods-
Market Equilibrium.

Thus far, we have looked at the equilibrium of production and demand.

Another way of looking at this is focusing on investment and savings. The first
one to describe this was economist Keynes.
Savings can be described as the savings of the consumers and the
government; S=Y −T −C.
The way of setting investments equal to the savings is called the IS
Relation, which stands for investment equals savings. It does not matter if you
choose for setting the production equal to the demand, or if you choose for
setting the savings equal to the investments. The equation will always be the
same;
1
Y= [ c 0+ I + G−c 1T ]
1−c 1

Overall it can be stated that savings in the short run could lead to a
recession, but will lead to a strong economy in the medium and the long run.

3.5; Is The Government Omnipotent? A Warning.

When we take a look at the equation, we could say that the government
itself could determine the demand. They just need to increase the government
spending’s, and keep the taxes at the same level. Many aspects of reality,
however, have not been incorporated in the model;
- Changing government spending or taxes is not easy.
- We have assumed that investment remained constant; Also imports will
fluctuate. This makes it hard for a government to predict the outcome of
their consumption response.
- Anticipations are likely to matter. It depends on the consumers how they will
see the actions of the government, and they will act to these actions.
- Achieving a given level of output can have negative side-effects.
- Cutting taxes and spending more can lead to high budget deficits and the
accumulation of the public debts.
Chapter 4; Financial Markets;

4.1; The Demand for Money.

Those are the economic terms for income, money and wealth;
- Income; Income is what you earn from work plus what you receive in income
and dividends. It is a flow; It is described over a given time period.
- Saving; This is the part of your income that you do not spend.
- Wealth; This is all your financial assets minus your liabilities. This is a stock
variable; It is determined at a given moment of time.
- Money; Financial assets that can be used immediately to buy goods.
- Investment; This is a term economists reserve for the purchase of new
capital goods.
Money will not pay you a certain amount of interest. In the real world
there are two types of money; currency, which are the coins and the bills, and the
deposit accounts, which are the bank deposits on which you can write cheques.
The sum of the currency and the deposits is called M1. Bonds pay a positive
interest rate, but they cannot be used for transactions. It will depend on several
factors that determine the proportion of money and bonds;
- The number of transactions made; You do not want to call your broker every
time you need to buy something, so you will save a certain amount in money.
- The interest rate on bonds; If the interest rate is higher, you might put more
money into bonds, and will keep less money on your hand.
Although not much people will hold bonds by themselves, everyone has
some bonds indirectly if they have a money market account with a financial
institution. Money market funds pool together the funds of many people, which
are then used to buy bonds.
The amount of money people want to hold is given by Md. To total
demand for money can be described by Md = €YL(i). €Y stands for national
income, and L(i) stands for the interest rate. In this equations, two assumptions
are made; The demand for money increases in proportion to the increase in
national income; The interest rate and the demand for money depend negatively
on each other.

4.2; Determining the Interest Rate; Part 1.

The deposit account are supplied by the bank, and the currencies are
supplied by the central bank. The equilibrium condition, in a market without
deposit accounts, which will be discussed later, is M = €YL(i). The equation tells
us that the interest rate must be such that, given their income, they want to hold
and amount of money equal to the money supply. This is called the LM relation,
in which the letter L stands for liquidity.
An increase in nominal income leads to an increase in transactions, which
will lead to more demand for money, and sufficiently will lead to a higher interest
rate. An increase in the supply of money leads to a decrease of the interest rate.
The central banks can increase or decrease the amount of money. If they
want to increase the level of money, it buys bonds, and pays for them by creating
money. If it wants to decrease the amount of money, they sell bonds, and take the
money received out of the circulation. These actions are called open market
operations, because they take place in the open market for bonds. If the central
bank increases the amount of money, it is called an expansionary open market
operation. If they decrease the amount of money in the market, the operation is
called a contractionary open market operation.
We can determine the interest rate of a bond if we know its price. If the
price of a bond is €90, and it will promise a payment of €100 after one year, than
its interest rate is (100-90)/(90) = 11.1%. In the same way, we can determine
the price of a bond, if we know its interest rate, by the equation; 100/(1+i).
After reading the first two sections we can conclude that;
- The interest rate is determined by the equality of the supply of money and
the demand of money.
- By changing the supply of money, the central bank can affect the interest
rate.
- The central bank changes the supply of money through open market
operations, which are purchases or sales of bonds for money.
- Open market operations in which the central bank increases the money
supply by buying bonds lead to an increase in the price of bonds, and a
decrease in the interest rate of bonds.
- Open market operations in which the central bank decreases the money
supply by selling bonds lead to a decrease in the price of bonds, and an
increase in the interest rate of bonds.
The central banks can thus determine the interest rates by increasing or
decreasing the supply of money.

4.3; Determining the Interest Rate; Part 2.

Modern economies are characterized by the existence of many types of

financial intermediaries – institutions which receive funds from people and
firms, and use these funds to buy financial assets or to make loans to other
people and firms. Their assets are the financial assets they own, and the loans
they owe to people and firms. Their liabilities are the money they owe to the
people and firms in the form of funds.
Banks receive funds from people and firms who either deposit funds
directly or have funds sent to their deposit accounts. At any point of time people
can withdraw the money from these accounts. Banks keep as reserves some of
the funds they receive. The banks do this for three reasons;
- The amount that gets withdrawn, and the amount that gets deposited may
not be the same, so the banks must keep some cash at hand.
- In the same way, people write cheques to people at other banks, and the
same way around. These amounts may not be the same.
- In Europe, there are special reserve requirements applied to banks in the
European area. In particular, the reserve ratio is equal to 1% on sight and
overnight deposits, on term deposits up to two years and on debt securities
with short maturity up to two years.
- Loans represent roughly 70% of banks non reserve assets. Bonds account for
the other 30%. We assume that the banks do not make loans, but that they
hold only reserves and bonds as assets.
The demand for money people is determined by the proportion of the
amount that people hold in currencies, and the amount that they hold in
deposits. The demand for currencies is given by Cud = cMd. The demand for
deposit account money is given by Dd = (1-c)Md. Both summed up give the total
demand for money.
The larger the amount of deposit accounts, the larger the amount of
reserves the bank must hold, both for precautionary reasons. Let Θ be the
reserve ratio, let R denote the reserves of banks, and let D denote the amount of
deposit accounts; This gives us the following equation; R = ΘD. The demand of
reserves of banks, combined with the other equations is thus given by;
Rd = Θ(1-c)M^d.
Call Hd the demand for central bank money. This is equal to the demand
for currency plus the demand for reserves; Hd = CUd + Rd. When we replace both
CUd and Rd, we get the following equation;

H d =c M d +θ ( 1−c ) M d=[ c+θ ( 1−c ) ] M d

When we replace the overall demand for money, we get our final equation;

H d =¿

The demand for central bank money will be less than the overall demand for
money, despite when people only hols currency or deposit accounts (c=1 or c=0).

4.4; Two Alternative Ways of Looking at the Equilibrium.

The interbank market and the overnight interest rate;

Instead of thinking for demand and supply for reserves, we can think for
demand and supply for reserves. The reserves are equal to the supply of central
bank money minus the demand for currency of the people. The central bank can
influence the interbank market, and thus the interest rate, in different ways.
The supply of money; the demand for money and the money multiplier;
We can think about the equilibrium in terms of the overall supply and the
overall demand for money. T get the right equation to do this, we need to start
with the initial equilibrium condition and divide both sides by [c + θ(1-c)].

1
H=€ YL ( i )
[ c+ θ (1−c ) ]
If we compare this equation with the market without banks, we can
conclude that the total supply is equal to the central bank money multiplied by a
constant term. Also notice, because the denominator is less than one, its inverse
is bigger than one. For this reason, the constant term is called the money
multiplier. The overall supply for money is thus equal to the central bank money
multiplied by the money multiplier.
Because the supply of money depends highly on the central bank money,
the central bank money is sometimes called high-powered money, or the
monetary base.
Chapter 5; Goods and Financial Markets: The IS-LM Model.

5.1; The Goods Market and the IS Relation.

Earlier in chapter 3 we considered investments to be constant. Invest

although, is far from constant, and depends primarily on two factors;
- The level of sales; If sales increase, the firm needs to buy extra machines or
build an extra plant.
- The interest rate; If the interest rate is too high, the firm would not buy the
machine, because the extra profit is used to pay the interest.
- If we sum this up, we get a new equation for investment; I =I ( Y , i )
If we take this into account into the original equilibrium equation, we gat
the following equation;
Y =C ( Y −T ) + I ( Y ,i ) +G
According to Figure 5.1 we can conclude that for a given level of interest
rate, demand is an increasing function of output, for two reasons;
- An increase in output leads to an increase in income and thus to an increase
in disposable income. The increase in disposable income leads to an increase
in consumption.
- An increase in output also leads to an increase in investment
- Both factors summed up lead to an increase in the demand for goods. The
correlation between output and demand is given by the upward sloping
function ZZ represented in Figure 5.1. The function ZZ has several
characteristics;
o The consumption and investment relationship are not linear, so ZZ is
rather a curve than a line.
o We have drawn ZZ so that it is flatter than the 45° line. We assume
that an increase in output leads to a less than one-for-one increase in
demand.
o The equilibrium in the goods market is reached at the point where the
demand for goods is equal to the output. The equilibrium level is
given by Y.
If the interest rate increases, in contrast to the situation in Figure 5.1, the
investments will decrease, and this will lead to a lower demand. The decrease in
investment leads to a decrease in output, which leads to a further decreases
consumption and investment, through the multiplier effect. The relationship
between the interest rate and output is represented by the downward sloping
curve in Figure 5.2(b). This is called the IS-Curve.
In Figure 5.2(b), both the government spending and taxes are taken as
given. Changes in these factors will cause the IS-Curve to shift. We can conclude
the following;
- Equilibrium in the goods market implies that an increase in the interest rate
leads to a decrease in output. This relationship is represented by the
downward sloping IS-Curve.
- Changes in factors that decrease the demand for goods, given the interest
rate, shift the IS-Curve to the left. Changes in factors that increase the
demand for goods cause the IS-Curve to shift to the right.
5.2; Financial Markets and the LM Relation.

It would be more convenient to rewrite the original function for money as

a relationship between real money, real income and the interest rate. Nominal
income divided by the price levels equals real income. The new equation in this
M
case will be: =YL ( i )
P
In this case, we face the real money supply (money stock in terms of
goods, not euros), and the real money demand. Real money sounds a little bit
confusing, but you can see it as the worth of goods. The equation stated above, is
also know as the LM Relation. The graph of this equation is given in Figure 5.4. As
we can see, an increase in income leads to an increase of the interest rate. When
income increases, money demand increases, while the money supply is given. In
this case, the interest rate needs to go up, so the decrease in the demand of
money because of the higher interest rate, will cancel out the increase in the
demand for money because of higher income. The relationship between output
and the interest rate is represented by the upward-sloping curve in Figure
5.4(b), called the LM curve.
Changes in either the nominal money stock, M, or changes in the price
levels, will cause the LM curve to shift. If the nominal money supply increases,
and the price level stays at the same level, the LM curve will shift downward. If
the supply for money decreases, the LM curve will shift upward;
- Equilibrium in financial markets implies that, for a given real money supply,
an increase in the level of income, which increases the demand for money,
leads to an increase in the interest rate. This relationship is represented by
the upward sloping LM curve.
- An increase in the money supply shifts the LM curve down: a decrease in the
money supply shifts the LM curve up.
Although we say that the money supply is a given amount, this is not what
normal central banks do. They may increase the money supply if the income
increases. If they increase the amount the same as the increase in income, the LM
curve will be flat. Normally, this is not what banks do. They increase the money
supply in this case, but not in the same amount as the increase in income. This
will lead to a flatter LM curve. The central banks follow the given interest rate
rule.

5.3; Putting the IS and the LM Relations Together.

The IS and the LM relationships determine both the input and the interest
rate. In Figure 5.7 both curves are put together in one graph. Any point on the IS
curve represents an equilibrium in the goods market. Any point on the LM curve
represents an equilibrium in the financial markets. Only at the point where both
curves intersect, both equilibrium conditions are satisfied.
Suppose the government decides to reduce the budget deficit and does so
by increasing taxes while keeping government spending unchanged. Such a
change in fiscal policy is often called a fiscal contraction or a fiscal consolidation.
An increase in the financial deficit is called a fiscal expansion. What are the
effects of this fiscal contraction on output, on its composition and on the interest
rate?
- Ask how the change affects equilibrium in the goods market, and how it
affects equilibrium in the financial markets; An increase in taxes will shift the
IS curve to the left. To the LM curve, nothing will happen due to the increase
in taxes. Taxes are not in the original function so nothing will happen.
- Characterise the effects of these shifts on the intersection of the IS and the
LM curve. What does this do to the equilibrium output and the interest rate?;
As we can see in Figure 5.8(c) the original equilibrium moves along the LM
curve to a new point, which causes Y to get decreased. The equilibrium does
not shift!
- Describe the effects in words; Due to the increase in taxes, which decrease
the disposable income, causes the people to decrease consumption. This
decrease in the demand leads to a decrease in output and income. The
decrease in income also decreases the demand for money, which decreases
the interest rate. The reduce of the interest rate reduces, but does not
completely offset the effect of higher taxes on the demand for goods.
In this case, we cannot tell what happens to the investments. Due to the
lower sales the investments would decreases, but due to the lower interest rates,
the investments would increase, so we cannot say anything unless we know the
exact figures.
An increase in the money supply is called monetary expansion. A decrease
in money supply is called money contraction or money tightening. Lets take the
case of money expansion, while the price level in the short run, is fixed. The
increase in the nominal money supply this leads to a one-for-one increase in real
money. In this case, the change in M does not affect the IS curve. The increase in
money supply will shift the LM curve downward. At any given level of income, an
increase in money supply leads to a decrease in the interest rate. In this case the
equilibrium moves along the IS curve, and the output Y increases, and the
interest rate, i, decreases. Shortly said; The increase in money leads to a lower
interest rate. The lower interest rate leads to an increase in investment and, in
turn, to an increase in demand and output.
Income in this case becomes higher, and the taxes are unchanged. The
disposable income goes up, and so does consumption. Because sales are higher,
and the interest rate is lower, also investment will go up.

5.4; Using a Policy Mix.

In fact, both the fiscal policy and the monetary policy are used together.
The combination is know as the monetary-fiscal policy mix, or simply, the policy
mix. Sometimes, both are used in the same direction. This has been the case after
the recession that faced the US and the EU in 2008. Sometimes, the mix is used in
the opposite direction. One that used it in this way was Bill Clinton. He wanted to
use fiscal contraction to reduce the budget deficit, but the did not want to harm
the economy, so he used monetary expansion. This lead to a steady decrease of
the budget deficit.

5.5; IS-LM and The Liquidity Trap.

Earlier in chapter 4 we assume that the central bank could affect the
interest rate unlimitedly. Although, there are some restrictions to this; The
central bank cannot lower the interest rate below zero. In the case the interest
rate becomes zero, the people are indifferent in holding bonds or keeping the
money in cash. We can see in Figure 5.8 that the demand for money increases if
the interest rate decreases, because the people want to hold more in cash. If the
interest rate becomes zero people are willing to hold at least the distance OB in
cash, or even more, because they became indifferent between cash and bonds.
Lets assume we have the case where the money supply is equal to the
point B in Figure 5.10. If the central bank increases the money supply, by buying
bond and creating money for this, the interest rate does not decrease below zero.
The people are willing to hold more money in cash. When the interest rate is
zero, monetary expansion becomes powerless. The increase in money falls into a
liquidity trap; People are willing to hold more money at the same interest rate.
It is possible to explain this graphically, as done in Figure 5.11;
- M d shows us the demand for money at a given level of income Y. The
combination of Y, and the interest rate gives us the first point on the LM
curve.
'
- M d shows the demand for money at a lower level of income. Lower income
means less transaction, and thus a lower demand for money and interest
rate.
''
- M d shows the demand for money at an even lower level of income. This will
lead to an interest level equal to zero.
If we increase the supply for money more, the interest level will remain at
zero. As we can see in Figure 5.12 the monetary expansion, the output Y will not
increase. When the interest rate is equal to zero, the economy will fall into a
liquidity trap. The central bank can increase the money supply, but this money
will fall into a trap.

5.6; How Does the IS-LM Model Fit in the Facts?

So far we ignored dynamics. Introducing the dynamics formally would be

difficult. Although, we can describe some basic dynamics;
- Consumers are likely to take some time to adjust their consumption
following a change in disposable income.
- Firms are likely to take some time to adjust investment spending following a
change in their sales.
- Firms are likely to take some time to adjust investment spending following a
change in the interest rate.
- Firms are likely to take some time to adjust production following a change in
their sales.
Basically, the signal is that it takes some time to adjust the behaviour after
fiscal or monetary changes. How much time can only be determined by old data
and econometrics. The outcome of such an econometrics study has been shown
in Figure 5.13. As we can see in this figure, the price level is only stable in the
short run. It is less stable in the medium run. Comparing the USA and the euro
area, we can conclude the USA reacts more rapidly to price changes. The two
important lessons of Figure 5.13 are;
- It gives us a sense of dynamic adjustment of output and other variables to
monetary policy.
- It proves the IS-LM model is not the right model. The IS-LM model looks like
a solid basis on which to build when looking at movements in activity in the
short run.
Medium Run;

Chapter 8; The Labour Market;

8.1: A tour of the Labour Market;

When you subtract the people under working age, and above the
retirement age, from the total population, you get the population in working age.
The labour force are the ones working or looking for work. The rest of the
population in working age is out of the labour force. The participation rate is the
ratio between the labour force and the population in working age. The
unemployment rate is the ratio of unemployed to the labour force. The
unemployment rate in the Euro zone is around 9.7%, but this is mainly because
of the high unemployment rate in Spain (24%).
An unemployment rate may reflect two kinds of situations; The active
labour market with many separations, new hires and so with many workers
entering and exiting new jobs, or it may reflect a sclerotic market with few
separations, few hires and a stagnant unemployment pool. The data of the
unemployment rate in more depth comes available through the Labour Force
Survey, which is presented every quarter.
In Figure 8.5 we can see that there are 6 million separations in this
economy. 1.5 million of them are leavers, which leave their jobs for better
alternatives. 2 million of them are layoffs; This means there is continuous jobs
destruction and construction among different firms. Some people are
discouraged workers; They are classified as out of the labour force, because they
are not looking for a job, but they would take one, if someone offered their a job.
That is why economists are more likely to focus on the non-employment rate;
The ratio of working age population, minus unemployment, to population, rather
than the unemployment rate.
The average proportion of unemployed leaving unemployment each
month is a very useful piece of information, as it allows computing the average
duration of unemployment, which is the average length people spend
unemployed. The average duration of unemployment equals the inverse of the
proportion of unemployed leaving unemployment each month. The average
duration of unemployment is an important implication. In a country where the
average duration is high, unemployment can be described as a stagnant pool of
workers waiting indefinitely for jobs. In a country where the average rate is low,
it a for the unemployed more likely to be a quick transaction.
From Figure 8.6 we can see some striking features;
- The big difference between the average duration between the USA and
Europe. The average duration in the USA is lower than in Europe.
- The divergent trends in Europe. Northern countries are quite similar to the
USA, while the Central and Southern countries have a much higher duration
of unemployment.
The average duration is also useful to think in another way about the
unemployment rate. The flows of workers becoming unemployed each month
multiplied by the average time they stayed unemployed. The same
unemployment rate can have different meanings. There may be much people
getting unemployed for a short time, or less people getting unemployed, but for a
longer time.

8.2; Wage determination.

Wages are set in different ways; Sometimes they are set by collective
bargaining, that is, bargaining between firms and unions. This plays an important
role in Europe. The higher the skills needed to do the job, the less likely there is
going to be bargaining. Although there is bargaining, there are still some rules to
determine the wage. Two facts stand out;
- Workers are typically paid a wage that exceeds their reservation wage, the
wage that would make them indifferent between working and being
unemployed. Workers in this case are more likely to be employed than to be
unemployed.
- Wages typically depend on labour market conditions. The lower the
unemployment rate, the higher the wage.
How much bargaining power a worker has depends on two factors. The
first is how costly it would be for the firm to replace him or her, were he or she
should leave the firm. The second one is how hard it is for him or her to find
another job. This has two implications;
- The level of bargaining power depends on the nature of the job. A worker at
McDonalds has a low level of bargaining power because it is easily to replace
this worker. A worker at a firm, which knows in much detail how the firm
operates, has more bargaining power.
- When there is a low unemployment rate it is easy for the worker to find
another job, and less easy for the company to find a replacement. This gives
the worker a high level of bargaining power.
Despite of the level of bargaining power, the firms may want to pay more
than the reservation wage. They want their workers to be productive, which can
be achieved by paying a higher wage. Paying a wage above the reservation rate
makes it more attractive for workers to stay. It decreases turnover and increases
productivity. Besides, employers want their workers to feel good about their
work. Feeling good promotes good work, which leads to higher productivity.
Economists call the theories which link the productivity or the efficiency of
workers to the wage they are paid efficiency wage theories. Efficiency wages
suggest, like the bargaining theory, that wages depend on both the nature of the
job and on labour market conditions.
- In a firm where the employees morale and commitment is essential to the
quality of their work, will pay more than at firms where the activities are
more routine.
- Higher employments leads to lower wages and lower unemployment rates
lead to higher wages because the firms, in the second case, want their people
to stay at the firm.
To determine the wage we use the following equation; where Pe stands
for the actual price level, u for the unemployment rate, and z for all other
variables that may affect the outcome of wage setting; W =Pe F (u , z )
The price level affects the wage because the firms and the employers care
about the real wages, not the nominal wages;
- Workers care about how much they can buy with their wage. They do not
care about the nominal wage, but about the real wage.
- Firms think in this case in the same way as the workers.
If the price level is expected to double in the eyes of the workers, and in
the eyes of the firms, the firms are willing to ay the double wage, which keeps the
real wages constant. The wage is normally set for one year. This means that
when the price level changes during this year the real wage can change.
The unemployment rate also affects the wage. The wage and the
unemployment rate have a negative relationship.
Other variables that affect the wage are given by the variable z. One of
these variables is the unemployment insurance. When it exists, it allows
unemployed workers to hold out for higher wages. The variable z has a positive
relationship with the wage.
The replacement rate, which is computed as the fraction of the last wage,
which the social security administration provides to a person that is no longer,
employed varies between countries and within each country. Another aspect that
is likely to affect the wage is the duration of the unemployment insurance. When
this is an insurance for a long time, the wage will be affected positively.
Another factor that affects wages is the employment protection. The
higher the legal protection for firms, the more firms need to pay to lay off a
worker. The higher the employment protection, the better the level bargaining
for workers, which leads to a higher wage. The level of unemployment protection
is higher in Europe than in the USA.
The minimum wage, which is set by the law of the country, also affects the
wage. The effects of this for unskilled workers are good, because they receive the
minimum wage, but some economists say that it leads to a high youth
unemployment rate. Normally, an increase in the minimum wage will not only
higher the minimum wage, but also the wages slightly above the minimum wage.
Besides everything, economists also state that high levels of
unemployment insurance, employment protection and high minimum wages
affect the level of unemployment in a negative way.

8.3; Price Determination;

The prices set by firms depend on the costs they face. The costs depend, in turn,
in the nature of the production function and on the prices of the inputs. For now,
we will assume that the firms only factor of production is labour. This leads to
the equation Y = AN. In this equation, Y is output, N is employment, and A is
labour productivity. The way of writing the equation implies that the labour
productivity is constant.
It should be clear that this is an oversimplification, because firms also use other
factors like machines and plants. Besides, there is technological improvement
which leads to a non-constant productivity for labour.
If there is perfect competition in the market, the prices of the goods are equal to
the marginal costs; P would be equal to W. But many markets are not competitive
which leads to prices higher than the marginal costs. Firms set their prices
according to; P = (1+ μ)W; In this case μ is the mark-up of the price over the costs.

8.4; The Natural Rate of Unemployment.

 The relation between the expected real wage and the rate of
unemployment, the real wage setting, is illustrated in Figure 8.10, by the
downward sloping curve. According to equation 8.6 we can see that the price
setting decisions determine the real wage paid by firms. An increase in the mark-
ups, leads to an increase in the prices, given the wage they have to pay. The
price-setting relationship is illustrated by the PS curve in Figure 8.10. The real
wage does not depend on the unemployment rate, since the nominal wage is
determined.
The equilibrium unemployment rate is called the natural rate of
unemployment. The terminology has become standard, so we will adapt it, but
this is actually a bad choice of words. The natural rate of unemployment is
anything but natural. Consider two examples;
- An increase in unemployment benefits; An increase in unemployment
benefits can be represented by an increase in z. It will lead to a shift in the
WS curve upwards. This will lead to an increase in the natural rate of
unemployment.
- A less stringent enforcement of existing anti-trust legislation; To the extent
that this allows firms to collude more easily and increase their market
power, it will lead to an increase in their mark-up. This will lead to a shift of
the PS curve, downwards, which will lead to an increase in the natural rate of
unemployment.
Associated with the natural rate of unemployment is the natural rate of
employment, the level of employment that prevails when unemployment is equal
to the natural rate. The relation between unemployment, U, employment, N, and
U L−N N
the labour force, L, can be denoted by; u= = =1−
L L L
Rearranging to get employment in terms of the labour force and the
unemployment rate gives; N = L(1-u).
Employment, N, is equal to the labour force, L, multiplied by 1 minus the
unemployment rate, u. So, if the natural rate of unemployment is un , and the
labour force is equal to L, the natural level of employment, N n, is given by
N n=L( 1−un ).
Finally, associated with the natural level of employment is the natural level of
output, the level of production when employment is equal to the natural level of
employment. The natural level of output is given by Y n= A N n=AL ( 1−u n ).
Y 1
(
Combining it with the other equations, we get; F 1− n , z =
AL ) 1+ μ
.
The steps we have taken in this section are;
- The expected real wage targeted by wage setters is a decreasing function of
the unemployment rate.
- The effective real wage firms are willing to pay is constant as the mark-up is
constant, as implied by the price setting equation.
- Equilibrium in the labour market requires that the expected real wage in
wage setting be equal to the effective real wage. This determines the
equilibrium unemployment rate.
- This equilibrium unemployment rate is known as the natural rate of
unemployment.
- Associated with the natural rate of unemployment is a natural level of
employment and a natural level of output.

8.5; Where We Go From Here;

The key answer to this question is simple;

- We have derived the natural rate of unemployment as the rate at which the
expected real wage by wage setters equals the effective real wage firms are
willing to pay.
- The price level, still, can differ. This means that workers that expect to
receive an effective wage, still can have a difference to what is real in the
long run. This will make the workers to decline some jobs, because they
deserve more than they actually get.
- Because expectations are wrong, in the medium run, the unemployment
tends to return to the natural rate, and output tends to return to the natural
level.
Chapter 9; Putting all markets together; The AS-AD Model.

9.1; Aggregate Supply;

The aggregate supply relation captures the effects of output on the price
level. When we combine the relation of wage setting and price level, we can
derive the natural rate of unemployment. Combining both equations we get;
P=P e (1+ μ) F (u , z). In this case we eliminated the nominal wage. The second
step is to replace the unemployment rate u with its expression in terms of
U L−N N Y
output. We will then get the following equation; u= = =1− =1− ; In
L L L AL
words this means that for a given labour force, and a given productivity, the
higher the output, the lower the unemployment rate. When we replace u for (1-
(Y/AL)) in the first equation we get the aggregate supply relation;
Y
(
P=P e ( 1+ μ ) F 1−
AL )
,z .
The AS relation has two important properties;
- Given the expected price level, an increase in output leads to an increase in
the price level. This is the result of four steps;
o An increase in output leads to an increase in employment;
o This leads to a decrease in unemployment and therefore to a decrease
in the unemployment rate;
o The lower unemployment rate leads to an increase in the nominal
wage;
o The increase in the nominal wage leads to an increase in the prices
set by firms and therefore to an increase in the price level.
- The second property is that, given unemployment, an increase in the
expected price level leads to an increase in the actual price level.
o If wage setters expect the price level to be higher, they set a higher
nominal wage.
o The increase in nominal wage leads to an increase in costs, which
leads to an increase in the prices set by firms and a higher price level.
The AS curve has three properties;
- The aggregate supply curve is upward sloping. Put another way, an increase
in output Y leads to an increase in the price level P.
- The aggregate supply curve goes through the point A, where Y=Y n and P=P e
- An increase in the expected price level shifts the aggregate supply curve up.
Conversely, a decrease in the expected price level will shift it down.

9.2; Aggregate Demand;

The aggregate demand relation captures the effect of the price level on
output. It is derived from the equilibrium conditions in the goods and the
financial markets. We thus use the IS and the LM relationships we described in
chapter 8. Using the IS and the LM curves we can derive the relation between the
price level and the level of output implied by equilibrium in the goods and
financial markets;
- Figure 9.3 (A) shows the IS and the LM curve. As we can see, the increase in
price level leads to a decrease in real money stock (M/P). This monetary
contraction leads to an increase in the interest rate, which leads in turn to a
lower demand for goods and lower output.
- The negative relation between output and the price level is drawn as the
downward sloping AD curve. An increase in the price level leads to a
decrease in output. This is called the aggregate demand relation.
- Any other variable than the price shifts also the AD curve.

9.3; Equilibrium in the Short Run and in the Medium Run.

The two relations are given by the following equations;

Y
e
- The AS Relation; P=P ( 1+ μ ) F 1−( AL )
,z
M
- The AD Relation; Y =Y ( ,G , T )
P
For given values of the expected price level, and given values for the
monetary and fiscal policy, both relationships determine the equilibrium values
of output Y and the price level P.
The short run equilibrium us captures in Figure 9.5;
- The aggregate supply curve AS is drawn for a given value of the expected
price level. It is upward sloping; the higher the level of output, the higher the
price level.
- The aggregate demand curve is drawn for given values of M, G and T. It is
downward sloping; the higher the price level, the lower the level of output.
When the AS and the AD curve intersect, the goods market, the financial
market and the labour market are all in equilibrium.
In the original situation, in the short run, in Figure 9.5, we can see that the
output exceeds the natural output. The price level is higher than the expected
price level. Due to this the wage setters will increase their expectations and set
the wages higher. Due to this the AS curve will shift upward. This will continue
until the output equals the natural output. At that point the adjustments will
come to an end. At this point output remains at the natural level.

9.4; The Effects of Monetary Expansion.

If the money supply goes up, the output will also increase, which leads to
a shift of the AD Curve to the right. This will then lead to a shift of the AS curve
along the AD curve, which will lead to the natural level of output. As we can see,
when the money supply increases, also the price level increases.
Due to the monetary expansion the LM curve will shift down. This leads to
a lower interest rate, and a higher output level. Following, the price level will go
up, which will lead to an upward shift of the LM curve. In the long run, the LM
curve will keep shifting upward until the output level is equal to the natural level
of output. The increase in nominal money is exactly offset by a proportional
increase in the price level. The real money stock is therefore unchanged. With
real money stock is unchanged, output is back to tis initial value, which is the
natural level of output, and the interest rate is also back to its initial value.
 In the short run, a monetary expansion leads to an increase in output, a
decrease in the interest rate and an increase in the price level. Over time, the
price level increases, and the effects of the monetary policy and on the interest
rate disappear. The neutrality of money in the medium run does not mean that
monetary policy cannot or should not be used to affect output. An expansionary
monetary policy can, for example, help the economy move out of a recession and
return more quickly to the natural level of output. But it is a warning that
monetary policy cannot sustain higher output forever.

9.5; A Decrease in the Budget Deficit;

Lets face an economy where the government has a budget deficit, and
decides to decrease this by decrease the government spending. This will shift the
AD curve to the left. In this case, the output and the price level decrease. This will
lead to a downward shift of the AS curve along the AD curve. The output level
and the interest rate in this case are lower than before.
If the government reduces the budget deficit, the IS curve will shift to the
left. In response to this, the output decreases, and thus the price level. This leads
to an increase in real money stock, leading to a little downward shift of the LM
curve. As long as the output remains below the natural level of output, the price
level continues to decline, leading to a further increase in the real money stock.
This will lead to a further shift of the LM curve downwards. This will lead to a
lower interest rate.
In the medium run, a reduction in the budget deficit unambiguously leads
to a decrease in the interest rate and an increase in investment.
The effects of fiscal policy are thus the following;
- In the short run, a budget deficit reduction leads to a decrease in output and
may lead to a decrease in investment.
- In the medium run, output returns to the natural level of output, and the
interest rate is lower. In the medium run, a deficit reduction leads
unambiguously to an increase in investment.

9.6; An Increase in the Price of Oil.

So far, we looked at the effects of variables that shift the aggregate

demand curve; an increase in the money supply and a reduction in the budget
deficit. Now that we have formalised the supply side, we can look at the effects of
variables that shift the aggregate supply curve. One of these variables is the price
of oil. This is very fluctuating and the first time it increased heavily was during
1973-1975 and from 1979-1981 when the formation of the OPEC (the
Organisation of Petroleum Exporting Countries), a cartel of oil producers, due to
disruptions sharply increased the price of oil.
In real terms, the oil price increased less in Europe than in the USA. Each
of the two increases of the 1970s was associated with a sharp recession and a
large increase in inflation – a combination macroeconomists call stagflation.
Lets look at what the oil price does with the unemployment rate. Due to
an increase in the mark up, due to the rise of the oil price the price setting curve
shifts downward, which leads to a lower real wage. This also increases the
natural unemployment rate. The rise in the rate of unemployment leads to an
decrease in the rate of employment and thus a decrease in output. An increase in
the price of oil leads to a decrease in the natural level of output.
The increase in the price of oil had the same effect as an increase of the
mark-up; It leads to an increase in prices at every level of output, which leads to
an upward shift of the supply curve. Due to the fact that there are events that
shift the aggregate demand curve to the left (oil producers spend more than oil
buyers) or to the right (cancelling of investment plans by firms). For now, we
assume that the effects cancel each other out. Under this assumption, only the AS
curve shifts in the short run. The price level increases and the output level
decreases.

9.7; Conclusions;

Table 9.1 gives a summary of the effects of several changes in the short run and
in the medium run. This chapter has given a general way of thinking about
output fluctuation (also called business cycles) – movements in output around its
trend;
You can think of the economy constant affected by shocks. Each shock has
dynamic effects on output and its components. These effects are called the
propagation mechanism of the shock. They show us how different shocks can
have different effects in the short run and in the medium run.
Chapter 10; The Philips Curve, The natural Rate of Unemployment and
Inflation;

10.1; Inflation, Expected Inflation and Unemployment;

In the aggregate supply relation, we face the variable F. For this variable
F, we can recall an equation; F ( u , z )=1−αu+ z .The Greek letter captures the
strength of the effect of the unemployment rate on the wage. When we place this
into the aggregate supply relation we get the following equation;
P=P e ( 1+ μ )( 1−αu+ z ) . Finally we have an equation for the inflation which is
denoted by; π=π e + ( μ+ z )−αu . We can conclude several things due to this
equation;
- When the expected inflation rate goes up, than the inflation rate will go up.
This can be related with the fact that the price rises, when the expected price
goes up.
- An increase in the mark-up, or an increase in the factors that affect wage
determination, will lead to a higher inflation.
- An increase in the actual unemployment rate will lead to a decrease of the
inflation.
- An increase of the parameter stated by α, will lead to a decrease in inflation.
Finally, we decide to write the inflation equation in terms of periods,
which will lead to; π t =π et + ( μ+ z )−α ut .

10.2; The Philips Curve;

Lets face a situation when the average inflation will be equal to zero. The
wage setters will expect the inflation to be equal to zero on average in the future.
When we fill this in in the equation given in 10.1 we can see that this gives us the
negative relation between unemployment and inflation that Philips found in the
UK. Lower unemployment leads to a higher price level this year relative to last
year’s price level – to higher inflation. This mechanism had been called the
wage–price spiral; this can be explained;
- Low unemployment leads to higher wages;
- A higher nominal wage leads to higher prices.
- Workers are going to ask for more wages, because of the higher prices.
- This will lead to an increase in the prices determined by firms.
- This race will go on, and result in a steady wage and price inflation.
This had been captured in the Philips curve from 1960 till 1970, but after
1970, the Philips curve vanished. This has several reasons:
- During the 1970’s the US faced several increases in the price of oil. This will
mean that the price level goes up, while the wages stay the same.
- Wage setters changed their way of forming expectations; From the 1960 the
inflation became positive year after year. It became persistent that high
inflation in one year, would lead to a high inflation rate in the next year. This
means that expecting zero inflation is systematically wrong.
 Setting the inflation form one year equal to the expected inflation leads to
the following equation; π et =θ π t .The parameter θ captures the effect of last years
inflation rate. The higher the inflation last year, the higher the parameter. From
1970 onward we faced an increase in the parameter. This means the simple
relation between unemployment and the inflation rate fades away. When we
take the parameter into account, and set it equal to 1, we get;
π t −π (t−1 )=( μ+ z )−α u t .From this equation we can make a new Philips curve,
which is often called the modified Philips curve, or the expected-augmented
Philips curve, or the accelerations Philips curve.
The original Philips curve implied that there was no such thing as natural
level of unemployment rate. If policy makers tolerated a high inflation, there
would be a low unemployment rate. By definition, the natural rate of
unemployment is the unemployment rate such that the actual price is equal to
the expected price level. Equivalently, the inflation rate is equal to the expected
inflation rate. This means that;

0=( μ+ z )−α u n

When we solve this for the natural rate of unemployment, we face;

μ+ z
un =
α

This means that the final equation becomes;

π t −π t−1=−α (ut −un )

The equation gives us another way of thinking about the Philips curve.
The change in the inflation rate depends on the difference between the actual
and the natural rate of unemployment. Besides that it gives us another way of
thinking about the natural rate of unemployment. The natural rate od
unemployment is the unemployment rate required to keep the inflation constant.
This is why the natural rate is also called the non-accelerating inflation rate of
unemployment (NAIRU).
If unemployment returns to the natural rate it follows that output must
return to the natural level. This means the former AD relation becomes;
M
Y n=Y ( P )
,G , T .If the natural level of output is constant, the right side of the
equation must be constant. This means that also the real money stock needs to
remain constant. This implies in turn that the rate of inflation must be equal to
the growth rate of money; π=g m

10.3; The Philips Curve and the Natural Rate of Unemployment in Europe.

One often heard statement is that one of the main problems in Europe is
its labour market rigidities. These rigidities, the argument goes, are responsible
for its high rate of natural unemployment. The critics have particularly in mind;
- A generous system of unemployment insurance; The replacement rate is
high in Europe and the benefits sustain for a long period. This means that
unemployed people are less eager to go out and look for a job, and that the
wages need to be paid by firms need to be higher.
- A high degree of employment protection; The purpose of employments
protections is to decrease layoffs. This makes it harder for the unemployed
to find jobs. The flows in and out of unemployment decrease, but the average
duration increase.
- Minimum wages; High minimum wages lead to less employment for the less
skilled workers, and this increases their unemployment rate.
- Bargaining rules; In some sectors there are extension agreements which is a
contract agreed to by firms and unions. This reduces the scope of
competition for non-unionised firms. Stronger bargaining power leads to
higher unemployment, which will lead to lower wages.
All these forms of protection give more bargaining power to the workers
which will lead to higher wages, and thus to a higher unemployment rate. Social
protection in Europe is higher than in the USA.
- Still, we can see that the unemployment is not always high in Europe. Since
the 1970s, although it has been increasing, but in some countries, the
unemployment rate is low. These increasing patterns can be explained by
several hypotheses;
o Institutions were different then and the labour market rigidities have
increased in the past 40 years. Despite this is not the case. Even in the
1960 when the social protection was higher in Europe than in the
USA, the unemployment rate was lower.
- Another fact is that, until the current crisis started, many European countries
had low rates of natural unemployment.
o During the last decade, some European countries with high
unemployment rates introduced major labour market reforms with
the aim of increasing employment. This has been done by reducing
bargaining power and the degree of social protection for the new
workers. This created two groups of workers; the standard
permanent workers, which still have the same rights, and the newly
hired workers that face short-term contracts. Despite, the
unemployment rate among the young people is still very high, which
shows us that reinforcement does not always lead to an improvement
of the labour market conditions.
- We can conclude that generous social protection is consistent with low
unemployment, but it has to be provided efficiently. Unemployment benefits
can be generous, as long as the unemployed are forced to take jobs if these
are available.
Another factor that could describe the high level of unemployment in
European countries is the way of price setting of the firms. The mark-up depends
on the level of competition. When there is much competition, the firms will lower
the mark-up so they do not lose market share. Besides, the mark-up also depends
on the regulations in the market. The higher the degree of regulation, the less
foreign goods can be imported, which leads to less competition and thus to a
higher mark-up. Higher competition means that firms face a more elastic
demand function. This will lead to a lower mark-up, and thus to an increase in
the real wages, and this will lead to a decrease in unemployment. Therefore,
lower product market regulation should be associated with higher wages, and
thus a lower unemployment rate.
In Europe the completion of the internal market has increased the level of
competition and real wages. Wages increased all over Europe due to a higher
level of competition.
There are good reasons to believe that the mark-up and the catchall
variable, z, vary over time. Still, it is hard to measure the natural rate of
unemployment because we face the actual rate of unemployment. Despite, it still
is possible by comparing average unemployment rates over several decades. We
can see that the natural rate of unemployment has increased in Europe after
1970. In the USA, it is quite different from the pattern in Europe. Here, the
unemployment rate has increased from 1950 to 1980, but it decreased from
1980 to 2007. The inflation was roughly constant, which means the
unemployment rate was close to natural.
In 1979 the unemployment in the US was 5.8%, but the inflation was
around 13%, which was partly because of the high oil prices, but this kept out of
account, it still was close to 10%. The Federal Reserve asked themselves how fast
they should reduce it. Volcker was appointed as chairman of the Federal Reserve
Bureau, and he needed to lead the fight against inflation. Fighting against
inflation meant tightening monetary policy, decreasing output growth and thus
accepting higher unemployment rates for some time. If we take equation 8.10 as
a starting point, we can see that the only way to reduce the inflation is by
accepting a higher natural level of unemployment, about 10% to reduce the
inflation to 4%. This meant that it should be vary costly to reduce the inflation.
Other economists stated that it could be less costly to reduce the inflation.
This is called the Lucas critique. He pointed out that when we try to predict the
effects of a major policy change, it could be very misleading to look at given
relations form the past data. He stated that wage setters could immediately take
the lower inflation into account when they were setting the wages, which should
lead to a constant rate of the natural rate of unemployment.
Still Lucas believed that unemployment should rise a little bit in case of
disinflation. Thomas Sargent looked at high inflations in the past an said that the
increase in unemployment could be small. It would depend on the credibility of
the monetary policy. If the credibility was high than the wage setters would
immediately take this into account for their expectations.
It turned out that Lucas and Sargent were not right. The decrease of the
inflation lead to a lower output, and an increasing unemployment rate. We can
state that there has not been a credibility miracle. Despite, the relation stated by
Lucas, between unemployment and inflation, by looking at the wage setters, still
stands.
The relation between unemployment and inflation is likely to change with
the level and the persistence of inflation. When the inflation rate becomes high,
inflation also tends to become more variable. Wage setters will take this into
account, and because of this wage agreements change with the level of inflation.
Wage indexation, a provision that automatically increases wages in line with
inflation, becomes more prevalent. These changes lead in turn to a stronger
response of inflation to unemployment. Lets face an economy with two type of
labour contracts; One group of the contracts is indexed, and a group of contracts
that is not indexed, which means the move with the expected inflation. Under
e
this assumption, we get; π t =[ λ π t + ( 1− λ ) μ t ]−α ( u t−u n ). This equation can be
−α
rearranged, which leads to the following; π t −π t−1= (u −u ).
( 1−λ ) t n
As we can see from the last equation, wage indexation increases the effect
of unemployment on inflation. The higher the proportion of indexed contracts,
the larger the effect unemployment rate has on the change in inflation. This can
be defined by; without indexation, lower unemployment leads to an increase of
the wages. Wages do not response on the price, so there is no further increase of
the price during the year. Under wage indexation, the prices will rises
continuously, so that the effect of unemployment on inflation within the year is
higher. When the most contracts are under wage indexation, a little change in the
unemployment rate can have huge effects on the inflation.
During the Great Depression the unemployment rate was very high. We
would expect a low inflation rate, or even a high negative inflation rate. Despite,
from 1934 to 1937 the inflation turned positive, while there still was a very high
unemployment rate.
One reason that can be given is that the Great Depression was not only
associated with an increase in the unemployment rate, but also an increase in the
natural rate of unemployment. This is from the economist’s views very unlikely.
Because of a shift in the aggregate demand curve, the unemployment rate
increased and not the natural rate of unemployment.
Another explanation is that when an economy starts to deflate, the Philips
curve relation breaks down. One possible explanation is the reluctance of
workers to accept a lower nominal wage. If this assumption is correct, the Philips
relation may disappear when the economy is close to zero inflation.
Chapter 11; Inflation, Money Growth and the Real Rate of Interest;

11.1; Output, Unemployment and Inflation;

When we take the assumptions of chapter 8 into account (employment

moves with the growth rate, which means unemployment moves with the
growth rate) we get the following equation; ut −ut −1=−g yt . When we need to
express this in words we can say that the change in the unemployment rate
needs to be equal to the negative growth rate of output.
Lets contrast this equation with Okun’s Law, given by the equation;
ut −ut −1=−0 , 4 ( g yt −3 % ) . When we compare this with the other equation we can
conclude something;
- Annual output growth rate has to be equal to 3% to prevent unemployment
from rising. In the first case we neglected the growth of the labour force and
the growth of the productivity of employment. When we take those into
account we can see that we need to have an actual growth rate of the output
of 3% per year to prevent the unemployment rate from rising. This growth
rate is also called the normal growth rate.
- A growth rate of 1% above the normal growth rate leads only to a 0.4%
decline in the unemployment rate. This is because of two reasons;
o Firms adjust employment less than one for one in response to
deviations of output growth from normal. Firms hoard labour in
worse times, for when the times get better. This is called labour
hoarding.
o When the times get better the labour force participation increase.
Some of the jobs will go to the people that have been out of the labour
force.
o When we write the equations with symbols rather than numbers we
get; ut −ut −1=−β ( g yt −ǵ y ).
e
The Philips Curve is given by; π t =π t −α ( ut −un ) . Because we assume the
expected inflation is equal to last years inflation, we can replace π et by π t−1.
In chapter 9 we derived the aggregate demand relation as a relation
between the level of output and the real money stock, government spending and
taxes based on equilibrium in both the financial and the goods market;
Mt
Y t =Y ( , G t , T t ). For the simplicity, we make two assumptions;
Pt
- To focus on the relation between the real money stock and output, we ignore
Mt
the other factors which gives us the equation; Y t =Y( ) Pt
.

- Second, we will assume a linear relationship between real money balances

Mt
( )
and output; Y t =γ
Pt
.Where the Greek letter is a positive parameter.

- Still, keep in mind that behind this relation, lies the IS_LM Model:
o An increase in the real money stock decreases the interest rate;
o The decrease in interest rate leads to an increase in the demand for
goods, and therefore to an increase in output.
From all these equations we can derive an equation that describes the
relationship between the growth rate of output, the growth rate of money and
the inflation rate; g yt =g mt−π t
If the nominal money growth exceeds the inflation, real money growth is
positive, and so is output growth. In other words, given inflation, expansionary
monetary policy leads to high output growth, and contractionary monetary
policy leads to a decrease in the growth rate.

11.2; Nominal versus Real Interest Rates;

There is a distinction between nominal interest rates and real interest

rates;
- Interest rates expressed in terms of units of the national currency are called
nominal interest rates. An example of these interest rates is the interest rates
on bonds of the government.
- Interest rates expressed in terms of a basket of goods are called real interest
rates.
o We go from the nominal interest rate to the real interest rate by
taking inflation into account.
o As we can see in Figure 11.2, the real interest rate is given by;
Pt
1+r t =( 1+i t ) e .
P t−1
o The exact relation between the real interest rate, the nominal interest
1+i t
rate and the expected inflation is given by; ( 1+r t )= .
1+π et+ 1
o Still, when the inflation is small, lets say less than 20% a year, the
relation is simply given by; r t =i t−π te+1. This equation has some
assumptions as we can see;
 When expected inflation equals 0, the nominal rate is equal to
the real interest rate.
 Because expected inflation is normally positive, the real
interest rate is typically lower than the nominal interest rate.
 For a given nominal interest rate, the higher the expected rate
of inflation, the lower the real interest rate.
Lets assume that the nominal interest rate is equal to the inflation rate.
The real interest rate will then be 0, for the borrower, but also for the lender.
 The real interest rate is based in the expected inflation rate. When the
expected inflation rate differs from the actual inflation rate, we will have a
different real interest rate. That is why we say that the interest rate is based on
ex-ante information.

11.3; Nominal and Real Interest Rates and the IS-LM-Model;

When we are talking about the IS-LM model, which interest do we need to
take into account: The nominal interest rate of the real interest rate;
- Take the IS relation first; Firms take into account the real interest rate
because they care about the amount of goods, not in terms of money. The IS
relation therefore is based on the real interest rate, which is denoted by r.
The IS relation then becomes; Y =C ( Y −T ) + I ( Y , r )+ G.
- Now turn to the LM relation; The demand for money depends on the nominal
interest rate. This is because the money hold in currency pay a nominal
interest rate of 0%, while the bonds pay a certain amount of interest rate.
M
This means that the LM relation is still given by; =YL(i).
P
- We can conclude that the effects of monetary policy on output depend on
how movements in the nominal interest rate affect the real interest rate.

11.4; The Effects of Money Growth;

Assume that the central bank maintains a constant growth rate of nominal
money. What will happen with the values of output growth, unemployment and
inflation in the medium run?
- The unemployment rate goes back to its natural level, which means, by the
Okun Law, that output must grow at its natural rate.
- The aggregate demand relation implies that also the inflation will be
constant. In the medium run the inflation must be equal to the nominal
money growth minus the normal output growth. If we define adjusted
nominal money growth as equal to the nominal money growth minus the
normal output growth, in the medium run, inflation equals adjusted nominal
money growth.
- If inflation is constant, then the inflation from this year needs to be equal to
last year’s inflation.
o In the medium run, the output growth is equal to the normal growth
rate. Unemployment is equal to the natural rate. Both are not affected
by the money growth; Nominal money growth only affects inflation.
In the medium run, output returns to the natural level of output. For the
aggregate demand relationship, we can assume that the real interest rate will
return to its natural rate for the real interest. When the output growth is equal to
zero, we can easily see what happens with the nominal rate on interest. The
inflation rate will be equal to the rate of nominal money growth.
In the medium run, the nominal interest rate is equal to the natural real
interest rate plus the rate of money growth. So, an increase in the money growth
leads to an equal increase in the nominal interest rate.
In the medium run, money growth does not affect the real interest rate,
but it affects both inflation and the nominal interest rate. A permanent increase
in the money growth rate of 10% will lead to an increase of inflation with 10%
and to an increase of 10% in the nominal interest rate. The fact that the nominal
interest rate increases with inflation is known as the Fisher effect, or the Fisher
hypothesis.
We are now going to see what happens in the short run. We start by
looking at the three equations;
- Aggregate demand relation; Given the initial rate of inflation, lower nominal
money growth leads to lower real nominal money growth and thus to a
decrease in output growth;
- Okun’s Law; Output growth below normal leads to an increase in
unemployment.
- Philips curve; Unemployment above the natural rate leads to a decrease in
inflation.
Tighter monetary policy leads initially to a lower output growth and
lower inflation. If it is tight enough, it may lead to a negative output growth, and
thus to a recession. Although, we can conclude, that in the short run, monetary
tightening leads to a slowdown in growth and a temporary increase in
unemployment. In the medium run, output growth returns to normal and the
unemployment rate returns to the natural rate. Money growth and inflation are
permanently lower.
We can compute the steps between the short run and the long run;
- As long as the real interest rate is below the natural real interest rate, the
output will be higher than the natural level of output, and unemployment is
below its natural rate;
- From the Philips curve relation, we know that, as long as unemployment is
below its natural rate, the inflation increases.
- As inflation increases, it eventually becomes higher than nominal money
growth, leading to a negative real money growth. When the real money
growth turns negative, the nominal interest rate starts increasing, and given
the expected inflation, so does the real interest rate.
- In the medium run, the real interest rate goes back to its initial value. Output
is then back to the natural level of unemployment, and inflation is no longer
changing. As the real interest rate converges back to its initial value, the
nominal interest rate converges to a new higher value, equal to the real
interest rate, plus the new, higher, rate of nominal money growth.
Economists have tried to finds evidence for the Fisher hypothesis in two ways.
The first one is done by the relation between the nominal interest rate and
inflation across countries. They should hold on average and from studies we can
see that it has substantial support. The other type of evidence is the relation
between the nominal interest rate and the inflation over time in a given country.
Again, it does not imply that the two move together from year to year, but it does
suggest that the long swings in inflation should eventually be reflected in similar
swings in the nominal interest rates. We can conclude some aspects from Figure
11.7;
- The increase in inflation form 1960 to 1980 was associated with an increase
in the nominal interest rate. The decrease in inflation in the mid-1980’s id
associated with the decrease in the nominal interest rate; this supports the
Fisher hypothesis.
- Short run effects can also be seen in the graph; the nominal interest rate
lagged behind by the increase in inflation in the 1970s.
- The other episode of inflation, during and after the Second World War,
underscores the importance of the medium-run qualifier in the Fisher
hypothesis. During that period, inflation was high, but short lived.

11.5; Money Growth, Inflation and Nominal and Real Interest Rates.

There are different aspects whether money growth leads to higher or lower
interest rates, mainly because of the distinction between the nominal interest
rate and the real interest rate, and because of the distinction between the short
run and the medium run;
- Higher money growth leads to lower nominal interest rates in the short run
but to higher nominal interest rates in the medium run.
- Higher money growth leads to lower real interest rates in the short run but
has no effect on real interest rates in the medium run.
We can now combine the LM relationship and the IS relationship with the
relationship between the real and the nominal interest rate. In this case, we get
the following equations;
- IS=Y =C ( Y −T ) + I ( Y , i−π e )+ G
M
- LM = =YL(i).
P
o The IS curve is still downward sloping. For a given expected inflation,
the real and the nominal interest move together. A decrease in the
nominal interest rate leads to an equal decrease in the real interest
rate, leading to an increase in spending and in output.
o The LM curve is upward sloping. Given the money stock, an increase
in output, which leads to an increase in the demand for money,
requires an increase in the nominal interest rate.
An increase in the real money stock will lead to a shift of the LM curve
downwards, which leads to a decrease in the nominal interest rate. The IS curve
does not shift, because the firms and the consumers do not adapt immediately.
This means that the output will increase, but the nominal interest rate, given the
expected inflation rate, will decrease, just like the real interest rate.

11.6; Disinflation;

Lets imagine an economy that is in medium run equilibrium;

unemployment is at the natural rate, output growth is equal to the normal
growth rate. The inflation rate is equal to adjusted money growth. The rate of
nominal money growth and, by implication, the inflation rate, is high, however,
and there is a consensus among policy makers that inflation must be reduced.
The relation of the Philips curve makes it clear that disinflation, the
decrease in inflation, can only be obtained at the cost of higher unemployment.
The unemployment rate needs to exceed the natural rate. The disinflation can
happen in a short time, with high unemployment over a few years, or by a more
slowly disinflation, with a lower unemployment rate of more years. Still the sum
of the unemployment will be the same in both situations.
 First, define a point-year of excess unemployment as the difference
between the actual and the normal rates of 1% point for one year. If the
unemployment rate is 2% higher than the natural rate for four years, the point-
year of excess unemployment is equal to 8.
When the central bank wants to decrease the inflation in one year, the
unemployment rate needs to be 10% higher than the natural rate of
unemployment. When they do it in 2 years, the unemployment rate needs to be 2
years 5% higher than the natural rate of unemployment. In each case, the point-
years of excess unemployment is equal to 10. The central bank cannot change the
point-years of excess unemployment.
We can state this conclusion in another way; define the sacrifice ratio as
the number of point-years of excess unemployment needed to achieve a decrease
in inflation of 1%. The ratio is then equal to 1/a, and independent of policy. This
does not mean that the speed of disinflation is irrelevant. It is determined by the
parameter β we saw earlier in Okun’s Law. The parameter determines how much
the growth rate actually needs to decrease when the unemployment rate goes up
by a certain value, due to the decrease of the inflation.
In what has become known as the Lucas critique, Lucas pointed out that
when trying to predict the effects of a major policy change, it could be very
misleading to look only at the past data. For the Philips curve, Lucas thought that
the wage setter would take the policy changes directly into account, because they
could change their expectations. If the wage setters expected that the expected
inflation would decrease, then also the actual inflation would increase, which
should not affect the unemployment rate, according to the Philips curve. A
recession was thus not necessary.
Lucas and Sargent both did not believe that disinflation could really take
place without some increase in unemployment, but Sargent conclude that the
increase in unemployment could increase only by a little, looking at historical
data. The essential ingredient of successful disinflation, he argued, was
credibility of monetary policy. This is the belief by wage setters that the central
bank was truly committed to reducing inflation.
Stanley Fisher and John Taylor took a different way. Both emphasized the
presence of normal rigidities, meaning that many wages and prices are set in
nominal terms for some time and are typically not readjusted when there is a
change in policy. Fisher said that a policy of disinflation should be announced
sufficiently in advance of its actual implementation to allow wage setters to take
it into account when setting wages. Taylor’s argument went one step further. He
argued that not all the wage contracts are signed at the same time. Instead, they
staggered over time. He showed that this staggering of wage decisions imposed
strong limits on how fast disinflation could proceed without triggering higher
unemployment, even if the central bank’s commitment to inflation was fully
credible. He showed that, under full credibility of monetary policy, there was a
path of disinflation consistent with no increase in unemployment. He showed
that the best policy for the central bank is to proceed slowly at the beginning of
the process while announcing it will proceed faster in the future. This
announcement leads to new wage settlements to take into account the new
policy. Disinflation can proceed much more quickly in this way.
Laurence Ball looked at different events to look at the best approach, and
he got three main conclusions;
- Disinflation typically leads to a period of higher unemployment. Put another
way, even if a decrease in nominal money growth is neutral in the medium
run, unemployment increases for some time before returning to the natural
rate of unemployment.
- Faster disinflations are associated with smaller sacrifice ratios. This
conclusion provides some evidence to support the expectation and
credibility effects emphasized by Lucas and Sargent.
- Sacrifice ratios are smaller in countries that have shorter wage contracts.
This provides some evidence to support Fisher and Taylor’s emphasis on the
structure of wage settlements.

Chapter 14; Saving, Capital Accumulation and Output;

14.1; Interactions between output and capital;

There are two relations between output and capital in the long run;
- The amount of capital determines the amount of output being produced;
- The amount of output determines the amount of saving and, in turn, the
amount of capital being accumulated over time.
We can write the following assumption between capital and capital per
Y K
worker; =F( ,1). Output per worker, Y/N, is an increasing function of capital
N N
per worker, K/N. To simplify the notation, we will rewrite the relation between
Y K
output and capital per worker simply as; =f ( ).
N N
We will make two further assumptions in this chapter;
- The first is that the size of the population, the participation rate and the
unemployment rate are all constant. This means that also employment, N,
remains constant.
o The labour force is equal to the population times the participation
rate.
o Employment is equal to the labour force times one minus the
unemployment rate.
 Under these assumptions, output per worker, output per
person, and output itself, all move proportionally.
- The second assumption is that there is no technological process, so the
production function does not change over time.
Y K
o Under these two assumptions the equation becomes; t =f ( t ). The
N N
variable N does not need a time index because it is assumed to be
constant over time.
To derive the second relation between output and capital accumulation, we
proceed in two steps;
- First, we derive the relation between output and investment. To do this, we
make three assumptions.
o We continue to assume that the economy is closed. I =S+(T −G).
o To focus on private saving, we assume the public savings, (T-G) to be
equal to zero.
o We assume private saving is proportional to income, so S=sY.
o This gives us all the following relation; I t=s Y t .
o Investment is proportional to output; The higher the output, the
higher the saving, and thus investment.
- Then we derive the relation between investment and capital accumulation.
o We assume the evolution of the capital stock is given by;
K t +1=( 1−δ ) K t + I t .
o When we replace the investment with the equation above, and divide
K K Y
the equation by N, we get; t +1 =( 1−δ ) t +s t .
N N N
o This can be rearranged to the following equation;
K t +1 K t Yt Kt
− =s −δ .
N N N N

14.2; The Implications of Alternative Saving Rates;

We start by replacing output per worker by its expression in terms of capital per
worker. This given us;
K t +1 K t Kt K
N
− =sf
N ( ) N
−δ t
N
The change in capital per worker from this year to next year depends on the
difference between two terms;
- Investment per worker, the first term on the right.
- Depreciation per worker, the second term on the right.
Now lets take a look at Figure 14.2. When we look at the curves we can assume
something about the components represented;
- The relation representing output per worker, has the same shape as the
production function except that it is lower by a factor s. Just like the output
per worker, investment per worker increases with capital per worker, but by
less and less as capital per worker increases.
- The relation representing depreciation per worker, is represented by a
straight line. Depreciation per worker increase in proportion to capital per
worker, so the relation is represented by the straight line, with slope δ.
The stage where the output per worker and the capital per worker are no longer
changing is called the steady state of the economy. The steady state value of
capital per worker is such that the amount of saving per worker is sufficient to
cover depreciation of the capital stock per worker.
How does the saving rate affect the growth rate of output per worker?
- The saving rate has no effect on the long run output per worker, which is
equal to zero. The economy will eventually come to a constant level of output
per worker.
- Nonetheless, the saving rate determines the level of output per worker in the
long run. Other things being equal, countries with a higher saving rate will
achieve higher output per worker in the long run.
- An increase in the saving rate will lead to higher growth of output per
worker for some time, but not forever.
Still, the government can affect the saving rate in various ways. First, they can
vary with the public saving, and it can affect the taxes, which affects the private
saving. Eventually, varying the saving rate, has no effect. An increase in the
saving rate, comes with an equal decrease in the consumption. There is a level of
saving rate, between zero and one that maximizes the level of steady state
consumption. Increase in the saving rate below this value lead to a decrease in
consumption initially, but to an increase in the consumption in the long run.
Although, the level of capital associated with the value of the saving rate that
yields the highest level of consumption in steady state is known as the golden
rule of capital